Let’s raise some debt and fuel speculation (Part 2 of 4)

Financial liberalization leads to favourable conditions for bond issuance

If financial disintermediation is set to increase in China, leverage via the bond market is set to replace the share of funding currently necessitated by bank loan financing. The Fung Global Institute (FGI) expects the bond market to necessitate bank loan financing for the following four reasons:

  1. Basel III – assuming the framework is fully embraced by Chinese banking regulators, commercial banks will face more stringent capital requirements, leading bond market growth to exceed bank lending.
  2. Restrictions on lending – new policy measures will restrict bank and shadow bank lending to local government financing vehicles (LGFVs), leaving municipal bonds as the only measure by which financing can be maintained. The Chinese Budget Law has formally legalized bond issuance by municipal governments. This allows current LGFVs to swap their bank and shadow banking obligations with newly issued municipal debt. An estimated RMB1 trillion of municipal bonds is expected to be issued under the swap scheme.
  3. Asset-backed securitization – ABS enables banks to offload parts of their loan portfolio to investors in the form of bonds, made available by new regulatory frameworks. ABS issuance has risen eight-fold over the past two years, according to FGI.
  4. Small and medium size enterprises – financial deregulation will shift attention towards SMEs in order for banks to maintain their net interest margins. This means that existing blue chip companies will continue to raise capital via debt issuance, thereby expanding investment-grade debt in the market and facilitate a large enough bond market that will encourage issuance of high-yield greater-risk bond issuance by SMEs.

Greater issuance in China’s bond market is being constrained by the following four non-exhaustive reasons:

  1. Ownership profile: Increased growth of the bond market requires a diversity of ownership, thereby spreading risk. Chinese banks are not only the biggest underwriters of bonds, outside the treasury segment, but also the dominant investor in the domestic bond market.
  2. Moral hazard: The issuers and holders of corporate and government bonds in China are, in a majority, directly or effectively linked to the government.
  3. Cornered market: The bond market of China is cornered. Commercial banks combine to hold 70% of onshore bonds, while non-bank institutions (insurance, pension and bond funds) hold a remaining 23%. This is a cause for concern regarding liquidity of the bond market, as non-bank institutions tend to be the most active participants. The table below is drawn from the FGI working paper.
  4. Convoluted regulation: There are multiple government organizations which regulated China’s bond market. This is a hindrance to bond market growth. Five regulators oversee the six types of bond instruments traded onshore and offshore. A lack of clear leadership and transparency makes regulation convoluted.

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There are five regulatory organizations in China:

  1. State Council Securities Commission is the main regulatory authority for capital markets in China, whereas the China Securities Regulatory Commission (CSRC) vets issuance of corporate bonds by publicly listed companies in China.
  2. National Development Reform Commission (NDRC) approves and regulates issuance of debt instruments of non-listed companies. These are normally SOEs.
  3. People’s Bank of China (PBoC) is the central bank, regulating interbank lending and bond markets. The PBoC approves the sale of short-term corporate bills and commercial paper issued in the interbank over-the-counter market.
  4. China Banking Regulatory Commission (CBRC) jointly approves with the PBoC bond issuance by commercial banks, including securitization of financial assets and bank guarantees for corporate debts.
  5. Ministry of Finance (MoF) is in charge of scheduling public borrowings – approving onshore bond offerings by foreign institutions, together with the State Administration of Foreign Exchange (SAFE) in approving the Qualified Foreign Institutional Investor (QFII) scheme.

Once issued, the secondary bond market in China is relatively simple: two exchanges (Shanghai and Shenzhen), the OTC market, and the interbank market (regulated by the PBoC). For comparison, Hong Kong has three primary regulators with clearly defined roles:

  1. Hong Kong Monetary Authority (HKMA) is the de facto central bank and manages the issuance of exchange traded fund bills and notes (EFBNs). The HKMA Central Money Markets Unit (CMU) is the central securities depository unit that provides clearing, settlement and custodian services for EFBNs.
  2. Hong Kong Exchanges & Clearing (HKEx) is the exchange and clearing system that facilitates the dealing in both EFBNs and listed government and corporate debt securities, which are traded OTC.
  3. Securities and Futures Commission (SFC) is the statutory body that oversees the enforcement of the Securities and Futures Ordinance (SFO), the law governing securities and futures markets.

Not only is the regulation of Chinese bond markets more convoluted than that of Hong Kong, market structure is also divided, for example: the Chinese government bond (CGB) benchmark yield curve is divided with the tenor under one year with de facto PBoC supervision, and with tenor after one year with de facto MoF supervision.

The Federal Reserve Bank of New York staff report that a divided regulation and structure can hinder bond market development but also suggested that, in the case of China’s onshore bond market,

Coupon-bearing securities, higher coupon rates, larger issuer sizes, longer maturities, and more recent issuance are all associated with increased trading activity.

Increased trading activity leads to greater market liquidity, addressed later on. More importantly, a more efficient regulatory structure and diversification of bond ownership will enhance the development of a more efficient benchmark yield curve, thereby facilitating greater trading volume and deepening bond market liquidity.

Table 2 below is a projection of bond market issuance in China through 2020, by FGI. The projected compound annual growth rate is a healthy 12% and expects the bond market to double in size from RMB28.7 trillion in 2014 to RMB56.7 trillion in 2020. As noted previously, nominal GDP is a proxy for bond issuance and FGI expect China’s nominal GDP to grow through 2020 at an annualized rate of 10%. Given bank loan growth is a projected 8% and bond issuance is projected to be greater than bank loan growth, the additional bond issuance provides for the 2% shortfall of bank loan growth to nominal GDP.

