I. Debt Markets: in the Context of Financial Sector Development

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1 China s Emerging Domestic Debt Markets: Facts and Issues (Pieter BOTTELIER 1 ) China s financial sector is experiencing rapid development as a result of WTO membership, but the capital market reform continues to lag behind. Within capital markets, debt markets lag behind equity markets. This paper reviews some data and issues of China s debt markets and identifies a number of institutional and policy changes needed to ensure that domestic debt markets will better serve China s broader economic reform objectives. I. Debt Markets: in the Context of Financial Sector Development Debt markets consist of bond debt markets and non-bond debt markets. Within the bond debt market, there are government bonds (GB) and corporate bonds (CB). In the early 1990s China experienced high inflation due to excessive credit expansion for investment financing. New policy instruments were introduced to deal with inflation. The introduction of central regulatory controls, also over the Shanghai and Shenzhen stock exchanges 2, was the beginning of financial market liberalization and state bank reform. Until the mid-1990s, China s state-owned commercial banks continued to act mainly as agents of the state. A series of financial sector reforms were introduced, including exchange rate unification, formal establishment and regulation of the inter-bank market (IM) for short term loans, the creation of an inter-bank foreign exchange market, the introduction of three specialized policy banks, the start of open market operation (OMO) by the Central Bank, and so on. The Central Bank Law and the Commercial Bank Law became effective in Together, these 1994/95 measures gave a strong boost to the development of the domestic market for GB. The other type of bonds, CB, has been issued since the mid-1980s in some local primary and secondary markets. 3 Only after the opening of stock exchanges in Shanghai and Shenzhen in December 1990, did the government begin to introduce formal regulations. The primary CB market has been reserved for a few selected State Owned Enterprises (SOEs) thus it has developed unevenly. Markets for CB still remain small. There is a need to broaden the financial base of Chinese enterprises, both state and non state, in order to reduce dependence on bank loans and exposure to the risk of higher interest burden as lending rates are gradually being liberalized. The broadening of instruments in which institutional investors can invest also requires the development of a debt market. 4 Financial sector reform moved front stage after the 1997/98 Asian financial crisis. The crisis made China s leaders aware of the potential vulnerability of the country s financial system, in particular the state-owned commercial banks, which had accumulated huge volumes of (until then unrecognized) non-performing loans (NPLs). Four state-owned asset management companies (AMCs) were established in 1998 to assist the NPL cleanup. This marked the beginning of a nonbond debt market in China. 1. The paper has benefited greatly from feedback by Oliver Fratzscher of the World Bank. 2 The China Securities Regulatory Commission (CSRC) was established in late 1992, about two years after Shanghai and Shenzhen stock exchanges started operations under local government supervision (Stephen Green). 3 Stephen Green, China s Stock market. A Guide to Its Progress, Players and Prospects. The Economist An excellent overview of China s rapidly growing institutional investor base is provided in Yongbeom Kim et. al., Developing Institutional Investors in People s Republic of China. World Bank Country Study Paper, September Perspectives, Volume 6, No. 2, June 30, 2005 Page 11 of 66

2 II. The Market for Central Government Bonds (GB) In most market economies, GB is the foundation for domestic debt markets. Therefore GB is a logical starting point to review China s emerging domestic debt markets. China s debt markets have been dominated by GB, which in 2002 accounted for about 95% of all traded debt, excluding NPLs. However, China s domestic GB market is still small compared to more developed market economies. It is also small relative to the needs of institutional investors and funds, which are rapidly growing in number and in size. Table 1 compares China with five selected countries by the assets distribution in three financial asset groups (other than cash) in Table 1: Distribution of Financial Asset Groups Other than Cash (in percentage, total for each country = 100). Year: 2000 Deposits Bonds Tradable Equity China South Korea Thailand Brazil Chile South Africa Sources: IMF and World Bank statistics The development of GB market China s GB market has experienced four stages of development: (1) : The government issued bonds every year since All were force-placed on the basis of administrative quotas and payments for bonds were often deducted from payrolls or withdrawn from bank accounts. 