China’s bright bond future casts shadows

As Chinese local bonds prepare to enter the Bloomberg Barclays aggregate index in April, unleashing an estimated US$5 billion monthly in foreign investor inflows, with the renminbi forecast also strengthened from the previous 7 per dollar, the International Monetary Fund (IMF) 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 admission to the World Trade Organization 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 administration of US President Donald Trump 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 of China revealed 3 trillion yuan in January issuance with 85 trillion yuan 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% over the past decade to almost $3 trillion at the end of 2018.

The IMF 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 activity lags trade and product integration, with the exception of bank lending to African and Asian countries under the Belt and Road Initiative 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 of “multi-tier bond and futures development.”

In the corporate segment in particular after the ratio of debt to gross domestic product hit 150% in 2016, the authorities demanded more efficient allocation and deleveraging, as last year’s private-company default ratio of more than 4% far outpaced the almost non-existent state-owned default ratio. 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 Chinese 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 15 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 10 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 renminbi 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 IMF 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.