China’s Bond Market Matures, Slowly
Ji, Chen
China’s success in developing a fully functioning capital market depends in large part on whether it succeeds in establishing a thriving market for bonds. The government has, until recently, restricted the types of bonds that can be issued in China. But China’s leaders have realized that there are powerful financial reasons to promote the expansion and deepening of the Chinese bond market. Among the most important are, first, that bonds would be desirable additions to the portfolios of Chinese insurance companies, banks, pension funds, and the country’s social security fund, and second, that bonds are preferred investments for international investors. The bond market is also where China’s growing business sector could raise long-term capital for expansion. A fully functioning bond market would also provide liquidity to China’s rapidly expanding economy, not to mention its relatively young private housing and auto loan markets.
Chinese characteristics
China began selling Treasury bonds (Tbonds) in 1981, marking the launch of the first domestic bond market since 1949. The domestic bond market has since expanded significantly, both in terms of participants and financial functions. Bonds have been underwritten for two major groups: PRC government bodies (usually for the central government in the form of T-bonds issued by the Ministry of Finance [MOF]) and selected Chinese enterprises. Domestic bond issues have been medium to long term (3 to 20 years). China now has almost enough bond issues to establish interest benchmarks, but interest rates are still under the control of central government economic planning bodies. All central government (sovereign) bonds are approved as part of a government capital allocation plan based on a quota set each year by the State Council. Chinese bonds are also traded on a secondary bond market as part of the Shanghai and Shenzhen stock exchanges. Some interbank trading also occurs.
China’s bond market today is a hybrid. In many ways, it functions like those in most developed and developing market economies. PRC government entities, financial institutions, and business enterprises all offer bonds; PRC government entities, financial institutions, and individuals may purchase bonds. Bond proceeds finance government deficits, government construction projects, financial institution liquidity requirements, and individual enterprise capital needs. The PRC government has also issued bonds in overseas markets denominated in US dollars, Japanese yen, and euros. Recently, the government approved short selling of bonds and instituted a bond index.
Yet the structures and practices of China’s bond market also exhibit significant “Chinese characteristics.” For example, because China’s currency is not fully convertible for capital account transactions (that is, for capital-related, as opposed to trade-related, transactions), most foreigners may not buy Chinese bonds denominated in renminbi (RMB). The only exceptions are the nearly 30 foreign institutions in the recently created category of qualified foreign institutional investors (QFIIs). China also lacks a futures market for bonds because the government shut it down in the aftermath of a speculative frenzy in 1995.
So far, the government has approved only a few large, state-owned enterprises to issue corporate bonds. An annual government quota determines the amount of government and commercial bond issues, and corporate bonds make up about 5 percent of offerings. And finally, it is the government, not the market, that sets bond interest rates, although a market-determined yield curve is being established.
Bond varieties
* Government bonds
Until 1995, China issued a number of different kinds of government and semi-government bonds (see the CBR, January-February 1998, p.30). State-owned investment banks issued semi-sovereign institutional domestic bonds for such groups as international trust and investment corporations (ITICs), but these were halted in 1995 after the Guangdong ITIC (GITIC), China’s second-largest, failed. GITIC’s foreign lenders were left with about 15 cents on the dollar (see the CBR, May-June 1999, p.36).
By 1995, the central government had consolidated bonds into four broad categories: two types of sovereign central government bonds, one for deficits and one for carrying out specific policies such as construction; overseas bonds issued by various governmental or governmentapproved groups; and corporate bonds, again requiring official examination and approval. MOF issues two kinds of sovereign bonds: 10and 20-year T-bonds to finance China’s annual government deficits, and 3- to 7-year bonds to support assorted Chinese construction and infrastructure projects. Together these two categories of bonds constitute about 95 percent of China’s domestic bond market.
