China’s Bright Bond Future Squint
As Chinese local bonds prepare to enter the Bloomberg Barclays aggregate index in April unleashing an estimated $5 billion monthly in foreign investor inflows, with the renimbi currency forecast also strengthened from the previous 7/dollar, the International Monetary Fund and government counterparts in Beijing released a several hundred page study on the market’s “bright” future despite opening and building challenges ahead. It coincides with the 40th anniversary of economic liberalization first concentrating on trade with World Trade Organization admission in 2001, and subsequently on capital market development, with the signature Stock and Bond Connects through Hong Kong aiding direct international access. The promotional hype around the publication, including an event at Washington’s Center for Strategic and International Studies, was in contrast to China’s reported delay of a World Bank report on “new growth sources” that has been ready for a year.
The Trump Administration did not weigh in formally on the bond roadmap but counts US inroads into the market as a victory even if underwriting and ownership totals remain paltry. The People’s Bank revealed RMB 3 trillion in January issuance with RMB 85 trillion outstanding overall, with the monthly government segment heavily provincial placement. State banks and enterprises remain a huge component, as the Paris-based Organization for Economic Cooperation and Development warned that corporate borrowing was up 400% the past decade to almost $3 trillion at the end of 2018. The Fund guide urges improved liquidity and risk pricing, implicit guarantee removal and further domestic and overseas investor outreach to balance allocation and stability on the way to maturity and global mainstream acceptance.
The research notes that cross-border financial lags trade and product integration, with the exception of bank lending to African and Asian countries under the Belt and Road and other aid-infrastructure programs. The push for a greater capital markets slice in the bank-dominated system was underscored in Premier Li Keqiang’s proclamation last year for “multi-tier bond and futures development.” In the corporate segment in particular after debt/gross domestic product hit 150% in 2016, the authorities demanded more efficient allocation and deleveraging, as 2018’s over 4% private company default ratio far outpaced the almost nonexistent state-owned one. As portfolio inflows increase domestic monetary policy will more closely mirror global trends, but better bank supervision and more exchange rate room than under the current band can act as buffers.
Sovereign paper was first introduced in the 1950s, but the corporate market is only 35 years old, and over the counter interbank dealing still is 90% of activity as stock exchanges slowly diversify into debt listings. The public sector including policy banks and local governments accounts for 60% of bonds, and corporates feature novel asset-backed and “green” structures. A quota regime was first introduced fifteen years ago for foreign institutional investors, and central banks and sovereign wealth funds gained full access in 2010. With the 2017 Hong Kong Bond Connect so-called northbound exposure “surged,” but international holdings are only 2% in comparison with the big emerging market average ten times that figure. With the addition of China’s currency to the IMF’s special drawing rights basket, foreign central banks boosted their share to the same 2%, with $200 billion in renimbi reserves as of mid-2018. With expected index insertion in the Financial Times and JP Morgan gauges beyond Bloomberg in April, with the weighting there rising in phases to 5%, passive investors will direct another $150 billion to local bonds, the analysis calculates.
Near term practical steps can be taken to smooth entry pending broader policy and regulatory decisions, the Fund team recommends. Tax treatment is uncertain despite a declared three-year exemption, and hedging tools are limited for onshore cash positions. Domestic banks and mutual funds overwhelmingly follow buy and hold strategies that could be altered with more market making and repo lending capacity, and the central bank and securities supervisors should harmonize rules and communicate common development objectives. Mandatory credit ratings involve a dozen approved agencies after a fragmented screening process, and grading is 95% “skewed” toward the top AA category. Standard & Poor’s was recently granted its own license within the Washington-Beijing trade dialogue, but alone cannot tip the ratings scale to emerging market norms without larger cultural and methodology changes, the report suggests.
