ChinaÆs immature bond market is impeding growth

China urgently needs to fix its bond markets, argues Standard Chartered Bank's China economist, Stephen Green.
At the National PeopleÆs Congress March 5, 2007, Premier Wen Jiabao told delegates that his government would accelerate the development of ChinaÆs debt market. This is a major challenge û and now we believe a priority for reform of ChinaÆs financial system.

In dollar terms, ChinaÆs official debt market is already the largest in ex-Japan Asia. By the end of 2006, outstanding government and semi-government debt totalled $665 billion, accounting for 42% of ex-Japan AsiaÆs official market.

However, measured in other ways, the market is still small. In terms of its significance for the local economy, it is one of the least important in Asia. Put aside official debt, and the market shrinks to a fraction of its former self. In addition, ChinaÆs bond market is still illiquid and is being held back by poor regulatory co-ordination.

This lack of bond market development is delaying important progress in other parts of the financial system, particularly interest rate reform. But there is growing recognition within government of the urgency of the problems faced and stirrings of substantial reforms. We think some of these problems will be addressed during 2007-08 û and the marketÆs potential should start to be realised.

More a mouse than an elephant

A first glance suggests that ChinaÆs debt market is large. The outstanding face value of all bonds and central bank bills at the end of December 2006 was CNY 9.2trn ($1,179 billion). Although not of the scale of developed markets (the US Treasury market alone is currently worth about $4,000 billion), this compares favourably with the rest of Asia (e.g. Indonesia $60 billion, Malaysia $125 billion, Singapore $185 billion etc.). Appearances are a little deceptive though.

PeopleÆs Bank of China (PBoC) bills, which are used to sterilise inflows of foreign exchange, rather than to raise finance, accounted for 35% of the entire market at year-end 2006, up from 0% in 2002. These are usually short-term instruments (i.e. less than one year) and are not designed for fund-raising purposes, so do not count as bonds. Subtracting PBoC paper, ChinaÆs bond market shrinks to some CNY 5,990 billion ($767 billion) outstanding at year-end 2006. This is still large compared to most other Asian markets in dollar terms. But relative to the size of its economy, ChinaÆs official bond market is small, only adding up to 14% of GDP at year-end 2006. The average Asian economy had an official bond market worth 28% of GDP. That means that ChinaÆs bond market is smaller than IndiaÆs, MalaysiaÆs, the PhilippinesÆ, SingaporeÆs and South KoreaÆs. Even Thailand and Indonesia give it a run for its money. Chart 1 shows ChinaÆs official market compared to its Asian peers.

The market is only growing slowly too. In 2006, bond market capitalisation grew by less than one percentage point of GDP, whereas in the previous three years the average rate of growth was 2ppts û already not exactly a blistering pace. Why is this happening? One reason is that Ministry of Finance (MoF) issuance has dwindled since its high point in 2003, as fiscal revenues have ballooned (and social spending, despite the official rhetoric, has not grown as a proportion of GDP).

The third reason why ChinaÆs bond market is actually small is that the official market is just about all there is. This is not unusual in the region. SingaporeÆs corporate bond market is an exception, and is worth some $90 billion (65% of GDP). Thailand has done well too, building a market worth $22 billion (9% of GDP), but Indonesia and the Philippines have markets worth only 2% and 1% of GDP respectively.

ChinaÆs corporate debt market, dominated by state entities (non-government entities have a really hard time issuing debt), is also only worth $36 billion (1% of GDP). Chart 2 shows the dominance that bank lending has over firmsÆ external financing in China. Despite the expansion of the debt market, firms still found 78% of their external financing from the banks in 2006. There are many well-known problems in ChinaÆs corporate market, including the annual issuance quota, a bureaucratic authorisation process and the need for bank guarantees.

Size is not the only problem û the market also lacks liquidity. Chart 3 shows the æturnover ratioÆ for official government bonds, defined as the annual (cash-) trading volume divided by the outstanding value of those bonds for a number of markets, including ChinaÆs Shanghai Stock Exchange and inter-bank bond markets (China has two active markets, in addition to the retail market where bonds are sold over the counter at banks; the IBM market is bigger and more liquid). This is a basic measure of bond market liquidity. China does not fare well. The IBM turnover ratio of 1.2 in 2006 outperforms Indonesia, but is below that of Malaysia and Thailand. The difference with more mature markets is even more stark û SingaporeÆs turnover ratio is 5.4, while Hong KongÆs and United StatesÆ (not pictured since they would distort the graph) are 35 and 38 respectively.