In 1994, the State Council ended MOF’s Communist-era arrangement under which the ministry funded the government’s deficit simply by drawing on the central bank. Consequently, the central government doubled its deficit between 1993 and 1994 from about ¥29.3 billion ($3.5 billion) to ¥57.4 billion ($6.9 billion) through sovereign bond issues. Since 1994, MOF has floated most of the national government bonds to finance China’s yearly deficits, which result largely from China’s relatively weak, but gradually improving, tax structure. The central government also has other financial responsibilities, such as funding social welfare programs. The share of national income used to pay interest on the national debt, though low, is also rising.
By 1997, the PRC government was issuing so many sovereign T-bonds to pay for its accumulating deficits and construction costs that together they accounted for 8.2 percent of GDP in 1997 alone.
The 1998 Asian financial crisis led to rising government expenditures and falling revenues. The resulting government deficit spending easily outpaced domestic GDP growth (see Table 1). To keep China’s economy going through the crisis, Premier Zhu Rongji called for more long-term construction projects to help stoke domestic demand, thus starting a fiscal stimulus policy that lasted for several years.
These projects were financed through the domestic bond market. From 1998 to 2002, China borrowed ¥660 billion ($79.8 billion) in long-term T-bonds to invest in about 10,000 projects in agriculture, water conservation, communication infrastructure, and technological upgrades (see Table 2 and the CBR, September-October 1999, p. 16). The combined costs of these two rising expensesdeficits from the government balance sheet and construction bonds-were equal to 28.9 percent of GDP by 2003.
PRC National Development and Reform Commission Minister Ma Kai recently noted that because the economic situation has improved since 2003, the government was able to issue fewer construction T-bonds in 2004. He also pointed out that with the heavy use of T-bonds since 1998, China’s economic growth has come to depend too heavily on government bonds, and alternatives need to be found.
* Corporate bonds
Corporate bonds are popular in Western countries that have strong legal and credit rating systems. The corporate bond market is valued at about 140 percent of the GDP of the United States, about 95 percent of Japan’s GDP, and about 85 percent of the European Union’s GDP. China’s low figure of less than 1 percent in 2003 is, however, comparable to most other East Asian countries except South Korea and Japan (see Table 3).
China’s first post-1949 corporate bond was issued in 1987. By 2002, commercial enterprises, mostly large SOEs handpicked by the government and listed on China’s stock exchanges, had issued about ¥270 billion ($32.7 billion) in bonds. By June 2003, 324 corporate bonds had been traded on the two exchanges. Twenty corporate bonds were still being traded in 2003, with a combined market value of about ¥45 billion ($5.4 billion), making corporate bonds about 5 percent of the total domestic bond market and less than 1 percent of China’s GDP. China Mobile Communications Corp. (China Mobile), for example, issued bonds worth ¥5 billion ($604.9 million) in 2001. Although corporate bonds are usually issued to finance particular projects, China Mobile planned to use the proceeds of its bond issue to retire bank loans.
The relatively small size and slow growth of China’s corporate bond market may also be the result of factors peculiar to China. First, it is difficult for qualified Chinese enterprises to obtain the required government permission to issue corporate bonds. One possible reason for this is that the government does not want to crowd out its favored enterprises, such as China Mobile, or its own T-bonds and construction bonds, even though depositors have more than ¥11 trillion ($133.1 billion) in Chinese banks. A second problem is that there is not yet a bond-rating agency able to monitor company performance (see the CBR, November-December 2003, p.36). And Chinese companies’ opaque accounting practices provide bondholders with insufficient information. Finally, China lacks a sound legal framework to deal with companies that renege on their bond obligations. As the ultimate owner of the bondissuing companies, the government has a conflict of interest-it does not want bondholders to take legal action against the government if the mostly government-owned companies were to default on their bond repayment obligations.
Moreover, the enterprises themselves, even if they are approved for bond issuance, may prefer to raise funds through bank loans. These loans are from state-owned banks that have traditionally been lax about demanding repayment. Listing on the stock markets may also be preferable to bond issuance because the corporations do not have to pay interest or principal on the money they raise. This is also why some corporate bond issuers would prefer to sell bonds that allow bondholders to convert to stocks. Since none of these barriers is likely to fall anytime soon, the corporate bond market will probably remain small for the near future.