5 All bonds had a zero-coupon structure and were non-tradable, but individuals and non-bank agencies began to trade government paper in unofficial curb markets. Total annual issues were small and debt service payments did not start until (2) : China s Ministry of Finance (MOF) began to issue tradable bearer bonds to be traded in the OTC market. Special financial agencies were set up in provinces and counties to facilitate the sale and trading of GB throughout the country. In the late 1980s, Chinese government gradually legalized bond markets and began to tailor new issues to market preferences: maturities were reduced and coupon rates increased to make bonds competitive with bank deposits. The secondary bond market developed quickly after the opening of stock exchanges (which could also list bonds) in Shanghai and Shenzhen. The first voluntary placement of GB occurred in (3) : The next major development was the government s decision to stop borrowing from the Central Bank for fiscal purposes from The primary and secondary markets for GB took off once the government financed all budget deficits through borrowing in capital markets. New bond instruments, including certificate bonds were introduced. Domestic GB issues jumped from RMB billion in 1993 to RMB billion in 1994 and rose steeply every year thereafter (Chart 1). 5 A. Kumar et. al., China s Emerging Capital Markets. FT Financial Publishing Asia Pacific, Perspectives, Volume 6, No. 2, June 30, 2005 Page 12 of 66

3 Chart 1. Central Government Domestic Bond Issues, Debt Service Payments and Outstanding Domestic Government Bond Debt in RMB billion, Bond Issues Debt Service Payments Bond Debt Outstanding Source: MOF, Finance Yearbook of China. Note: this chart does not include forex denominated government Bonds or bonds issued by state-owned financial organizations such as policy banks and the four AMCs. (4) 1997-present: In August 1997 the GB market was split between the inter-bank market (IM) and the stock market. This was the result of a Central Bank s decision to ban commercial bank trading on the stock exchanges and lending to securities firms (usually on the basis of repos) in an effort to curb speculative stock trading. Short selling was officially prohibited in June However, the use of repos to get leverage has remained a big problem. Market fragmentation, combined with unequal standards for different categories of market participants, has created opportunities for rent seeking. 6 GB trading among banks was shifted to the IM to curb harmful speculation on the stock exchanges by securities firms and others. In order to increase liquidity and transparency, the government broadened access of non-bank financial institutions to the IM for GB trading. The total amount of new GB issues has increased rapidly, especially after 1998 when China started a multi-year fiscal stimulus program. 2.2 The composition of the GB market Apart from the central government, the second largest issuer of tradable domestic bonds is the China Development Bank (CDB), which specializes in financing infrastructure projects with long gestation periods. From 1995 to 2002, CDB issued RMB 1,203 billion domestic bonds (44% of the amount of GB issued during the same period). According to CDB s 2002 Annual Report, the amount of securities outstanding at the end of the year was RMB billion (42.4% of the amount of GB outstanding during the same period). CDB bonds are not formally guaranteed by 6 For example, banks and institutional investors can deal in repos up to 12 months while securities firms can normally only deal in repos up to 7 days. Source: Oliver Fratzscher of the World Bank. Perspectives, Volume 6, No. 2, June 30, 2005 Page 13 of 66

4 the government and are not included in official government debt statistics. 7 When analyzing China s public finances, however, CDB bonds should be regarded as semi-official government debt. 8 There are very small price differences between comparable CDB and GB in secondary markets, suggesting that the market expects CDB bonds to be substantially backed by the government. In September 2003 CDB successfully issued US$ 500 million bonds in China s domestic market. It was the first domestic dollar denominated bond issue by a public agency in China. The third largest issuer of domestic bonds is the group of four state-owned asset management companies (AMCs) established in 1998 to help recycle non-performing loans (NPLs) of stateowned commercial banks and CDB. The estimated face value of AMC bonds issued is RMB 1,162 billion. In the primary GB market, the government began, in 1994, to experiment with market-based distribution systems through specialized underwriters and primary dealers. This has gradually become the rule. An over-the-counter (OTC) market for bearer bonds has existed since the late 1980s. 9 There is a more recently established OTC market, which is part of the inter-bank market (IM), for the trade in book-entry bonds and policy bonds (bonds issued by policy banks) between institutional investors. In addition to the stock market, the IM and the OTC market, a fourth market for GB was created in February 2002 when the Central Bank allowed the trading of newly issued certificate bonds (also called savings bonds or savings certificates). Such bonds had been non-tradable until then and carried a higher interest rate than tradable bonds for that reason. When newly issued certificate bonds were made tradable the premium interest over long-term deposit rates was removed. The market turnover of GB has increased exponentially from RMB 34 billion in 1991 to about RMB 13 trillion in But the majority