The Chinese government is now pushing to develop China's nascent corporate bond market. At present, only 11 corporate bonds are listed on China's two stock exchanges. But steps are being taken to unlock capital to aid SOE reform, raise revenues for the government's stimulus programme and to support its ultimate goal of liberalising interest rates, says Dr Stephen Green, Associate Fellow of the Asia Programme at the Royal Institute of International Affairs. Even domestic currency convertible bonds are on the agenda...
FA: Given the tendency by the state sector in China to guzzle capital, why has the bond market's development been so slow?
Green: The government has issued large amounts of treasury bonds. However, it has not put a lot of effort into developing a market for them, making them fairly illiquid, since banks, insurance companies and retail investors tend to buy and hold.
With regard to corporate bonds, they have historically been neglected in favour of China's state banks which were convenient channels for distributing capital by government decree. In addition, the booming stock market - until recently - also seemed a fool-proof way of raising capital. In fact, a corporate bond market did exist in the 1980s but rampant speculation caused the government to crackdown.
Apart from raising money for State Owned Enterprises, why is the development of the bond market important for China's financial modernisation?
Interest rates in China are currently set administratively. Over the long term, they need to be liberalized to reflect the market price of money. To do this, the central bank needs to have a yield curve, which tells it what the market thinks inflation will do in the future. To produce a curve, the central bank needs to auction short-term treasury bonds. But at the moment, it only issues three and five year bonds at rates it fixes itself.
So how genuine can bond market reforms be until rates are liberalized?
The two go hand in hand. The government must begin to develop its short term T-bond market as a central plank of its monetary policy. The Ministry of Finance understands this and is moving towards putting in place the needed infrastructure.
What kind of infrastructure is this?
At the moment, government bond policy is a function of its need for investment funds - issuing long term bonds for infrastructure projects. The State Development and Planning Commission sets a yearly bond quota, irrespective of tenor: if the MoF kept issuing short term bonds, it would quickly fill the quota, but without being able to keep the cash long term.
In addition, having to repay short term bonds at regular intervals makes it difficult for the MoF to forecast how much cash will be on hand at any one moment: essentially, a cash management problem. But now, the MoF is putting in place systems to manage and forecast cash flows. Once these are in place, short-term bond issuance will become possible allowing the central bank to gauge the market price of money.
You mentioned some problems with the corporate bond market in the 1980s which caused the government to set up very tight regulations.
Yes. The corporate bond market was kicked off by enterprises in Shanghai, Shenzhen and Sichuan and Liaoning provinces, in 1984. By 1986, some Rmb 10 billion ($1.2 billion) worth of corporate bonds had been issued - but many companies defaulted, causing investor anger and the threat of social unrest. The market was chaotic.
So in March 1987, the State Council cracked down by limiting debt issuance to state-owned enterprises (SOEs) and limiting coupons to a maximum 40% above the comparable bank interest rate. The government has kept a tight hold over the market ever since.
Who within the government actually regulates the bond market?
The State Development and Planning Commission determines the kinds of companies that can issue debt, and sets a quota each year. The People's Bank of China (PBOC), the central bank, sets all interest rates, including the extent to which bond rates can differ from deposit rates, while the China Securities Regulatory Commission (CSRC) supervises the trading of bonds that actually make it to the market. Supervision by these departments was so tough that during the mid-1990s only about Rmb15-20 billion in corporate bonds were issued, below the annual quota of around Rmb20-30 billion.
Why have Chinese companies traditionally focussed so heavily on equity financing?
It reflects the immaturity of China's capital markets. Basically, in China shares are cheaper to issue. In the developed world, corporate financiers tend to go for debt issuance first, because issuing equity dilutes owners' profitability and control. Debt payments are cheaper because the bondholder bears less risk. But in China, poor corporate governance, low dividend payments, and shares that don't confer genuine ownership rights mean that shares are cheap to issue. Money for nothing, in some cases. That's why there are only 11 corporate bonds listed in China.
Has bond issuance been increasing?
