China corporate bond market opens up - slowly.

The Chinese bond market, long a dormant beast, has been showing signs of life in the past 12 months.

With about Rmb80 billion ($9.75 billion) issued over the course of its history, both the listed and unlisted Chinese corporate bond market has come to encompasses a wide range of China blue chips and infrastructure projects, such as the Three Gorges, Guangdong Nuclear Power, Baosteel, CITIC, Sinopec, the Ministry of Railways and China Mobile.

In 2002, a massive Rmb37 billion was raised and with demand from insurance companies, pension funds and mutual funds running strong, market participants believe that 2003 could easily surpass this (Sars notwithstanding).

Figures show that five companies were approved for issuance late last year and three of these have now raised Rmb 6.5 billion ($783 million). A further Rmb10 billion was also approved earlier in the year, but has yet to be issued. Approvals take place at regular intervals throughout the course of a year and so far, Rmb 6.5 billion has been approved in 2003. There are now six bonds listed in Shenzhen worth Rmb8.5 billion and 16 in Shanghai worth Rmb19.3 billion.

All this stands in stark contrast to 2000 when the total market consisted of 13 bonds from six issuers worth about Rmb10 billion and trading volume was a meagre Rmb50 million a day.

Market participants say strong growth is being driven by a lack of decent returns elsewhere. Insurance companies, for example, raised Rmb 305 billion in premiums last year, but are not permitted to invest in the stock market. China's fledgling fund management industry also has 71 funds with assets of Rmb 100 billion under management, all looking for a good home.

"With the stock markets performing poorly for political reasons over the past months, the bond market is becoming interesting for investors," comments Lin Shoukan, China International Capital Corporation's head of equity capital markets in Beijing. "It offers better returns than bank deposits and issuers can try to raise some cash by a different route than IPOs".

A ten-year bond coupon pays around 4.3%, while bank deposit rates for the same period stand at just 2.79%, making the corporate bond sector rather attractive.

Many have mocked the development of China's bond markets. This is because the "most important price of all, the price of money is fixed," as Royal Institute of International Affairs China specialist Stephen Green put it in an interview with FinanceAsia - although he himself believes the markets are developing healthily.

This is a reference to one of the prime functions of a bond market - the pricing of money or funds through the sale and buying back of government bonds by the government to the market. A follow-up function, for which flexible pricing is necessary, is the pricing or risk: but China's fixed interest rate regime does not allow that.

These problems makes hostile observers somewhat scornful of China's recent attempts to get a grip on its debt market, although this is an especially important mission given the legacy problems of the stock markets.

"What's the point of boasting of the increase in corporate bond issuance when it utterly fails to fulfill the crucial function of a bond market, which is to price risk, " says one disgruntled China observer.

On the other hand, Irene Ho, a financial sector specialist at the World Bank, has extensive experience of China's debt market and points out that there is solid evidence the government is serious about reform.

"Insurance companies have now been permitted to invest in bonds issued by four major state-owned enterprises under the direct control of the government and that list will in all likelihood be extended," she says.'

In addition, the government is increasing issuance of the seven-year bond to create a reliable benchmark in the same way that the 10-year bond works in the US.

Finally, a major innovation will be the 'delivery versus payment' trading system, which is set to go live next year. "That will provide a big boost to liquidity in the bond market, since the system removes the need for trust in, and knowledge of, the counterparty," she says.

"As the government bond market matures and sets credit benchmarks under the ministry of finance, it will create positive momentum for a spillover effect in the corporate bond market," she concludes.

All agree that the debt market is becoming more important than at any previous stage of China's history as the country extends and deepens its modernization plans.

Healthy capital markets are normally composed of a tripod of equity markets, bond markets and the banking sector, but since the first and third sectors in China are sick, this is encouraging the development of the bond market.

The government most recent effort to manipulate the stock market in order to divest huge stakes in the economy, have highlighted the role equity markets have played in China's recent economic history.

"The stock market has been a way of raising funds to help bankrupt state-owned enterprises, and now it's being used for the government's sell-down of its assets, many of which are poor, or at least very hard to value," says one Hong Kong banker.

One of the most galling aspects to free market fundamentalists is the way that corporate bonds are introduced to the market. They are all rated A or above, usually AAA. This, however, is not a reflection of essential credit quality, but a reflection of the fact that they are guaranteed by state-owned banks.

"The guarantee system, like all such systems is flawed because it doesn't allow companies to be judged on their merits," says one banker-turned-academic.

And because companies are not judged on their own merits, he adds, they have no incentive to become transparent and release accurate information to potential investors. This is also why there is no commercial demand for credit rating agencies.

Observers also note that a major problem with the guarantee system is that it kicks the financial risk right back to the government through the state owned banks.

"What you are not getting is a diversification of risk across the whole economy," the academic states. "Instead, by using the guarantee system, a systemic risk is created."

Systemic risk is all the greater since the state-owned banking system is reckoned by most observers to be bankrupt, with capital adequacy ratios insufficient to balance vast mass of non-performing loans.

CICC's Lin also says that there are sound historical reasons for being extremely careful about corporate issuance in China. "Actually, the corporate bond market boomed at the beginning of the reforms in China in the 1980s and 1990s, but because change outpaced the regulatory framework, numerous companies defaulted and hurt investors," he explains.

Smarting from the lessons of an unfettered free market the government has therefore passed control of the bond market to itself.

"But the government doesn't yet have the expertise and institutions in place to control the market with a light touch; that's why control over the markets comes across as so heavy-handed," says one banker.

Lin concurs. "The government, through the State Planning Committee, which answers to the State Council, has in effect taken over the role of rating the credibility of borrowers."

Everyone interviewed for this article agreed the government has woken up to the need of reforming its bond markets. What observers are now watching closely is whether the government will get the balance right between speed and efficiency. That tension will continue to create plenty of debate between supporters of International Monetary Fund-style shock therapy and the more pragmatic gradualists.