This has important implications. If there is no trading, there will be no prices and with no prices, there is no yield curve. This has big implications for other bits of ChinaÆs financial market. How is a bank supposed to price a three-year loan if it has no reference point on a risk-free curve? And without this ability how can the PBoC feel comfortable to let the banks try setting their own rates? In other words, without success in promoting a liquid bond market, interest rate reform for the banks is stuck. The same thing goes for corporate debt.

Why the liquidity drought? We think there are at least seven reasons, which we outline in the guide. Here we outline three.

The first, and we believe the most important reason, is the split market. The SSE, IBM and OTC are separate markets, with distinct rules, systems and regulators. Most of the liquidity is now on the IBM -- the stock exchanges accounted for only 5% of all trades in2006. More important is the fact that regulation has been fragmented, delaying progressive reforms. The PeopleÆs Bank has tried valiantly to push forward corporate bond reform, but its efforts have been constrained by opposition within Beijing. The MoF is primarily concerned with funding the budget.

A second reason is the lack of variety of investors. As in much of the rest of Asia, bond investors in China are mostly banks. Banks in total held 71% of outstanding bonds at year-end 2006. Banks tend to have similar asset positions and investment needs/strategies, which tends to result in a lack of diversity in the market. A third reason is that PRC banks tend still not to like trading. For them, lending is still king û the risks are relatively low, and margins are fat û and if one cannot lend money, one simply parks it at whatever yield is on offer. This disposition to buy and hold (rather than trade) has been exacerbated by the recent rise in deposits and constraints on lending.

Solving the problems

How to save ChinaÆs bond market? All the issues we have discussed above appear to be well understood by the many regulators. Much is being done, and much more is being thought about. In our full report, ChinaÆs Bond Market: The Standard Chartered Guide we lay out 10 ideas in detail. Here we outline three.

First, streamline regulation. One example of this is that in the corporate bond market, we think the CSRC will soon gain authority over corporate bond issuance, leaving the NDRC overseeing state-investment project bonds. This should be welcomed. We expect the CSRC to move rapidly once this transfer of power is announced. In store is a stream-lined issuance process (much like the one that now governs IPOs); the elimination of the need for bonds to carry bank guarantees; and improvements to credit rating agency regulation. There should also be further relaxation on coupon rates.

Second, expand the types of investors, allowing in corporates and overseas institutions. Corporates of all stripes should be able to directly trade bonds. At present, only large state corporates are allowed on to the IBM. Another useful move would be to open up the market more to foreign institutions. Current limits on onshore international institutions, such as commercial banks like SCB in China, mean they can only trade MoF and financial debt, and not STCBs, corporate bonds, or securitised debt etc. The overall market would benefit if such restrictions were relaxed.

Third, facilitate short selling, through, among other things, getting the MoF or central bank involved in lending securities. In recent years, market regulators in Singapore, Malaysia and Indonesia have all set up mechanisms by which they themselves will lend bonds into the market in order to allow banks et al. to short. The Monetary Authority of Singapore (MAS), for instance, offers to repo bonds with market makers each morning. The transaction is structured as a general collateral repo, which is like a normal repo but instead of swapping a bond for cash collateral, two bonds are swapped û allowing banks et al. to get access to bonds they want to short. Such moves have done much to facilitate shorting û and given the problems that face ChinaÆs market are very similar to those previously faced in Southeast Asia, this solution should be considered.

In conclusion then, there is much to do. But now that stock market reform has been successfully started, it is time for the focus to turn to ChinaÆs bond market. Increasing the size of ChinaÆs bond market would be relatively easy, but the real challenge for 2007-08 lies in boosting liquidity and sorting out the fragmented regulatory framework. Lay the right groundwork now, and the next decade would see investors being able to diversify their risks, households gaining access to higher return assets, banks being able to step away from financing the entire economy (and thus reduce their risks), and corporates gaining a richer choice of financing options. Interest rate reform would also be possible. In short, bond market reform is essential for the next stage of economic and financial reform in China.

Stephen Green is a senior economist at Standard Chartered Bank in Shanghai.
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