IFR Asia RMB Bonds Roundtable 2018: Part 1
IFR ASIA: Welcome to this annual discussion on RMB bond markets. Ricco, what has changed since we met last year?
RICCO ZHANG, ICMA: There’s a lot to mention over the last year. The first one is the Panda bond guidelines, which were finally released last month. People have been expecting that for at least two, three years, so this is quite encouraging. The guidelines definitely give a lot of clarification on the Panda bond issuance process, as well as the different regulatory requirements for issuers, particularly around which regulator oversees which type of issuer. Except for financial institutions, which now belong to the PBoC, all other issuers will need to file applications to NAFMII, which is easier.
That sends a very positive signal that onshore regulators want to make life easier for foreign participants, even with the background of the trade war and a cooling economy. The regulators want to attract more foreign participation for the onshore market.
That’s linked to the second big change this year. We’re also seeing different financial institutions and rating agencies allowed to own subsidiaries or joint ventures in China. Basically the Chinese authorities have opened the gates. HSBC is a very typical example, with the securities licence in Qianhai allowing them to expand in onshore China. We also expect more participation from the international big three rating agencies. There’s a commitment from the Chinese authorities to open the market to international participants.
I also want to mention Bond Connect. Last year, we were still arguing about whether it would work or not, compared to different access channels. So far, we have seen very positive feedback from the international community, and investors will see that this is quite convenient. Also, on the Bond Connect anniversary in July, the PBoC announced quite a few further reforms, including DVP [delivery versus payment] and tax issues. They’re all resolved already, so I think the route to the onshore market is just much more open than before.
IFR ASIA: Ko-Wei, so what does this mean then for your issuer clients? Has it opened new avenues for them?
KO-WEI HSIUNG, HSBC: Definitely. We work with a lot of international clients that are looking to fund themselves in RMB. Before, there were only selective options for international issuers. The onshore market, which is the third largest bond market in the world, just opens up an entire new avenue for them to look for RMB funding.
The Chinese regulators have also sent a very strong signal for issuers that were looking to tap the onshore market, including clarifications on the process, making the access much easier, linking onshore requirements with the offshore practices, rating reforms, and so on. All those make access to the onshore markets much easier than before, which is very, very welcome to the international issuer base.
IFR ASIA: Paula, what have you seen in terms of how investors access the RMB bond markets now? What’s changed over the last year or so?
PAULA CHAN, MANULIFE: It’s actually quite interesting, as Ko-Wei said. We have heard from European investors, especially pension investors, that they are keen to look at the Bond Connect route. They were already quite interested in the logistics of it, now, with the so-called Bond Connect enhancement, they are actually looking to invest. I’ve just been to Europe in June and received some positive feedback from investors who are looking for managers specifically for onshore bond investments. Having said that, they’re still quite sceptical about the credit market, so the mandate is more on the high-grade side, like the CGBs and the policy bank issuers. For the Chinese state-owned enterprises, a lot of investors are more comfortable with the US dollar market, because of the documentation and the legal framework that comes with an offshore issue. So that’s the recap.
IFR ASIA: Are investors suddenly looking because they are now able to invest? Or is there a more fundamental reason why RMB markets might be more attractive?
PAULA CHAN, MANULIFE: It’s definitely the index inclusion story. It’s structural. They’re all quite familiar with the story and they have been doing a lot of work about the potential inflows once RMB bonds are included in global indexes. The numbers really vary, depending on how we look at passive or active flows. Based on our research, we’re looking at about US$600bn coming into the onshore market, eventually.
IFR ASIA: Once all the indexes are aligned.
PAULA CHAN, MANULIFE: Yes, correct. So that’s just passive. The active flow is usually much more aggressive. So it’s definitely a structural change. Whether we expect the RMB to depreciate, appreciate or whatever, the inflow has to be there. We are looking at about a 5% weighting on the main indexes; that’s a lot of money going into China.
IFR ASIA: We mentioned credit ratings a couple of times already. Tony, tell us what’s changed on that front.
TONY TANG, PENGYUAN: Yes. Ricco mentioned the Chinese authorities have opened up the credit rating industry. So far, no licences have been granted for international participants. All the submissions were due by the end of September, so the reviewing process is underway.
The China ratings market has been running for more than two decades, so the rules are well established. Personally, I think it would be hard for big players to come in and change the whole market practice. I think they will add value, but they’re not going to shake up the entire industry. Based on the documents submitted to NAFMII so far, S&P is planning to create a new set of criteria for the onshore market, which means they will not be in line with the current practice in global markets. Moody’s has not made it clear, but I heard that they’re probably going to use their existing criteria.
