Financial Services Special Report: Demystifying China s Bond Market

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1 March 2016 Financial Services Special Report: Demystifying China s Bond Market SUMMARY China s onshore bond market has grown six-fold over the past decade. Standing at RMB43tn (USD6.7tn), it is now the third largest bond market in the world. There is still significant room to grow as China seeks to diversify risks in the financial system, liberalise access, and continues with the local government debt-bond swap programme. Further development of the bond market has been prioritized by the Government in the Five-Year Plan and if reforms are successfully delivered, the market could triple in size to RMB120tn (USD20tn) by 2025, creating vast opportunities for both domestic and international investors. China Economics Network For comments, suggestions, questions, please contact us: Sean Zhou, Financial Policy Advisor, British Embassy Beijing Kunal Khatri First Secretary Financial and Trade Policy, British Embassy Beijing The Landscape: Size, Category and Structure At RMB 43tn (USD6.7tn), China s bond market is the third largest in the world. However, China s bond market remains small relative to its GDP (Fig 1) and to total credit in the financial system (Fig 2). This is principally due to strict regulations and high thresholds in terms of financial soundness and credit performance of issuers. Fig 1: China's onshore bonds outstanding/nominal GDP 2015 Q1; Source Haver Analytics, Asia Bonds Online Fig 2: Total social financing outstanding (RMB tn); Source, Gao Hua Securities Research China has three bond markets: the interbank-bank bond (IBB) market, the exchange bond market, and the Overthe-Counter (OTC) market. The IBB market is the overwhelmingly dominant market, accounting for more than 90% of total trading volume. Within these three markets, there are five main categories To view of bonds. previous These editions, are listed below in order of importance to (rather than size in) the Chinese bond market: please visit: Treasury Bonds - issued and listed in IBB market by Ministry of Finance (MoF), these bonds are traded in all three markets and represent around 25% of total outstanding bonds across the entire market. Historically, MoF has issued long term bonds (5-7 years) rather than short-term bonds (<1yr) which has made it difficult for the market to price risk across other segments of the market. Recently however, MoF (and the PBoC) has started to actively issue short-term (3 month) bonds to help develop an RMB market based interest rate,

2 partly in response to IMF recommendations through their review of inclusion in the Special Drawing Rights. Local Government/Municipal Bonds issued and listed in the IBB market by China s local governments, these bonds are traded in all three markets and account for around 7% of total outstanding bonds (see below for further details on this market). Financial Bonds issued and listed in IBB market by China s policy banks, commercial banks and other nonbank financial institutions, these bonds are traded only in the IBB market. Financial bonds issued by policy banks account for the largest share of the bond market at around 26% (Fig 3). Typically rated in the same band as treasury bonds. Central Bank Notes - short-term securities issued and listed by the PBoC in the IBB market as tools for monetary policy, these securities are traded only in IBB market. The short maturity of Central Bank Notes also makes them very popular instruments in money market for liquidity management, and as such they are currently the most actively traded bonds. Non-financial Corporate Bonds - a broad category that includes enterprise bonds issued by institutions affiliated to central government and large State Owned Enterprises (SOEs), normally with maturity of 5+ years. Other bonds in this category with shorter maturities include commercial papers (<1 year) and corporate bonds (1<, <5 years). Bonds in this category are mostly issued, listed and traded in the exchange market, and account for a small part of the entire bond market in terms of both size and trading volume. Fig 3: Size of various bond categories in the China market (Dec 2014); Source - Wind Regulation of the onshore bond market cuts across five different institutions (see Fig 4). The division of responsibility adds a significant degree of complexity for international investors and firms seeking to capitalise on onshore bond market opportunities. Market Type Regulator Interbank Bond Market Exchange Bond Market CSRC Over-The-Counter Market Bond Type Regulator Government Bonds Treasury and Local Government Bonds, MOF Central Bank Notes Policy Bank Bond Financial Bonds Commercial Bank Bond; Non-bank institution bond CBRC, Securities Firm Bond CSRC, Enterprise Bond NDRC, Non-Financial Bonds Medium Term Notes, Commercial Papers NAFMII, International Institution Bond, MOF, NDRC Corporate Bond CSRC Fig 4: Regulation of China s bonds markets, Source China Bond; : People s Bank of China; MOF: Ministry of Finance; CSRC: China Securities and Regulatory Commission; NDRC: National Development and Reform Commission; NAFMII: National Association of Financial Market Institutional Investors;

