Reform takes priority
A clampdown on irregular trading and a cash crunch have left credit traders in no doubt that China is stepping up efforts to reform its capital markets. As traders and investors wait for clearer signals, however, the uncertainty is choking liquidity.
The arrest of a number of bankers and brokerage executives earlier this year proved to be only the first step in a nationwide clampdown on China’s fast-growing bond market. Investigations into alleged profit-skimming, involving a practice known as substitute holding, marked the start of a co-ordinated effort to eliminate irregular transactions and improve transparency.
Each market regulator outlined a host of new rules to close loopholes and enforce existing rules restricting the ability of unregulated investors to trade bonds.
The People’s Bank of China, which regulates the Rmb24.4trn (US$4trn) interbank bond market, first warned credit traders during a closed-door meeting that it would restrict the participation of certain types of investors, and pledged more lenient treatment for institutions that reported suspicious trades themselves.
The China Securities Regulatory Commission and the China Banking Regulatory Commission each followed with orders for banks and securities firms to report suspicious or irregular fixed-income transactions and to examine their own practices in order to provide details of substitute holdings, something that may have allowed some investors to work around existing restrictions.
Later, the China Government Securities Depository Trust & Clearing, or CDC, and the Shanghai Clearing House jointly notified commercial banks they could no longer trade bonds between their own proprietary accounts and the wealth management products they managed for clients.
Finally, China Central Depository & Clearing, or Chinabond, and the National Association of Financial Market Institutional Investors joined the clampdown in suspending all clearing operations for Class C accounts and requiring underwriters in the interbank market to base new-issue prices on real-time secondary-market levels.
Faced with an onslaught of new rules and reporting requirements, traders cut positions and, as a result, trading volumes wilted.
There was, however, more to come. In late June, a sudden liquidity squeeze hit the interbank money market, with traders reporting a chain of defaults on short-term repo transactions. At one point on June 20, the overnight repo rate was quoted at 30%, the highest in more than a decade.
The squeeze eased after the PBoC stepped in with a promise of liquidity, but the episode spooked investors in a bond market where banks are the main buyers. Longer-term yields rose as a result, causing a huge drop in both the volume of secondary jtrading and primary issuance.
New bond sales in June amounted to Rmb314.79bn, a 50.42% drop from the record Rmb634.944bn in May, according to totals registered with Chinabond.
Although repo rates returned to normal in July, investors in longer-term debt seem to be finding it difficult to return to their old buying habits. Many asset management accounts and proprietary accounts not only stopped investing, but started selling bonds in the secondary market.
“Primary demand is very weak. Even CDB and the MoF [Ministry of Finance] paid high yields recently,” said a bond trader. “It is not a good sign when both trading accounts and asset allocation accounts stop market activities.”
Qu Qing, chief bond analyst at Shenyin Wanguo Securities, said in his investment strategy quarterly report that “overall liquidity will shrink and credit bonds will enter winter”.
A source at an insurance asset management company also admits they are having a tough time.
“We are not investing now, but pursuing out a ‘hold-to-maturity’ plan,” said the source. “If we sell now, we’ll lose money, but, if we don’t sell, we need to make sure there is enough short-term liquidity to support the outstanding investments. It is not easy to achieve.”
The only good news, however, is that bankers generally believe the first default in China’s domestic bond market is still a long way away. They believe default rates in loans and trusts may increase as regulators move shadow banking business back onto bank balance sheets, but expect the capital markets to remain immune to such restructuring.
“If there is no big change in the overall attitude towards local government debt, I still don’t think the bond market will be allowed to be a default-testing field,” said an asset manager at a securities firm.
Policy the key
Policy developments remain the biggest driver, but market players say they are at a loss when it comes to figuring out the direction of future moves.
“I think at least for the second half of the year, the market will be more affected or even driven by policies from the new government,” said a DCM banker. “It has been very obvious that the market is still quite fragile in the face of a strong administration.”
Until the administration offers more clarity on its plans to reform China’s wider financial system, few people are prepared to take on new risk.
“The PBoC stepped in and helped the repo rate get back to a fairly normal level. However, we also know that economic restructuring and bank deleveraging are also required. So, what and how exactly the top bosses want this to work is crucial to us,” said the second banker.
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