There is certainly more competition coming to the domestic market from outside China. I think that would help the industry to improve in terms of fundamental analysis and rating quality, as well as the quality of the analysts. It is a big industry, so it will be small changes each year for a long period time.
On the other hand, we also see Chinese ratings agencies are coming outside of China, so there is another side to the story. We are establishing our practice in Hong Kong, and there are a few other agencies also practising in Hong Kong now. I think this will also provide a different voice to this line of work.
IFR ASIA: Ricco, just on the rating point. On the new Panda guidelines, there is no rating requirement anymore, is that right?
RICCO ZHANG, ICMA: It’s not a regulatory requirement anymore, it’s up to the market. In the onshore market, every bond issuance must have a domestic rating from a Chinese agency. The Panda market is the exception. It’s not a regulatory requirement anymore, it’s just for the market to decide if a rating is necessary or not. That will depend on investor feedback.
This will give more flexibility for issuers that already have a very high rating in the international market. If the onshore investor feels comfortable investing in such bonds without a domestic rating, that’s fine. If it’s, say, a less well-known corporate and the rating is not that high, the investor may feel different.
Now, as Tony said, the gate is open for the international players, but it’s not easy. Don’t forget, foreign participation in the onshore market is still less than 2%; the vast majority is onshore investors. The first question there is do they trust these international players? Second, what will issuers pay for? When you imagine an international rating agency giving BB, and Chinese rating agencies give AAA, what will issuers choose? I will say that there will be changes over the years, because we all know that it’s hard to differentiate between Triple A issuers in the domestic market. Triple A in the onshore market may mean investment-grade in the offshore market.
We will have to see what further reforms the regulators will put in place. One option is to change the whole rating system to make it more consistent with the international one, but that’s only one option. Over the coming years we will see how the market responds and which way the rating regime will go.
IFR ASIA: Steve, credit risk, is one of the most interesting topics at the moment in China. Do you think ratings reforms would make a difference?
STEVE WANG, CITIC CLSA: At the end of the day, there’s no replacement for doing good credit analysis yourself. My colleagues and I have to put ourselves in the shoes of investors and think about whether we are comfortable taking on a particular credit or not. We go to visit companies and talk to people onshore. We are also very fortunate to have a very large team of onshore credit analysts at Citic Securities, so we get a download on what is happening onshore.
We do look at the onshore credit rating when we do our research. I recognise there are a lot of challenges there but the rating services they provide are very valuable. They provide a lot of detail and a lot of background on the issuer and some rating reports are very long and detailed. I actually find onshore rating reports very useful as a starting point but to get deeper you need to do your own research.
IFR ASIA: Have you changed the way you approach that analysis, now that default rates are rising?
STEVE WANG, CITIC CLSA: I started to look at this market in depth about a year or so ago, and at that point people were already well aware of the deleveraging campaign, and the squeeze on liquidity. It’s quite obvious that we can’t just rely on simple rating brackets to decide relative value, or even gauge the risk of default.
There are some sectors that require a different approach to credit analysis, such as LGFVs [local government financing vehicles]. This year, at the CLSA Investors’ Forum, we explained our methodology to investors. We look at the fiscal strength at each government level to help identify how strong each LGFV issuer might be, or might not be.
IFR ASIA: It’s not just the support that you expect them to get from the top.
STEVE WANG, CITIC CLSA: That is still very important, as we have seen in some recent cases, but we have to also look at why do they deserve to be supported? I think that’s the most important question.
IFR ASIA: I’m interested if this rise in defaults is a major hurdle now. Paula, have you had to change the kind of securities you buy as a result?
PAULA CHAN, MANULIFE: Yes, we have been staying away from the LGFVs for some time, simply because we think the issuers are a bit challenging to understand, and getting the information is another hurdle. We know we will probably miss some great opportunities, but we think that we can catch up by investing in other asset classes.
On that note, I would say we’re quite balanced. For the onshore market we’re more focused on government bonds, and government issuers, simply because we think the credit cycle in the onshore market is still at an early stage of correction. Also, credit spreads are trading homogenously, so even if we step down the credit curve, we don’t get enough compensation.
For the same type of credit risk, we would be happier to get ourselves involved in the offshore credit space. We don’t necessarily compare the same credit in different markets, because we can’t hedge it, but we think that taking outright credit risk would be much more meaningful in the offshore market, at this stage.
IFR ASIA: So it’s not that credit risk has suddenly come up, it’s more about getting paid for the risks involved.
PAULA CHAN, MANULIFE: Correct. We still run valuations every day; where we get the most alpha, that’s what we are looking at.
