China’s 12th Five Year Plan, which was promulgated at the end of 2011 and is being executed by Xi Jinping’s administration starting last year is not a relic of the old days of Politbureaus and Cold Wars. It is a vitally important blueprint that has the imprimatur of the “people”. It determines promotion and ascension for all senior leaders. It is the administrative guidepost for the economy.
From the point of view of the financial system, the foundation of this 12th Five Year Plan is very simple. According to a McKinsey report, China’s Achilles heel is that unsecured bank loans are about 40% of total capital circulating throughout the system. (The other types of capital are equity, corporate debt and government debt). The only other countries at these levels are in Eastern Europe. The global average is 20%. This dependence on bank credit must fall to below 30% in the next few years.
There are three ways for China to do this. The first is municipal bonds. The second is asset management companies (AMCs). And the third is securitized debt. These three “arrows” are intended to turn short-term loans into long-term securities that are tradable and enable price discovery. These will offer a more transparent picture of the underlying health of the system. This will provide the makings of a yield curve and allow the currency to be priced and, therefore, tradable. Without a fixed-income yield curve, there can be no freely floating currency.
China currently has next to no municipal bond market, reits, derivatives nor securitised debt. It is a bank credit market and an equity market, which is 50% of GDP, one of the lowest ratios globally.
So, there is plenty of scope to create a mature and robust capital market.
The first part of this is the AMCs. Cinda has already listed and it is now busy restructuring debt, consolidating assets and turning around companies. It has a vast capacity to take on more troubled assets as its leverage (the ratio of assets to equity) is just three times. Compare this to a global average of 15 times for financials. It has guaranteed bond funding at low rates from the Ministry of Finance until 2020.
Then we have municipal bonds. This is a way to turn local government funding vehicles into long term, tradable and transparent bonds, which can be bought by the growing pension and insurance firms who do not want equity. This becomes interesting: not only will institutions like Citic Securities be active in this, but new-economy companies such as Alibaba are becoming financial intermediaries and may also play a big role in selling these bonds to the public.
The third arrow is securitization. Let’s take an example of Agricultural Bank of China (ABC). ABC removes a loan from its loan book and transfers it to an issuing vehicle such as a trust like Citic Trust. ABC retains a legal interest in the company. The securitized loan can then be rated by a ratings agency and the market can offer an appropriate yield given the articulated risk of the underlying asset. The market will decide.
Indeed, ABC was the guinea pig this past three months. It issued a total of Rmb2 billion worth of asset-backed securities with yields which had an average of about 6% in three tranches and the three tranches were all oversubscribed. Citic Securities and CICC were the main underwriters.
This is all early days, but if you read the 12th Five Year Plan carefully (and we should), there will be a large, liquid and tradable market for fixed income securities by 2017 in China. Don’t miss it. You can say you were present at the creation of what will become the second biggest fixed-income market after the US.