of GB trading has been in the form of repos. Spot trading of GB is very small. Less than 3% of the turnover on the IM and only 20% of the turnover on the Shanghai stock exchange have been spot trading. This suggests a shortage of tradable GB in the market relative to demand. Another reason for the preponderance of repo trading over spot trading is fiscal: capital gains on bond sales are highly taxed in China whereas profits earned in derivative trading (e.g. repos) are tax exempt. Domestic demand for GB, especially from the growing number of institutional investors, has expanded faster than supply. The yields on tradable GB in the secondary market tend to be low. Institutional owners prefer to use GB for liquidity management through repos and keep them, rather than sell them when they need cash GB and Open Market Operations The Central Bank undertook open market operations (OMO) for the first time in All OMO now takes place in the IM. In September 2002 the Central Bank converted outstanding repos into Central Bank bills for a total of RMB billion. From April 2003 the Central Bank has exclusively issued its own bills for OMO; it had run out of GB in earlier attempts to slow the 7 CDB was the first public agency in China to issue long-term floating rate debentures, subordinated debt, strip bonds and other new instruments contributing to capital market development and diversity in China. 8 Before 1998, CDB bonds were guaranteed by CITIC; no such guarantees were extended in later years. The earlier CITIC guarantees appear to have been withdrawn; they are no longer mentioned in official reports. 9 For example, MOF announced on 18 August 2003 that it would issue RMB 46 billion worth of Book-entry Bonds between August 20 and 26. Of this amount RMB 36 billion was to be sold through the IM and the stock market, while RMB 10 billion was reserved for OTC sales to individual investors through banks around the country. Perspectives, Volume 6, No. 2, June 30, 2005 Page 14 of 66

5 growth of base money. The total amount of such bills outstanding at the end of September 2003 was RMB 440 billion. 10 Almost all are short-term maturity in order to fill a market gap. Because of the continuing rapid inflow of foreign exchange (mostly in capital account transactions related to market expectations of RMB appreciation and speculative real estate investments), the volume and frequency of Central Bank bill issues to sterilize excess liquidity is likely to remain high in the near term future. The Central Bank currently conducts OMO through 43 primary dealers. Repo and reverse repo transactions (using securities as collateral) are an integral part of OMO and represent about 97.5% of IM turnover. All OMO instruments are tradable and all transactions are voluntary. There continues to be a shortage of short-term bonds, but even long-term bonds are in short supply, partly because the decline in stock prices since the middle of 2001 has shifted demand to bonds. The range of GB maturities has been gradually increased from 1 year to 30 years, and MOF is considering introducing 3-months and 6-months instruments, to complete the range. This will make it possible to construct more meaningful yield curves for GB Making GB trading more efficient The total supply of tradable domestic bonds in China at the end of June 2003 was RMB 3.4 trillion (US$ 411 billion). Table 2 shows the details. Table 2. Supply of Tradable Bonds in China (end June 2003), in RMB billion Type of instrument Total of which: Bonds traded in the IM 2,740 GB 1,480 Policy bank bonds (mainly CDB) 1,020 Central Bank Bills 240 Bonds traded in the stock markets GB CB 32.7 Bearer bonds traded in the OTC 300 Total 3,403.5 Source: PBOC, China Monetary Policy Report, Q2, 2003, except for the number for Bearer bonds, which is the author s estimate. The aggregate supply of tradable bonds at the end of June 2003 was the equivalent of about 32% of GDP. In developed market economies, this number is around 100%. Although the volume of new issues and market turnover has increased sharply and the regulatory framework has been improved, China s GB market remains fragmented and thin. The negative consequences of market fragmentation and unequal standards are getting government attention and are subjected to corrective policy action. The World Bank Group is providing technical assistance to China in these matters. There is room for further improvement: 11 1) The three kinds of GB (a) book-entry bonds (held by financial institutions and traded in the 10 PBoC statistics. 11 Some of the suggested changes are based on a Conference Report by Justin Sommers dated 9 May 2002 on the conclusions of a conference sponsored by the Asia Society on Investing In China s Capital Markets: Where Will WTO-Sparked Reforms Lead?, and on Takeshi Jingu, Moving Forward in Reforming China s Capital Market. Nomura Research Institute paper No. 40, 1 January Perspectives, Volume 6, No. 2, June 30, 2005 Page 15 of 66

