An internal report from HSBC on the Chinese domestic bond market has given some interesting insights into this rapidly changing area of the country's capital markets. The market is developing quickly, but while government issuance has boosted the size of the bond market, it still suffers teething problems. One such problem is the absence of a credible interbank offer rate pricing mechanism by which the market can more easily estimate the cost of borrowing.
According to research by HSBC, year-to-date issuance (to August) stood at Rmb187 billion, ($22 billion) compared to last year's total issuance of Rmb548 billion. The total number of debt instruments under custody amounts to Rmb1.4 trillion, the bulk of which is government or quasi-government issues - represented by policy bond issuance by China Development Bank and The Export and Import Bank of China.
Corporate bonds have been crowded out for two reasons: firstly, the Ministry of Finance and the policy banks needed substantial funding to fulfil their policy initiatives. And secondly PRC regulators are very concerned about the social impact stemming from corporate bond defaults. As a result, corporate bonds accounted for only 1% of the overall market this year (to June), compared with around 2% for 1999.
Changing the rules
Nevertheless, the PRC authorities do acknowledge the importance of the corporate credit market and are actively rectifying regulations and market infrastructure to make way for a more vibrant domestic bond market. Specifically, the consolidation of the supervisory authority of the corporate (non-Government/Quasi-Government) bond sector under SDPC (State Development and Planning Commission) and CSRC (China Securities Regulatory Commission) for stock exchange listings of domestic bonds is a major step towards a better-defined regulatory framework.
The investor base in government bonds is mainly banks, which have combined assets of at least Rmb1.6 trillion. Institutional investors are not legion, although existing insurance companies have to put 85% of their assets into government bonds. HSBC quotes from the latest PBOC annual report that the combined premium income of the country's insurance companies in 1999 is in the range of Rmb131 billion, a fraction of bank assets.
Mutual funds are still small, with a combined net asset value of only Rmb79billion as at June 2000. There is however a potentially huge retail investor base to be tapped by the setting up of custody accounts in bank branch offices throughout the country. Retail buyers will then be able to buy and sell government bonds at their local banks. Given the low deposit rate of just 2.25% for one year deposits, this should increase demand for domestic debt instruments.
Last year, the government introduced an important innovation in the government bond market. The banks now bid for the bonds on a Dutch auction basis. Nevertheless, a special feature of the PRC government and quasi government bond pricing mechanism is these bonds are priced as a premium over the equivalent maturity bank deposit rates. Hence in effect, the Ministry of Finance and policy banks as issuers of Government and policy bonds respectively have to pay up (over commercial bank deposit rates) for their requisite funding.
While the auction system permits a more accurate pricing of capital, the government still sets deposit rates and lending rates, thus ensuring a comfortable margin for the banking sector. Nor is the China interbank offer rate (Chibor) a particularly satisfactory benchmark. Mark Bucknall, Global Head of Debt Capital Markets for HSBC Group points out that although Chibor is the official rate for interbank borrowings in the domestic money market, it is however thwarted by a lack of transaction volume, and is therefore not a good indicator of the true cost of funds.
Conceptually one can visualise the PRC banking system as having two classes of citizens, the large and the small institutions. The large institutions comprise the Industrial and Commercial Bank of China, the Agricultural Bank of China, Bank of China and the China Construction Bank. Small institutions comprise city commercial banks and co-operative banks.
The large banks have implicit government guarantees and are in an active mode of commercialization, but the situation with the smaller banks is not clear given their lack of capital and expertise. Indeed, eventually some of the weaker institutions may be allowed to fail.
During this ongoing transition period, the large institutions either trade amongst themselves and avoid the smaller ones, or price themselves out altogether. As a result, Chibor as a benchmark becomes weakened because it thus reflects the average of a small sample of widely differing rates. While the banks are big buyers of government bonds, the market overall suffers from banks being restricted to the interbank bond market.
Banks were shut out of the stock market in 1997. As a result, by the end of 1999, bonds listed on the stock exchange stood at Rmb71 billion a fraction of the size of the interbank bond market which is the beneficiary of the steady flow of government and quasi-government bond issuance. Stock market listed bonds now represent just 2% of all outstanding bonds.
Hong Kong shows the way
The lack of liquidity in the interbank market is reflected by a comparison with Hong Kong. The HSBC report on the Chinese bond market points out that in the first half of this year the average daily turnover of cash bonds in the interbank bond market was Rmb23 million compared to a total of Rmb1.4 trillion under custody. In contrast, the Hong Kong Monetary Authority reports that Hong Kong has a daily turnover of HK$24 billion compared to an amount under custody of HK$319 billion.
Thus while 8% of outstanding debt securities are traded each day in Hong Kong, the figure for China's interbank bond market is 0.002%. All that said, the drive to build an effective domestic bond market will continue. At this juncture, with the industry's strong call for an efficient capital market, and more willingness on the part of the Government to further develop market infrastructure, laws and regulations, there is more reasons for optimism than pessimism.