That China’s financial system—even in the midst of reform and development—has acquired significant international influence is evident. The 8.9 percent drop of the Shanghai Composite Index on February 27, compounding certain remarks on the U.S. economy by Alan Greenspan the previous night in Hong Kong, triggered global share price declines the following day and much nervousness on capital markets thereafter. The explanation for Shanghai’s impact surely does not lay in extensive foreign ownership of Chinese A shares (probably no more than 2 percent) or in the size of China’s stock markets (less than 5 percent of the market cap of the NYSE). A more plausible explanation lies in the cross-listings of large Chinese enterprises in Hong Kong and in psychological factors, including a growing international awareness of: (1) the significant extent to which the China’s economy has become “globalized”; (2) the fact that China is now the fourth largest economy in the world and the third largest trader; and (3) the enormous appetite of foreign investors for Chinese equity. While there is far less foreign appetite for Chinese debt, it is likely that China’s domestic debt markets will attract greater foreign participation as the financial system gradually liberalizes. It is possible that certain Chinese debt instruments will eventually also be used as international reserve assets by other countries.
History of Government Bonds in China
When China’s unorthodox but effective market reforms first began in the late 1970s, its financial system was essentially limited to a single bank: the People’s Bank of China (PBoC), which served as a cash agent for the state, foreign exchange bank and de facto central bank. There were no insurance companies, institutional investors or capital markets. In line with the thinking on market reforms at the time, the Ministry of Finance began to issue bonds in 1981, but it also continued to borrow from the PBoC for fiscal purposes as it had done before. Throughout most of the 1980s, government bond issues were small and in essence a form of taxation; they were part of the national credit plan. The bonds were force-placed on the basis of administrative quotas, and payments for bonds were often deducted from payrolls or withdrawn from bank accounts . All interest rates were state-controlled. Informal and essentially unregulated domestic markets for government bonds as well as company shares began to develop spontaneously in the 1980s. Following the opening of the Shanghai and Shenzhen stock markets in 1990 and 1991, respectively, the government began to sell bonds on a voluntary basis through these exchanges.
An important development occurred in 1993 when the government denied itself the option of borrowing from the PBoC for fiscal purposes, as a matter of policy. From then on, significant efforts to develop and regulate capital markets, including debt markets, have been seen. In the primary bond market, the government began to experiment with market-based pricing and distribution through specialized underwriters and primary dealers. This gradually became the accepted rule. In August 1997, the market for government bonds was split between the interbank market and the stock market. This was the result of a central bank decision to ban commercial bank trading on the stock exchanges and lending to securities firms (usually on the basis of repurchase agreements) in an effort to curb speculative stock trading. (Short selling by securities firms has been a recurrent problem in China.) Since that time, the government has typically sold about 25 percent of new bond issues though the stock market and the remainder through the interbank market, which became China’s principle market for bonds and other tradable debt .
Broadening and Deepening of Domestic Debt Markets
The range of debt instruments available for trading in secondary markets has widened significantly over the past few years, while interest liberalization is progressing slowly but surely. Market participation, or the number of actors involved in the trading of debt instruments, has increased, while arbitrage between markets is becoming easier. The introduction of short-term corporate bills in 2005 was a very positive development. The markets for both long-and short-term debt are gradually becoming more genuine markets. As a result, yield curves for government bonds are becoming more meaningful as benchmarks for the pricing of other debt instruments. Yield curves, typically flat or even inverted a few years ago, are now showing a more normal upward sloping pattern.
In recent years, especially since 2003, China’s government has made considerable effort to develop, integrate and better regulate its domestic capital markets, including bond markets. In market economies, debt markets have several important functions, including: reducing the dependence of corporations on banks for their funding needs; assisting lower level governments in the financing of infrastructure; satisfying the need of institutional investors for a broad range of financial instruments; permitting market-oriented monetary policies by the central bank; facilitating the recycling and ultimate disposal of non-performing loans (NPLs); and facilitating the gradual opening of China’s capital account.
The government has therefore actively promoted the development of new debt instruments including: subordinated bonds issued by commercial banks (June 2004); bonds issued by banks other than the three Policy Banks—Shanghai Pudong Development Bank, Industrial Bank (the former Fujian Industrial Bank) and China Merchant Bank (April 2005); asset-backed securities, including mortgage loans and even NPLs (April 2005); short-term corporate bills (May 2005); and RMB-denominated “Panda Bonds” issued by the Asian Development Bank and the International Finance Corporation (October 2005).