6 IM and the stock market), (b) Certificate bonds (held by individual investors and, since February 2002 tradable in the stock market), and (c) Bearer bonds (held by individual investors and enterprises, and tradable in the OTC market) can be merged into one single or at most two instruments. This will facilitate market integration while improving transparency and liquidity. 2) Since the ban on commercial bank lending to securities firms and trading on the domestic stock exchanges (1997) there have been three separate markets for GB: the IM, the stock market and the OTC market. The scope for arbitrage between these markets is widening, but further measures could promote further market integration. For example, new GB issues could be sold in a single auction to which all market participants have access. 3) Regulation and supervision of the GB market is divided between three agencies: MOF for new issues, the Central Bank for trading in the IM and CSRC for trading in the stock markets. A harmonization of policies and standards would contribute to market integration and transparency. 4) Clearing and settlement processes for stock exchange trading remain inefficient, which reduces liquidity. Liquidity is especially important for institutional investors. As market participation by institutional investors is growing, there is a need to streamline relevant procedures Interest Rate Liberalization and GB Yields China s interest liberalization is progressing gradually, but full interest liberalization cannot be adopted because important parts of the financial system remain undercapitalized or otherwise unreformed. Premature full liberalization of all rates could lead to unhealthy price competition damaging bank earnings and triggering massive SOE bankruptcies. This also means that China cannot afford to further open its external capital account until domestic financial sector reform has been substantially completed. Furthermore, full liberalization requires meaningful benchmarks in the bond market. Therefore, as long as interest rates in China remain essentially government controlled while there is no adequate supply of short maturity GB, yield curves for such bonds cannot be used as a guide for the pricing of other instruments such as CB (benchmarking). Chart 2. Yield curves for Chinese GB (RMB) and US Treasuries (US$) traded on 7 Oct RMB US$ Yield in % Years to maturity The typical yield curves for Chinese GB and US Treasuries are compared in Chart 2. The data is for actual market transactions on 7 October 2003 as reported by Bloomberg. The yield curve for Chinese GB is relatively flat, reflecting that interest rates are government controlled and that Perspectives, Volume 6, No. 2, June 30, 2005 Page 16 of 66

7 there is little or no correlation between coupon rate and the year to maturity for Chinese GB. The US Treasuries, on the other hand, show a yield curve that rises with years to maturity, as expected in a developed capital market. The abnormality of yield curves for Chinese GB suggests that the financial system is vulnerable to inflation. III. Domestic Corporate Bond (CB) Market Internal corporate savings are the most important form of enterprise investment financing in China. Of the intermediated funds used for enterprise investment (on average in recent years), about 95% has come from bank loans, about 4.5% from share issues and about 1% from enterprise bond issues. China s corporate bond (CB) market remains small and under-developed. Chart 3 shows the amounts raised through the domestic stock exchanges and through CB from Chart 3. Funds raised through domestic share and corporate bond (CB) issues in RMB bn A. Domestic share issues B. Domestic CB Issues Sources: Shanghai and Shenzhen stock exchange reports and CSRC. From 1984, some enterprises were allowed to issue CB. In 1992, the amount of CB issued (mostly by locally owned SOEs) reached an all-time record of RMB 68 billion. It was part of the widespread financial sector irregularities that contributed to overinvestment and high inflation at that time. In 1993 the responsibility for controlling new CB issues was given to the State Planning Commission, which tightened the quota system. Since 1993, the market for CB has been reserved for large, centrally owned SOEs. After the opening of the Shanghai and Shenzhen stock exchanges in 1990, new CB issues began to decline relative to stock issues because SOEs preferred to issue stocks over selling bonds. But this perception began to change when stock prices began to fall in 2001 and regulation and supervision of capital markets was improved. When new stock issues dropped in 2001 and 2002, CB issues rose from RMB 4.9 billion in 2000 to RMB 35.5 billion in During the three-year period nineteen SOEs sold a total of RMB 58.3 billion bonds in 31 separate issues. 12 All CB except CITIC s are guaranteed by another agency of the state or a state-owned bank; and not by the government. Maturities range from 3 to 20 years. Coupon rates are generally 150 to 250 basis points higher than the state-mandated 1-year bank deposit rate. As 12 Among the prominent SOEs that have been allowed to issue bonds in recent years are the Three Gorges Corporation, Shanghai Baosteel, China Mobile, CITIC, China Ocean Shipping, China Guandong Nuclear Group and the State Power Corporation. The Three Gorges Corporation accounts for almost one quarter of new issues since Perspectives, Volume 6, No. 2, June 30, 2005 Page 17 of 66

