China has taken a number of key steps to develop and deepen its domestic debt capital markets, but much work still needs to be done.
China is quickening the transformation of the domestic debt capital markets as fast as it can to wean borrowers from bank financing and to create a more market-driven system that offers borrowers better access to capital.
Among the recent milestones are the launch of a municipal bond market and allowing a public bond to default. The default was a signal to borrowers and investors that the government will not backstop every bond issue and is serious about letting the market determine actual investment risks, which is key to a fully functioning capital market.
Still, while China’s domestic bond market is now the third biggest is the world, it has a long way to go to create the diversity and transparency required of a fully developed market.
The steps China’s State Council, the nation’s cabinet, took recently prove the government is serious about developing a sophisticated debt capital market. Last month, the council spelt out nine broad capital market reform principles for the next five years aimed at addressing weaknesses in the system. These address the equity markets and futures markets, as well as debt markets, among other things.
“The goal of the recent reforms is to allow Chinese local governments and corporates more direct access to the debt capital markets, and to lower their reliance on bank financing,” said Changchun Hua, China economist from Nomura.
Bank lending remains China’s main form of financing. Bank loans to corporations in China totalled 1.24 times GDP as of the end of 2013, a ratio lower only than Singapore and Hong Kong in Asia. China’s corporate bond-to-GDP ratio, meanwhile, was only 14%, far below those of more developed Asian nations, such as Singapore’s 31%, Hong Kong’s 31% and South Korea’s 83%.
“China’s funding channel has always been dominated by banks,” said David Cui, Shanghai-based China Strategist from Bank of America Merrill Lynch. “So, it’s important for China to develop other direct funding channels, such as the bond market and trust financing.”
“China’s funding channel has always been dominated by banks. So, it’s important for China to develop other direct funding channels, such as the bond market and trust financing.”
The PRC’s small corporate bond market relative to GDP meant there was considerable room for growth, said Ryan Song, manager director at HSBC China and head of global markets.
Nevertheless, the growth of China’s bond markets has been impressive.
Total outstanding bonds in China grew to Rmb30trn as of 2013, double the amount in 2009.
The introduction of commercial paper in 2005 and medium-term notes in 2008 aided growth, especially of the corporate bond market. The government took further steps recently to develop an asset-backed securities market and introduce government bond futures, Song said.
Yet, a dearth of market players in China means pricing discovery is poor and the market is, therefore, less efficient. Aware of this, the government is trying to introduce more investors from both inside and outside the PRC.
“A few years ago, most bonds were held by banks, now funds, including wealth management products, are fast emerging as major buyers,” BofA Merrill’s Cui said.
Meanwhile, Song said, Beijing was encouraging the participation of retail and corporate investors, as well as foreign investors through the qualified foreign institutional investors (QFII) and offshore renminbi QFII (RQFII) programmes. Currently, foreign institutions only hold about 5% of onshore bonds.
“Encouraging stronger bond markets, and the associated global institutional players, would allow larger companies to raise funds in the bond markets, hence allowing banks to lend more to small and medium[-sized] enterprises,” said Emir Hrnjic, director of education at the National University of Singapore Business School’s Centre for Asset Management Research and Investments.
While pushing ahead with more market-oriented reforms, Beijing took an important step towards developing a more efficient credit culture when it allowed Shanghai Chaori Solar Energy Science & Technology to default on a coupon payment in March.
Still, investors in the PRC have long believed the Chinese Government provided an implicit guarantee to all bonds, an assumption that has distorted bond pricing and kept investors from learning to assess true risks. The Chaori default is the first to dispel that assumption.
“It is important to raise investors’ risk-awareness in order for China’s bond market to develop well,” Cui said.
Hrnjic from NUS called the default “creative destruction” for a better system.
“It seems clear that the Chinese Government is determined to move towards a more market-driven economy and more efficient allocation of resources,” Hrnjic said. “In that sense, the Chaori default is simply symptomatic of a process known as creative destruction. This is the process that improves the economy from within; destroying the old, inefficient firms or technologies and creating new, better ones.”
The Chaori default is also in line with China’s reform goals. In a May report, HSBC analysts said the intention of China’s debt capital market reforms was to improve credit-enhancement mechanisms, strengthen the mandatory responsibilities of issuers and investors, improve default monitoring and settlement mechanisms, and support restructuring efforts that debt-holders had initiated.
“Thus, it [Chaori default] is a strong signal that the government is committed to its promise of a more transparent and market-driven financial system,” Hrnjic said.
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