Additional debt instruments planned or under active consideration include: RBM-denominated bonds issued by mainland banks (e.g. China Development Bank) in Hong Kong to take advantage of the rapidly growing RMB deposit base in the territory; bonds issued by qualifying municipalities and provinces for the financing of local infrastructure; RMB-denominated bonds issued by foreign corporations operating in China (to reduce foreign exchange inflow and thus ease upward pressure on the exchange rate); and foreign currency-denominated debt issued by domestic firms in the domestic market.
Corporate Bond Market Lags, But Changes are Afoot
The least developed part of China’s domestic debt markets remains the corporate bond market. Since 1993, issue rights have been limited to a few dozen large state-owned enterprises such as the Three Gorges Development Corporation, PetroChina, China Mobile, Baosteel and China Grid. As all issues had to be guaranteed by one of China’s large state-owned banks, these bonds are almost all “triple A” rated by China’s rating agencies. This author estimates that the total amount of corporate bonds outstanding at the end of 2006 was less than $90 billion. The vast majority of China’s corporations has at present no access to the corporate bond market and remains heavily dependent upon bank loans for intermediated funds (close to 90 percent on average in recent years).
It seems, however, that things are about to change and that corporate bonds will become a more important source of funding for the corporate sector in general. A recent government decision to require state-owned enterprises to start paying dividends will encourage the growth of the corporate bond market. This will be reinforced by a parallel decision to assign significant responsibility for the development of a commercial corporate bond market to the China Securities Regulatory Commission. (Since 1993, the power to authorize corporate bond issues had rested exclusively with the National Development and Reform Commission.) These changes are consistent with Opinions of the State Council on Promoting the Reform, Opening and Steady Growth of Capital Markets, a set of guidelines for capital market development approved in January 2004 . A substantial broadening and deepening of the long-term corporate bond market is critical not only to balance corporate funding, but also to spread risk in financial markets and to reduce system vulnerability to shocks. It is also needed to facilitate portfolio balancing by the growing ranks of domestic institutional investors in China. A large and well-functioning corporate bond market may also be expected to help improve corporate governance, which remains on balance very weak in China.
Size and Composition of China’s Debt Markets
China’s domestic short- and long-term debt markets have expanded enormously since the late 1990s in terms of new issues, amounts outstanding and turnover. The amount of outstanding tradable bonds (excluding central bank sterilization bills—special debt issued to prevent inflation from China’s enormous dollar reserves—and commercial paper (drafts), but including short-term corporate bills) grew from only five percent of GDP in 1997 to over 37 percent of GDP by the end of 2006 . Comparable ratios for other Asian countries are approximately: 24 percent for Indonesia, 43 percent for the Philippines and 75 percent for South Korea . The total amount of tradable domestic debt outstanding (excluding NPLs) was about double the market capitalization of tradable A and B shares, but only a little more than 50 percent of the amount of outstanding bank loans .
The largest component of domestic tradable debt at present consists of central bank sterilization bills. This is an unusual and potentially troublesome situation and has nothing to do with corporate funding. Rather it reflects central bank efforts to suppress domestic inflation that would otherwise result from foreign exchange purchases aimed at preventing or slowing exchange rate appreciation. When the central bank ran out of government bonds for open market (sterilization) operations in 2003, it began to issue its own bills for that purpose. In the first half of 2006, the amount of outstanding central bank sterilization bills began to exceed the amount of outstanding government bonds. China is now trying to reduce further reserve accumulation through a variety of means and for a numbers of reasons, including the wish to avoid the need for further large-scale sterilization through the sale of central bank bills.
The promotion of healthy domestic debt markets is a vital element of China’s economic reforms. A number of key reform challenges, including further interest rate liberalization, the development of corporate bonds and the relaxation of investment restrictions on institutional investors, have witnessed nascent growth and are now on the critical path of development. China’s corporations at this stage remain overly dependent on banks for intermediated capital. Yet, the institutional foundations for a more mature and diversified domestic capital market have been laid. It is likely that debt and equity markets will soon begin to play a much larger role in corporate funding, and as capital markets develop, their growing role will lead to an inevitable decline in dependence on bank loans.
1. A. Kumar et al. China’s Emerging Capital Markets. FT Financial Publishing Asia Pacific, 1997
2. Mu Huaipeng, The Development of China’s Bond Market, BIS paper No. 26, 2006.
3. Some Opinions of the State Council on Promoting the Reform, Opening and Steady Growth of Capital Markets. People’s Republic of China State Council, January 31, 2004.
4. Goldman Sachs, Global Economics Paper No. 149, November 20, 2006.
6. For more detailed data and composition of China’s tradable domestic debt, see Standard Chartered, China’s Bond Market. Special Report No. 1, March 6, 2007.