8 in the case of GB, the relative illiquidity of CB reflects a supply scarcity and fiscal discrimination against spot trading. Chart 4 shows the 31 CB issued during We can see that there is no clear relationship between CB maturity and coupon rate, an anomaly also observed in China s GB market. Chart 4. Maturity and Coupon Rate of Corporate Bonds Issued in years to maturity coupon rate CB maturity in years and coupon rate in % CB issues during Source: China Chengxin International Credit Rating Co., Ltd. Almost all listed CB carry a domestic AAA credit rating (a few bonds are rated AA or AA+ 13 ) reflecting the presumption of a government guarantee. At the end of 2003, there were four domestic credit agencies focused on corporate bonds, of which Chengxin (a JV between Chengxin, Fitch and IFC) is the best known 14. None of them is truly independent and their ratings are largely irrelevant in the market. CB issues continue to be rationed by the National Development and Reform Commission, successor to the State Planning Commission. This somewhat atavistic arrangement reflects that financial market reforms in China are not yet complete and that direct state influence on financial markets remains strong. Emerging corporate financial needs, both in the state and non-state sectors, require significant broadening and deepening of the CB market. It is a fortunate coincidence for China that this corporate need is mirrored in the sharp increase in domestic market demand for CB. Since the decline of equity prices in China from the middle of 2001, individual and institutional investors have been eager to diversify their portfolios into CB (as well as GB). Anecdotal evidence suggests that people are willing to wait many hours in line to buy CB. IV. Lower-level Government Borrowing Lower level governments in China are officially required to balance their budget without borrowing from multinational development agencies such as the World Bank and ADB. However, many local governments do borrow, usually indirectly, through corporations or agencies. They 13 Source: China Chengxin International Credit Rating Co., Ltd. 14 The four agencies are: Chengxin, Dagong, Lianhe and Shanghai Far East. All of them are struggling financially because there are so few bonds to be rated. Source: Scott Kennedy, China s Languishing Credit-Rating Industry: Canary in the Mine? Mimeo. Indiana University, Perspectives, Volume 6, No. 2, June 30, 2005 Page 18 of 66

9 borrow mostly from banks, but also by issuing informal local bonds. Many local governments borrow unofficially also from workers, pensioners and suppliers in the form of arrears in wagepension- and/or bill payments. There is clearly a need for the development of official, non-sovereign provincial and municipal bonds. The current ban on such instruments is increasingly in conflict with lower level government needs for infrastructure financing in a large, diversified market economy with a great deal of decentralized economic decision making. As is the case of CB, the development of provincial and municipal bonds will require a legal and regulatory environment and independent rating agencies. Local government access to domestic capital markets could be regulated such that the system promotes and rewards fiscal responsibility. 15 On the demand side: institutional investors need access to a broader range of bond types and bond yields than currently available in the domestic Chinese market. V. Debt Markets and NPL Resolution Although the precise magnitude is hard to assess 16, China s NPL-related contingency debt is certainly enormous. Officially reported NPL-ratios have been dropping since the end of For example, the four large state-owned commercial banks, which in 2002 accounted for nearly 70% of all bank deposits and over 60% of bank loans, had an aggregated NPL ratio of 29.9% in December 2001, then dropped to 26.1% in December 2002, continued to 21.3% in September and finally dropped to 15.2% in December PBoC set an NPL ratio target of 15% for the four banks at the end of 2005, which was achieved at the end of This ratio may permit the full recapitalization of state-owned commercial banks to precede or coincide with the complete opening of China s financial markets for foreign banks under WTO accession terms at the end of However, the most important factor of the fall in aggregate NPL ratios is the dilution due to loan portfolio growth. Therefore, there is no guarantee that the ratios will not rise again in the future. Capital markets, in particular debt markets will have to play a central role in NPL resolution The Role of State-Owned Asset Management Companies (AMCs) In the wake of the Asian financial crisis of 1997/98, China created four state-owned asset management companies (AMCs) to assist in NPL clean up. The AMCs are mandated to dispose of their NPL portfolios and wind up their business within ten years after their establishment. In 1999 and 2000 the four large state-owned commercial banks and the China Development Bank 15 Australia offers an interesting example of a well regulated and highly developed market for local Government bonds that might be of interest for China. 16 China s loan classification system for commercial banks was changed in 2001 from four categories (normal, overdue, doubtful and bad) to five (performing, special mention, substandard, doubtful and loss). Moreover, the old system was primarily backward looking while the new system is primarily forward looking. This makes it difficult to compare the NPL ratios before and after the system change. The Central Bank assigns loan recovery probability rates, but the banks determine themselves in which category each of their outstanding loans falls. Actual recovery rates are unpredictable and vary with changing circumstances and with collection effort. 