3 Local Government Bond Market Over the last 10 years, local government debt has increased substantially in order to finance infrastructure and capital spending. Total local government and city investment debt stood at around RMB16tn in 2015 (the latest government audited figures), approximately 40% of the current total size of China s bond markets. Prior to 2015, local municipalities were not permitted to raise debt themselves through the bonds market. Instead debt was realised through special purpose off-balance sheet instruments. Chinese local government finance is undergoing significant reform as it shifts towards direct market financing to improve transparency and efficiency, and removes the central government implicit guarantee. The Ministry of Finance leads on this reform programme and plans to swap all RMB16tn of local government debt into bonds over the coming years. The 2015 swap program amounted to RMB 3.8tn, with the subscribers mainly being large Chinese commercial banks. The market expects the annual swap quota for 2016 to be above RMB 4tn. In addition to this, since 2015, all provincial-level local governments have been allowed to issue new bonds. There are nonetheless three key challenges facing the market. Firstly, varying degrees of information disclosure, and different local practices across the country, making it difficult for investors to accurately price risks. Many are simply continuing in the expectation of implicit central government guarantee for local government bonds. Secondly, due to limited issuance at this stage and a lack of investor diversity, local government bond liquidity remains low, hampering the development of yield curves. Thirdly, local government bonds come with a lower nominal interest rate than the short-term bank loans that commercial banks had previously lent. In effect, the swap represents a hair cut for those banks. Foreign Participation: Investment and Issuance Investment China s onshore bond market has historically offered very attractive fixed-income investment opportunities to global investors. In particular, investors have been attracted by: (1) higher onshore interest rates compared to other major markets (see Fig 5), (2) a belief that a strong sovereign credit rating effectively stands behind the majority of bonds in the market, until last August (3) a strong and consistently appreciating RMB. Despite rapid growth in recent years, foreign investment in the Chinese bond market remains small. As of 2015H1, foreign institutional investors accounted for only 3% in the IBB market, with holdings of outstanding bonds less than 2% of total. This is due firstly to concerns over fiscal transparency and differences between Chinese technical standards and international practices on accounting, auditing and credit ratings. Secondly, uncertainty about the RMB exchange rate has led foreign investors to focus on the shorter maturities end of the market. Finally, lingering capital controls that hamper liquidity and the lack of risk management tools such as repos, futures and forwards, especially foreign private investors, has deterred investors. In February this year however, the announced a bold new initiative to fully open up its IBB market to foreign medium and long-term private investors, and most importantly, without the use of quotas. As of last year only foreign sovereign wealth funds, central banks and international financial institutions had enjoyed such access. Now, foreign private investors such as commercial banks, insurance companies, securities firms, asset management firms, pension funds, charity funds and endowment funds will all have quota-free access to China s IBB market. Issuance In addition to allowing greater foreign investment, China has been actively promoting its onshore bond market as a destination for foreign issuers to raise RMB funds through panda bonds. Panda bonds are RMB-denominated debt financing instruments issued by foreign entities in China s financial markets in different kinds (e.g. commercial paper, medium-term notes) and maturities through either public or private placement. First introduced in 2005, the panda bond market has been slow to take off. This was due to restrictions on the onshore interest rate and the inability to repatriate funds. In addition, comparatively lower offshore interest rates as well as RMB appreciation made it less costly to raise RMB offshore (see dim sum bonds below). However, a series of policy changes last year have made panda bonds much more attractive and led to a spate of issuances. HSBC (in