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If the projections above are correct, doubling the size of China’s bond market could help absorb potential shocks resulting from cross-border capital flows, assuming China begins to open its capital account. This would provide the PBoC with another cushion against Trilemma, known as the choice of two of the following three: a fixed exchange rate, free capital movement (absent of capital controls) and independent monetary policy.

A developed bond market provides tools to the central bank in carrying out monetary policy, whether it be conventional or unconventional. The PBoC utilizes monetary policy tools similar to that of the US Federal Reserve, albeit a tiny fraction of the US in terms of trading activity:

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Given market size and liquidity are positively related, a more developed bond market would establish stable benchmark rates from which hedging tools could be established and thus support further corporate and municipal bond growth along the way. Since the 2008 financial crisis, risk management has become a major concern to market participants – a key issue central to the development of Hong Kong Exchanges and Clearing Limited, according to its Chairman, Charles Li. Exchanges and clearing houses in Europe have been undergoing M&A as they have felt the pressure to evolve and innovate.

As liquidity is one of the main proponents for greater bond market issuance in China, let us briefly explore the theory behind the function of liquidity of a bond market. Market liquidity is defined as,

The ability of buyers and sellers of securities to transact efficiently and is measured by the speed with which large purchases and sales can be executed and the transaction costs incurred in doing so.

To put this in context, price volatility is dependent on market liquidity, such that transaction volume can lead to big price swings if trading volume in the market is thin. The optimal amount of market liquidity is somewhat arbitrary and depends on the type of market and product being traded. Structurally, if the size of a bond market were to grow 5% per year, would transaction volumes need to increase concurrently or by a greater or smaller percentage? The answer is arbitrary.

In the aftermath of the subprime mortgage scandal, the Federal Reserve, led by Chairman Ben Bernanke, decided to boost transaction volume in the bond market, through quantitative easing, This was purported to provide liquidity. However, quantitative easing is only possible if a nation’s bond market is developed and deep (i.e. large) enough to provide the liquidity pool from which market participants can diversify risk. As a result, bond risk premia was contained as the spread between corporate and government bond prices remained close. In fact, there is empirical evidence of the increasing divide between equity risk premium and the risk-free rate:

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Large transaction volumes, fed by the Fed, propped up corporate bond prices and reduced the risk premium. So you ask, why is risk premium so important? Risk premium is modelled into equity valuations, specifically any capital asset pricing model and discounted cash flow valuation. The greater the risk premium, the greater the ‘discount’ on future cash flows, resulting in lower equity valuations today – dragging on stock prices during market turmoil.

In the US, regulation is viewed as a strain on bond market liquidity as dealers, acting as market makers, have found it increasingly expensive and difficult to hold inventories. This is shown in the below graph as net dealer position in corporate bonds (red line) have dropped since the financial crisis began in 2007, and the volume of government bonds (blue line) has increased. That said, a reason for the divergence in net dealer position could be due to the open market operations of the Federal Reserve in buying corporate bonds for US treasuries.

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Market liquidity is a key component to dealer commission – derived from the bid/ask spread of the bond trade – whereby the commission generated reflects the transaction cost associated with holding and dealing in bonds. Thus, reduced bond inventories will likely cause a reduction in liquidity and as such, dealers command a discount on the bid price and a premium on the ask price, causing the bid/ask spread to widen. This leads to reduced liquidity, thereby making capital raising by corporates more expensive as investors demand a higher yield to offset the associated risk with lower liquidity. This compensation in yield could be thought of as the increased transaction cost.

Liquidity of the bond market seeks to raise the efficiency of the pricing mechanism. China has acknowledged the need for greater transparency, a key factor in transparent pricing. In 2015, the Chinese government established a debt ceiling of RMB16 trillion and is set to include local government debt balances in the annual budget management. Furthermore, the municipal bond market was officially launched in 2015, leading to coordination between the PBoC, MoF and CBRC on administrative rules regulating the issuance and budgetary conditions of municipal bond issuance. As a result, the average financing cost to LGFVs was reduced from 10% to 3.5%, and the average life of debt was more than doubled from 3 years to 6.5 years.

Financial liberalization can lead to greater bond issuance in China, but has this been performed for the right reasons? According to DB research:

  1. The CSRC has relaxed restrictions on to all issuers of corporate bonds, both financial and non-financial, and relaxed administrative controls over the refinancing by property developers. This is concerning since property developers accounted for 43% of outstanding corporate bond issuance in 2015.
  2. The NDRC now allows the use of corporate bond proceeds to repay bank loans, within new limits. The ability to repay bank loans has been closely watched by participants as non-performing loan ratios (addressed below) is centre of attention to the Financial Times.
  3. The NDRC has promoted issuance of enterprise bonds to support infrastructure projects.  Enterprise bonds account for 6% of the bond market outstanding.
  4. The NDRC has simplified the approval process of enterprise bond issuance and relaxed credit rating requirements for issuers from AAA-rated to AA-rated.
  5. The PBoC has simplified the registration of ABS issuance. ABS account for 1% of the bond market outstanding.
  6. The PBoC cut its policy rate and reduced the required reserve ratio (RRR) of banks in 2015.

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