17 It should be noted that by the end of 2003, none of the four large state-owned commercial banks had been audited by international auditors to international standard. CCB engaged KPMG for that purpose in the course of Independent economists have suggested that NPL ratios in China may be higher than officially reported by the banks themselves. 18 After an additional write off of NPLs by BOC and CCB following the transfers of $45 billion ($22.5 billion each) by PBoC to those two banks on to strengthen their capital base. Perspectives, Volume 6, No. 2, June 30, 2005 Page 19 of 66

10 (CDB) transferred RMB 1.4 trillion worth of NPLs (about US$ 169 billion) to the AMCs. 19 It is unclear exactly how these NPL purchases were financed. Researchers from the Bank for International Settlements (BIS), using available information, suggested that the purchase was financed by (1) Equity capital (cash) provided to the AMC by MOF 3 %; (2). Low-interest PBoC credit 14 %; and (3) Low-interest 10-year AMC bonds 83 %. 20 The 10-year non-tradable AMC bonds - the largest components of the financing package - are not the same as sovereign bonds, because Chinese law forbids MOF to grant formal guarantees to SOEs (which all four AMCs are). At the same time, the AMCs cannot realistically expect to recover more than about 20% of the NPLs in cash or equivalent, so AMCs will inevitably end up with large losses that the state will have to cover one way or another. NPL disposal takes various forms, including debt/equity conversion, debt rescheduling, debt recovery through legal action and NPL sales to both domestic and foreign buyers through auctions and otherwise. Debt/equity conversions have been carried out through the issuing of shares valued by the AMCs (for accounting purposes) at the same level as the nominal value of the NPL exchanged. A total of 580 SOEs were selected for the conversion of RMB 405 billion of NPLs (almost 30% of the total amount transferred to AMC) into equity. This has two undesirable side effects: (1) transferred shares are not tradable at the conversion price, which means that AMC assets are overstated on their balance sheet; and (2) the resulting enhanced profitability of participating SOEs (due to a lower interest burden) is more apparent than real. 21 Debt-for-equity conversions have undoubtedly an important role to play in NPL clean up, but if the purpose is to enhance financial sector transparency, transactions must be market-based. For a lasting solution of the NPL problem it is extremely important that such assets are tradable at market value. The AMCs have also been active in disposing of NPLs through loan recovery and cash sales. Table 3 shows accumulated cash recovery results at the end of March Since the best assets were presumably marketed first, it is likely that cash recovery rates will fall over time. The sale of NPLs will accelerate as experience is gained and as the two recently approved JVs (between Huarong and Goldman Sachs and Huarong and Morgan Stanley Dean Witter) for NPL clean-up enter the market. Most NPL sales have been domestic. Huarong organized an international auction in 2001, which was a qualified success. Huarong s second international auction, held in December 2003, attracted only a few buyers and cash recovery rates fell to less than half those of the first international auction. Table 3. Cash recovery by AMC through the end of March 2003 AMC NPL disposed (RMB billion) Cash recovered (RMB billion) Cash recovery rate (percent) 1. Huarong (ICBC) Greatwall (ABC) Orient (BOC) Cinda (CCB/CDB) Totals (average) Source: 19 The four AMC are Huarong (for ICBC NPLs), Orient (for BOC NPLs), Great Wall (for ABC NPLs) and Cinda (for CCB and CDB NPLs). 20 Guonan Ma and Ben S.C. Fung, China s asset management corporations. BIS Working Paper No. 115, August Edward Steinfeld, China s Problem of Debt-Equity Swaps: Government Failure of Market Failure? Harvard University conference paper (unpublished) Perspectives, Volume 6, No. 2, June 30, 2005 Page 20 of 66

11 5.2. Changes in the State Bank Loan Portfolios State banks are trying to improve the quality of their portfolios through lending to non-state customers for non-traditional purposes. In 2002, SOEs received only about half of the net increase in lending by the four major state-owned commercial banks. Consumer loans, mostly for mortgage loans for housing and car financing, along with forex lending to foreign invested companies 22, are seen as important vehicles for loan portfolio strengthening. Private car ownership in China is growing at 30-40% per year and some of this extraordinarily high rate of increase is due to new consumer loan options. Private ownership of housing in major cities has also become common. In Beijing and Shanghai 65% and 62% of the households now own their homes 23, already higher than the 50% rate in Hong Kong. As a result, mortgage loans accounted for over 10% of the portfolios of the major state commercial banks at the end of Once tradable mortgage-backed securities are developed in China, domestic debt markets will see a quantum leap in volume and depth. It remains to be seen whether the increase of the share of consumer loans and mortgage loans in the portfolios will improve the overall quality of state banks portfolios. China s credit culture, though improving, is still far from what it ought to be. There have already been problems with collecting car loans and mortgage loans. Since repossession and foreclosure laws in China are weak or unenforceable, the actual result of bank efforts to reduce NPL ratios through shifting away from traditional SOE customers is unclear. 