In 2000, seven SOEs in key sectors were permitted to raise RMB8.9 billion. Last year, China Mobile and four others raised RMB16.4 billion. The China Development Bank says at least RMB23 billion of corporate bonds will be issued this year. And it is important to note the market is getting more sophisticated.
In July 2000, the Three Gorges Development Company issued the first ever floating-rate bond - most companies previously simply offered a fixed rate, irrespective of interest rate movements. And the domestic RMB5 billion China Mobile issued in June 2001 was the first to use market pricing, rather then the government setting the price. In addition to those developments, maturities are getting more varied: the longest now is a 15-year Three Gorges issue.
Has the recent abysmal stock market performance encouraged bond issuers?
Yes. The bear market in equities that started in from August 2001 has forced SOEs to scout around for other sources of money. Of course, the fact that real interest rates are low is also encouraging bond issuance. There is even talk of a ninth drop in nominal rates before the end of the year.
China is building up its fund management industry and its institutional investor base. Are they pushing to be allowed to buy corporate bonds?
Currently, investment funds and securities companies do not have much opportunity for buying corporate bonds, since only 11 are listed. Insurance companies are forbidden outright. So the fund managers rely on buying equity and bank deposits. The former are very risky, and the latter provide very low returns, so corporate bonds would fill a gap.
Banks and insurance companies are interested in corporate bonds for the higher returns, since they can only hold Treasury bonds. And small investors are interested in corporate bonds, especially since a recent CSRC ruling raised the costs of buying shares at IPO, which traditionally soared in the secondary markets. At least one fund management company, Nanfang, has already pitched the idea to the CSRC for an open-ended bond fund to invest in T-bonds and corporate issues.
What are the main policy issues that remain to be resolved?
The corporate bond issuance quota needs to be relaxed to let more companies issue bonds. At the moment, rules restrict issuance to large SOEs, requiring net assets of RMB30 million at stockholding companies, and RMB60 million at limited responsibility companies. A minimum of RMB50 million worth of bonds must be issued.
Since all issuers have de facto AAA ratings (since they are government owned) and offer higher rates than bank deposits, investors tend to hold the bonds until maturity, making the market illiquid. The PBOC should allow some flexibility in the rates offered by these bonds - currently limited to 30%-40% above a comparable bank deposit rate - to aid risk assessment but this also means credit rating agencies will have to become stronger.
One important issue is how to conduct bankruptcy proceedings since SOEs must currently ensure they have met all their wage and welfare liabilities before creditors get a cent. In other jurisdictions, it is bondholders who are protected first.
Convertible bonds have been popular in other parts of Asia. Whatíªs the outlook in China?
There has been some experimentation with convertibles although in 2001, only two traded on the stock exchanges, so there is plenty of potential. One hopeful signs is that in April 2001, the CSRC issued new rules to develop convertibles, but the criteria were quite strict. For example, it restricted the issuance of convertibles to listed companies, whereas previously key non-listed SOEs had also been permitted.
Companies also need to have recently distributed cash dividends, have had an outstanding performance, have had no recent asset reorganisations or disclosure problems, and demonstrate that in the previous three years they have had sufficient profits to pay interest on a convertible bond. A 10% return on assets is also required, or 7% if the enterprise is involved in energy, infrastructure or natural resources.
Those are pretty tough requirements.
Indeed, but so far some 61 companies have announced their intention to issue convertibles, raising at least RMB40 billion in total. It has been reported that 50 more have been given the green light. The first to go since the 2001 rules were announced was Shenzhen Wanke, which issued a RMB1.5bn convertible with a 1.5% coupon in June 2002.
Some analysts have complained that these conditions are too harsh, and are not suitable for developing the market. If you look at the US, only 20% of convertibles are investment grade. There, convertibles tend to be issued by SMEs. In contrast, the CSRC says that a listed company requires a debt-equity ratio of less than 70% to issue convertibles, a ratio which only 85 of the 1,160 listed companies manage.
On the other hand, of course, given past crises and panics, the CSRC's stance makes a lot of sense and could actually serve to help attract investors. I get the sense that they know what they are doing.