Recently, the government has discussed ways to encourage banks to lend to small and medium-sized enterprises, possibly setting them on the path taken by larger state-owned enterprises, which have progressed from taking out bank loans, to listing securities, to issuing bonds. Despite the great promise that corporate bonds may offer, it appears that Chinese corporations will remain in step with most other East Asian companies by not depending much on bonds, despite their many benefits.
Role of foreign investors
Foreign investors wishing to make a “China play” in bonds will find the Chinese bond market inhospitable, at least in the short term. First, the government is apparently ambivalent about the economic benefits of foreign investors’ participation, either in selling or buying bonds. A number of advisors to the PRC authorities have pointed out the benefits of foreign involvement in the Chinese bond market, such as better corporate governance, but foreign investors have so far been unable to participate, except as QFIIs. The International Finance Corp., the private sector investment arm of the World Bank, and other multilateral institutions including the Asian Development Bank, hope to be able to float RMB bonds in China soon and use the proceeds to make development loans and support various development projects in China. A few foreign banks, after receiving permission to do business in local currency in China, would benefit from the ability to float RMB bonds. These bonds would provide the local currency reserves needed to make RMB loans, but the central government has yet to approve this proposed move.
One obvious impediment to foreign companies issuing bonds in RMB is the lack of RMB convertibility to foreign currency. The best bet for foreign financial institutions in the near future is to partner with Chinese domestic investment bankers to gain permission to jointly float RMB-denominated corporate bonds in China at the current low interest rates in order to build resources for lending in the Chinese market. Foreign banks may be able to gain permission for that kind of participation, but only within the state quota system that sets limits on the scope of foreign participation in the financial system.
Would-be foreign individual investors, for their part, may also be deterred by the lack of liquidity of Chinese bonds, although the secondary market in government bonds is active in Shanghai and Shenzhen. Potential foreign individual investors, then, will likely follow a “wait and see” strategy.
The wait for maturity
China already has a significant bond market that serves the needs of the PRC government in two important ways: by financing a growing deficit and by providing long-term financing for much-needed infrastructure projects. The Chinese companies that can get government support to float corporate bonds, such as large SOEs, will probably still prefer Chinese bank loans and stock offerings for some time to come. Some PRC corporations, such as Sinopec or Baoshan Iron and Steel Co., Ltd., that have a proven ability and willingness to repay and that need loans to expand or develop in proven markets, or to pay back existing bank loans, will issue corporate bonds.
Chinese individual investors will probably stick with government bonds, in which they now make up the majority of investors, because of the safety and tax-free status of government-issued bonds and the scarcity of investment alternatives caused by an uncertain stock market, low and taxable bank interest rates, the RMB’s lack of convertibility, and the lack of confidence in most Chinese companies.
As the Chinese regulatory and legal structures for bonds improve, enterprise regulations become more comprehensive, company activities and financial records become more transparent, and China’s banking system more developed, Chinese investors currently holding vast amounts of savings may channel more investments into corporate bonds. The need for higher-paying pension instruments, for long-term and reliable investments for insurance companies, and the investment needs of personal retirement funds will also stimulate demand in the Chinese bond market.
Yet reforms will be gradual and will only take place if their promised results convince leaders that the reforms will benefit the country, rather than simply being consistent with international practice. Foreign participation in China’s bond markets will have to meet a similar litmus test, although some foreign participation may be permitted on the general principle of keeping good relations with foreign businesses that have been patiently waiting to do business in China.
The development and current state of the Chinese bond market again demonstrate that China is capable of making important reforms to develop its economy and improve its competitiveness in the global market. But they also show that China will continue making reforms in a carefully controlled and gradual way to ensure that they will not lead to major problems for the government or costs to the Chinese people. Foreigners will continue to play important advisory roles in these reforms and will, eventually, benefit financially by providing services that are consistent with Chinese economic objectives.
Reforms will be gradual and will only take place if their promised results convince leaders that the reforms will benefit the country, rather than simply being consistent with international practice.
Copyright U.S.-China Business Council Jan/Feb 2005
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