4 Hong Kong), Bank of China (HK), Standard Chartered (HK), Bank of China (HK), China Merchants Holding (HK), Province of British Columbia, and Republic of Korea all issued panda bonds at the end of In particular, a simpler regulatory process, greater flexibility on repatriating funds, and a weaker trajectory for the RMB have increased the appeal of panda bond to foreign fundraisers in need of RMB funds. The dim sum bond market remains an important part of the RMB bond market. Dim sum bonds are RMB denominated assets that are issue onshore, and since their launch in 2007, have provided a popular means for foreign companies to access RMB denominated assets. London s leading role in the dim sum market was bolstered by last year s issuance of PBoC central bank bills and Agricultural Bank of China s (ABC) issuance of green RMB bonds. Both were multiple times oversubscribed and are important milestones in helping to develop RMB bond yield curves in the offshore market. At last year s State Visit, the Chinese Ministry of Finance also committed to issue a sovereign bond in London, its first such issuance offshore. The offshore RMB bond market will retain its appeal but will face tougher competition from the panda bond market this year, not least if the RMB continues to weaken. Future Prospects On current trajectory, by both outstanding and trade volume, China will soon overtake Japan to become the World s second largest fixed income market. New supply will be driven by further local government debt-bond swaps, fund-raising to finance China s strategic initiatives (AIIB and OBOR), as well as ongoing corporate and panda bond issuances. On the demand side, volumes will be in part driven by international investors seeking to diversify investment portfolios into RMB assets and away from equities into fixed income assets. RMB s inclusion into the SDR basket whilst not an immediate catalyst for greater investment (except for a handful of institutions with SDR balance sheets) is nonetheless an important recognition of China s reforms to date and trajectory on market liberalisation. Future decisions by major index providers (MSCI in particular) to include the Chinese bond and stock indices would further boost foreign investment. Bond market development has been prioritized by the Government through the Five-Year Plan, with key priorities identified as broadening market access, improving information disclosure and technical standards, and opening up to foreign participation. If further reforms are successfully delivered, Goldman Sachs forecast that the market could triple in size to RMB120tn (USD20tn) by There are nonetheless risks associated with China s evolving bond market. Phasing out of the implicit government guarantee and the defaults that might follow could cause shocks to the market if poorly managed. An increase in the non-performing loan ratio in the banking sector could pose, or be seen to pose, systemic risk, and affect the appeal of China s bond market. There also remains the risk that reform appetite for further capital account liberalisation cools as greater volatility enters the market. Opportunities for the UK The development of China s bond markets provides significant new opportunities for UK bilateral engagement, and commercial opportunities for foreign investors and services providers. The UK has taken the lead to establish London as the world s leading offshore RMB bond market, and the Embassy, FCO and HMT are leading a number of initiatives to build on that foundation. Last year s issuance in London of central bank notes by PBoC and first ever RMB green bonds issued outside Greater China by Agricultural Bank of China, set important benchmarks for further market activities. We are continuing to work closely with MoF to assist in the first ever RMB sovereign bond issuance in London, and a first outside Greater China. We are also sharing UK expertise with MOF to help develop and open up the local bond market. London s strength in foreign exchange (FX) business also provides significant commercial opportunities as China s bond markets develop. In particular as foreign investors enter the onshore market, there will be increased demand for offshore RMB FX tools such as derivatives and structured products. Furthermore, the China Foreign Exchange Trade System (CFETS) has committed to open an office in London which will help establish connections between London and the IBB market.

5 The onshore opening up of IBB market will unlock significant intermediary business opportunities for UK banks and firms seeking to raise capital. This is particularly so for those banks that have obtained bond-underwriting licences. With strong overseas networks and local capacities to run trading, custodian, settlement and other agency businesses, UK financial services firms stand to benefit from increased inward investment. UK firms seeking to raise RMB funds will have increased opportunities through the panda bond market and we are supporting ongoing efforts by NAFMII and the International Capital Markets Association to educate firms and investors on these opportunities. At the same time there will be increased demand for advisory services on regulation, technical standards, and legal issues to the benefit of leading global professional services providers

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