5.3 Recapitalization of State Commercial Banks A massive up-front recapitalization of the four large state commercial banks is not necessarily the best option, because it creates adverse selection and moral hazard problems. It will reduce bank s incentives to collect delinquent loans and to strengthen their capital base through other internal efforts. Therefore, recapitalization of these banks should be tailored to the needs and circumstances of each bank. In some cases it may be better to delay full recapitalization; in other cases bank closure or breakup may be preferable to recapitalization. On the last day of 2003, PBoC transferred US$45 billion (in dollars) from China s official foreign exchange reserves to two state commercial banks CCB and BOC ($22.5 billion each) -- that were preparing for listing. This transaction was made through a new state-owned financial holding company created for this purpose. This transaction should bring the capital adequacy ratio (CAR) of both banks close to or even above the minimum 8% Basel requirement and facilitate the listing. At the moment of writing it is not exactly clear on what terms this large amount of capital has been made available to the two banks. Nor is it clear when in the future, and at what exchange rate, the foreign exchange will be converted into local currency on the balance sheet of the two banks. This transaction is unusual and raises important questions about the extent to which China s large foreign exchange reserves can be used for the recapitalization of domestic banks and other enterprises. Before this recapitalization from foreign exchange reserves of BOC and CCB, most observers expected that the bulk of financial resources needed for recapitalization would have to come from 22 Domestic forex lending by state banks has increased so rapidly in recent years that the market share of foreign banks in this line of business declined from 15 percent in 2001 to only 7.4 percent in Financial Times, 9 September Quoted in the Far Eastern Economic Review of 14 August, Perspectives, Volume 6, No. 2, June 30, 2005 Page 21 of 66

12 the state budget (taxes) or from the proceeds of the sale of state assets, in particular state-owned shares in listed SOEs. The government and agents of the state together own about two-thirds of the shares of SOEs listed in Shanghai and Shenzhen. 24 These shares are now non-tradable, but they represent a vast amount of (theoretical) market value. The problem is that these shares, even if they were made legally tradable, could not be sold in the open market without a significant drop in share values. 25 This is a dilemma for the government. It may be possible, however, to mobilize the (theoretical) value of such shares by using them as backing for bonds or second tier Tracker Fund-type shares. 26 This approach could facilitate the absorption of NPLs through the market. Another possibility might be to allow the AMCs to issue asset-backed bonds or convertible bonds to purchase additional NPLs from the state banks and achieve their partial recapitalization this way. The amount required to solve China s twin financial problem NPLs and state bank recapitalization is very large relative to the country s GDP. In principle, it does not matter whether the NPL problem is solved through the sale of state assets, through their use as collateral for bonds, or through additional taxation. In practice, however, because China s state-ownership in the economy remains too large, it does make a difference. The Chinese state can make the economy more efficient and solve a lot of internal public debt problems, by further reducing its ownership in the economy. VI. Concluding Remarks In summary, China s bond markets have grown large, but they remain segmented. Bond markets are dominated by GB and underdeveloped in other respects. The secondary market for GB is dominated by repurchase contracts (repos); the spot market is relatively small. Because of China s growing fiscal deficits and the needs of a growing number of institutional investors, both the primary and secondary GB markets are likely to grow fast and the range of offered maturities is likely to widen in the coming years. At the same time, the government should accelerate the liberalization of domestic interest rates to ensure a more efficient allocation of capital and to permit a normalization of yield curves for government bonds needed for benchmarking purposes. The most urgent need in the domestic debt market is to promote primary and secondary markets for corporate bonds (CB) and to extend issue rights for such bonds to non-state corporations. The high dependency of many Chinese corporations on bank credit is potentially dangerous as lending rates are gradually being liberalized. If equity prices in China remain depressed relative to Chinese expectations, 27 a significant portfolio shift from stocks to bonds will occur if the supply of appropriately priced GB and CB is expanded to meet the demand. To increase the supply of new issues of CB, the government should relax restrictions and quotas and permit selected non-state companies and selected 24 In addition, the State owns shares in SOEs that are incorporated in China and listed in Hong Kong (H shares) and shares in Chinese firms that are both incorporated and listed in Hong Kong (red chips). 