IFR ASIA: Is this something you’ve noticed, Ko-Wei? How do you explain to issuers that there might be no pricing benefit from an RMB bond?
KO-WEI HSIUNG, HSBC: There are a few ways to really look at this. First of all, I have to agree that some issuers do look at this market hoping to get some sort of arbitrage over their funding curve. While other issuers will look at this market as a way to fund a business onshore.
There are also other reasons for going into the market. Some issuers are purely looking to build stronger ties with China; that’s also a possibility. While I agree that trying to get the best pricing outcome is perhaps the common goal for a lot of issuers, we cannot overlook the other reasons why they may consider this market.
IFR ASIA: Do you see people issuing onshore RMB bonds instead of Dim Sum, even if they have to pay a little bit more?
KO-WEI HSIUNG, HSBC: Certainly. For example, if you have operations in China, if you were to issue a Dim Sum bond offshore and apply the funds onshore, it will take up your onshore foreign debt quota. But if you satisfy certain criteria and issue a Panda bond onshore to fund your onshore operations, it actually allows you to keep your foreign debt quota for other uses.
That makes a very big difference for some issuers when they are looking to decide which funding routes they’ll be using. Essentially what you’ll be comparing is the cost of an issuer funding itself onshore, rather than comparing the Panda pricings versus Dim Sum pricings, which could be affected by market conditions from time to time.
RICCO ZHANG, ICMA: That’s definitely one of the biggest incentives in the new Panda bond guidelines. If such issuers want to fund their onshore projects, their life will definitely be easier – although it’s subject to further detailed rules from SAFE, and it also depends on the issuer’s corporate structure.
Two years ago, we rana survey, co-organised with NAFMII, asking different issuers if they were interested in issuing Panda bonds, and why. We found that their treasury structure made a difference. For some treasuries, when they get funds, they are required to get the funds back to head office, either in the region or to their global headquarters. Then they need to allocate those funds back to China. In that case, it’s way more complicated, and then a Panda bond is probably not an option. If they’re allowed to leave the money in China to fund their onshore business, then it’s definitely attractive.
IFR ASIA: So, in the new rules, is it easier to get approvals for a Panda bond if you’re keeping the money onshore?
RICCO ZHANG, ICMA: Exactly, yes.
KO-WEI HSIUNG, HSBC: Just to make one clarification here. The rule itself doesn’t explicitly differentiate the process based on the use of proceeds. It does mention that issuers should follow the applicable regulations published by the various regulators in China related to account opening, fund remittances and cross-border settlements.
IFR ASIA: I see. On the investor side, Paula, you talked a bit about the Bond Connect enhancement. Does that basically mean that international investors are comfortable coming into the onshore market?
PAULA CHAN, MANULIFE: The currencies definitely still play a big part. We talk about diversification benefit, tracking error, Sharpe ratio – whatever numbers you plug into your model the outcome is very one-sided. We have to include China, no matter how you slice and dice it, China is the most attractive market right now. Having said all that, to be very honest, the RMB performance against the dollar is a problem. A lot of people are still stuck on that, even if they can hedge it in the offshore market, the CNH market.
Pension investors will normally swap it back to, say, euros or Swiss francs. To them, they are looking at negative rates, so anything above zero is great, but it still doesn’t work for them. Deep down, they’re still looking at the currency performance.
IFR ASIA: Are there still any concerns about China’s capital controls? Can investors move their money around freely now?
PAULA CHAN, MANULIFE: They can, but these pension investors are looking at three, five years investment horizon. They are not a hedge fund or a normal asset manager like us, where it is all about whether we beat the benchmark or not. If they are really going into the market, they want to stick around. Bond Connect definitely is a good thing, and we like it. We like the transparency, we like that we can hedge. Whether other global funds really want to get involved, that is a separate question.
RICCO ZHANG, ICMA: Well, the Chinese market is a very unique market. It’s a developing market and it’s quite closed. On the other hand, it’s one of the biggest bond markets in the world. There are two perspectives now for investors looking at the Chinese market. One is economics. The RMB is now in the SDR basket and bond index inclusion is coming. A passive investor will definitely look at accessing the RMB, through onshore or offshore options. You can see this year the RMB is still depreciating against the dollar but we’ve seen net inflows into China, particularly from central banks, big pension funds and asset managers. That shows the commitment of the offshore investors to the onshore market. That’s not something the Chinese authorities can control, but they can make the market more accessible.
The other view is the technical perspective. We now have Bond Connect, direct access, RQFII. It’s all about making the process simpler, and that is opening up new opportunities. Under Bond Connect, the DVP improvement is quite important, because previously some big investors say they cannot get through their internal compliance without true DVP. The feedback actually is well received by the Chinese government, and that is already quite a change from the past. They are very interested in feedback around international market practice and how to help get RMB bonds into global indexes.