25 The State-owned Hong Kong shares present no serious problem in this regard, because Hong Kong shares are not overvalued like Shanghai and Shenzhen shares, while non-chinese buyers have free access to the Hong Kong market. 26 The Hong Kong Tracker Fund was established to dispose of a large amount of shares purchased by the Hong Kong Monetary Authority on the Hong Kong Stock Exchange in 1998 to counter speculative attacks on the currency during the Asian financial crisis (see 27 They are only depressed relative to 2000 and the first half of 2001 when P/E ratios were typically over 50; they are not depressed relative to the prices of sister H-shares listed in Hong Kong and P/E ratios, though much lower than a few years ago, are still generally above 30. Perspectives, Volume 6, No. 2, June 30, 2005 Page 22 of 66

13 provinces and municipalities to issue bonds in the domestic market to facilitate the financing of local infrastructure. At the same time, the development of a healthy and active bond market in China will require an effective bankruptcy law, reliable and efficient courts to implement and enforce the law, effective foreclosure procedures, truly independent credit rating agencies and significant further improvements in disclosure and accounting standards. A complete legal framework for developing China s bond markets is still lacking. This is an opportune time for China to quickly expand the domestic for non-gb, especially CB. China s non-bond debt markets began to emerge only recently. They are limited to recycle the non-performing loans by four state-owned AMCs and two associated joint ventures. A secondary market for other non-bond debt instruments such as trade bills and receivables does not yet exist. Direct loan sales by the banks should also become possible. Debt market development is also needed to facilitate the process of NPL clean-up. State bank recapitalization will require vast amounts of real resources. There is room for a more imaginative use of the large pool of state-owned non-tradable SOE shares for recapitalization purposes. The creation of asset-backed bonds and Tracker Fund-type second tier equities could facilitate NPL absorption in the economy. There are potentially significant synergies between debt market development, NPL resolution and market-oriented economic reforms in general. On the demand side, the rapid growth of China s institutional investor base and their projected expansion assures that a much wider range of debt instruments will be readily absorbed by the market. Debt market development and interest rate liberalization in China will at the same time facilitate the development of equity markets and permit the gradual further opening of the capital account. (This paper was written in the fall of 2003, updated in early 2004 and edited by Perspectives staff. The author served as Chief of the World Bank s Resident Mission in China from 1993 to He teaches graduate courses on China s economy at Johns Hopkins University.) Bibliography Bloomberg, China Chengxin International Credit Rating Company, China Development Bank, Annual Report for CSRC, Green, Stephen. China s Stock Market:. A Guide to Its Progress, Players and Prospects. The Economist Jingu, Takeshi. Moving Forward in Reforming China s Capital Market. Nomura Research Institute paper no. 40, 1 January Kennedy, Scott. China s Languishing Credit-Rating Industry: Canary in the Mine? Mimeo. Indiana University Kim, Yongbeom, et. al. Developing Institutional Investors in People s Republic of China. World Bank Country Study Paper, September Kumar, A., et. al. China s Emerging Capital Markets. FT Financial Publishing Asia Pacific, Lin, Shuanglin. China s Government Debt: How Serious? China: An International Journal, Vol. 1, No. 1, March Perspectives, Volume 6, No. 2, June 30, 2005 Page 23 of 66

14 Ma, Guonan, and Ben S.C. Fung. China s Asset Management Corporations. BIS Working Paper No. 115, August Mehran, Hassanali, et. al. Monetary and Exchange Rate Systems in China: an Experiment in Gradualism. IMF Occasional paper, No. 141, Ministry of Finance (China), Annual Financial Yearbook. Moody s Investors Service, China Banking System Outlook, October OECD, China in the World Economy. The Domestic Policy Challenges. Paris 2002 People s Bank of China, China Quarterly Monetary Policy Report, Shanghai Stock Exchange, Sommers, Justin. Investing in China s Capital Markets: Where Will WTO-Sparked Reforms Lead? Asia Society Conference Summary 2002, Steinfeld, Edward. China s Problem of Debt-Equity Swaps: Government Failure or Market Failure? Harvard University (unpublished conference paper) Perspectives, Volume 6, No. 2, June 30, 2005 Page 24 of 66