IFR ASIA: The Bloomberg Barclays index announcement about including RMB bonds came with a list of conditions. After the last enhancements to Bond Connect, is that all done?
RICCO ZHANG, ICMA: Well, technically there are still some hurdles. The onshore market does not use the same repo agreements as the international market, where market participants value the Global Master Repo Agreement, which ICMA manages. That’s one further technical issue.
Economically, the currency, trade war, the impact on the Chinese economy, the way people see Chinese credit risk – all of those are hurdles. That’s why some investors still want to wait and see. But the investors who are getting into the market now will definitely encourage others to follow.
IFR ASIA: Steve, are your clients concerned about change to indices?
STEVE WANG, CITIC CLSA: Absolutely. And echoing Paula’s point, it’s all about currency. The RMB is in a very interesting situation right now. Earlier this year, when the policy situation was less certain, there was a lot of speculation that the yuan could weaken past 7 to a dollar. By now the Premier and state council has drawn a line in the sand and the in-flows that we’ve seen this year have continued to be pretty good through the Bond Connect.
There is a very valuable window of opportunity for global investors to take a closer look at the RMB bond market. Right now, the currency is inexpensive after coming down substantially from the beginning of the year. A little bit of weakness is also good to stimulate the economy, and the RMB has definitely outperformed against its Asian peers. I’ve looked at China for a good part of my career, in rates, economics and credit, and it always comes down to currency.
What the central bank is doing is really important. Lo and behold, right after the Golden Week holiday they cut 100bp from the reserve ratio requirement, which will help stabilise liquidity. They’re still saying that they’re not loosening the monetary side, but there’s a number of things they can do to smooth out market liquidity. This has been very well-orchestrated. With the global market struggling a little during the past few weeks, it’s actually quite a big confidence booster from the PBoC.
IFR ASIA: It seems to me that China is saying that its deleveraging campaign is not going to get out of hand – especially after a bit of a blip earlier in the year.
STEVE WANG, CITIC CLSA: May 2018 was the toughest time for all of us in the market, and it was a turning point. Into the summer we saw infrastructure spending start to contract. That was really the warning bell and triggered the turn in policy stance. That’s very positive. Of course, we’re still dealing with a rising default rate, but the overall default rate in China is very low by global standards, and the bond default rate is still much lower than the bank NPL rate. From a credit investor’s perspective it’s still a very attractive proposition to look into the RMB onshore market, as Paula mentioned. My only advice is do your homework and identify the best performers.
I think the LGFV sector deserves a lot more attention because it has the real potential to grow into a major asset class, like the property sector over the last decade. It’s in a state of transformation. People running LGFVs are trying very hard to make their business more sustainable, either from a cash flow perspective or from actually cementing closer ties with the city’s development.
IFR ASIA: Tony, what do you think? How does policy affect credit risk?
TONY TANG, PENGYUAN: I’ll just add two things first on why people invest in RMB bonds. The onshore bond market represents the true China, with a much more diversified range of asset classes and different issuers. That is a big opportunity, whether you’re a hedge fund investor or pension manager, because you can still find the assets you want. It’s a much better representation of China than the offshore dollar bond market or Dim Sum market.
Secondly, the onshore RMB bond market also has a very low correlation with the other major global asset classes. You can see the contrast in recent years with quantitative easing in the US and Europe. China offers great diversification benefits to the offshore investor, and of course index inclusion will help that to accelerate the process. Eventually, I believe the onshore RMB bond market will be one of the most important asset classes in the world.
Policy this year is still focused on deleveraging. If you recall, at the end of last year in the Central Committee Economic Work Conference, the central government set one of its three main work priorities over 2018-2020 as preventing and controlling the financial systemic risk. They will have to continue deleveraging, because they know China cannot continue the current path forever, but they also don’t want to cause a bubble to burst. It’s a very delicate dance they have to do.
Given the backdrop of the trade tensions between the US and China, they’re probably going to relax a little bit, I would say, just to avoid a sudden drop in economic growth or jump in credit events, particularly in the property market. Even though this year property sales have been good, we do see a lot of property companies, whether it’s Vanke, Country Garden or even Evergrande, they are all coming out with pretty conservative comments going forward. Actually, we’re in the process of reviewing the entire sector right now. I would say that sector remains one of the biggest risks for China. A trade war with the US may be an external shock that is hard to model, but I think its impact is still manageable for China at this moment; I believe the real risks are still very much originating from the domestic economy.