Is a Commercial Corporate Bond Market in China Finally Emerging?

The transfer of responsibility for the approval of medium- and long-term corporate bond issues by listed companies from NDRC (National Development and Reform Commission) to CSRC (China Securities Regulatory Commission) may turn out to be a watershed decision in China’s transition to a more market-oriented economy. The involvement of CSRC in corporate bond issues since the new rules were issued in August 2007 (Business Week, August 8, 2007) is a natural sequel to the establishment of a market for short-term corporate bonds (one year maturity or less) under the auspices of China’s central bank (PBC) in May 2005. Depending on how this institutional change is followed through in practice, it marks a potentially important relaxation of state control over the economy. There is now a chance that a commercial corporate bond market will finally emerge in China. This is a high priority for the reform and development of China’s financial system since the move would reduce corporate dependence on bank loans, stimulate capital market development and serve the need of institutional investors for debt instruments with a wider range of maturities and risk profiles [1]. Most Chinese bonds are issued by the government and government-owned policy banks and the corporate bond market provides only 1.4 percent of the total financial needs of corporations in China (about 85 percent is financed by banks and about 14 percent by equity) [2]. Early indications are promising: during the first half of 2008, 21 listed firms raised about $10.9 billion (RMB 74.5 billion) from non-guaranteed corporate bonds authorized by CSRC, more than the amount raised by all listed companies in the stock market during the same period (China Daily, August 1). The development of a commercial corporate bond market would improve the efficiency of China’s financial system by reducing the capital bottlenecks that pervade the system.

There are indicators that suggest the government has selected the Tianjin Binhai New Area in the northeast as the next hub for concentrated development and for trying out new ideas for financial reform that could, if successful, be replicated elsewhere in the country. Tianjin could become the next Shenzhen or Pudong. The Tianjin Binhai New Area, which consists of three administrative districts (Tanggu, Hangu and Dagang) and eight industrial zones currently under construction, offers an excellent opportunity to accelerate capital market development in China. Earlier ideas for the development of Tianjin as a financial center, namely to make the RMB freely convertible in the Binhai New Area and to make Bank of China’s Tianjin branch the gateway for direct and unlimited household investments on the Hong Kong stock exchange were grounded just as soon as the idea took off. However, global financial volatility has breathed new life in China’s financial reforms.

Recently Vice-Premier Li Keqiang, while inspecting the port city, stated that local officials should accelerate efforts to develop the Binhai New Area into “a northern portal of the country’s reform and opening up drive, a base of modern manufacturing and scientific research and application, and an international shipping and logistics center” (Xinhua News Agency, August 19). Cui Jindu, vice mayor of Tianjin for financial affairs, stated that the city would concentrate on the development of venture capital and private equity investments and position the city as a center for non-securities funding (Trading Markets, September 2). He also wants to promote corporate bonds as an alternative funding source for enterprises established in the Tianjin Binhai New Area.

Corporate Bonds and Financial System Development

Some local, unofficial and essentially unregulated markets for corporate bonds and equity shares emerged spontaneously in the mid-1980s [3]. It was not until after the opening of local stock exchanges in Shanghai and Shenzhen (1990/91) that the central government began to piece together a national framework for their regulation and supervision. These efforts were initially frustrated by the overheating of China’s economy in the early 1990s [4]. The high inflation of those years, combined with high rates of loan and corporate bond defaults led Beijing to recentralize administrative control over the financial system, introduce parallel fiscal reforms and promote a more serious credit culture. To punish PBC for its lax supervision of the financial system, Beijing replaced its governor and transferred responsibility for corporate bonds from PBC to SPC (State Planning Commission–predecessor of NDRC) in 1993 [5]. However, SPC did not use its new mandate to develop commercial capital markets, but to raise funds for selected state-approved projects through “corporate bonds”, instead of bank loans or budget appropriations. The terms for such bonds, which had to be fully guaranteed by a major state commercial bank, were set by SPC (NDRC). The rate of interest was usually not related to bond maturity. Because of the 100 percent state bank guarantee and other administrative controls, practically all corporate bonds were rated AAA by state-sponsored rating agencies. Only about half the corporate bonds issued under that system were listed on the exchanges; market turnover was low and yield curves were essentially flat. During the 1980s and early 1990s priority was given to the reform and marketization of the real economy. Financial institutions continued to serve as agents of the state for plan implementation. They did not yet operate on commercial principles.

Financial sector reform per se began to receive more serious attention in the mid-1990s when China’s economic planners realized that—like the markets for goods and services—financial intermediation had to be based on market principles. China became a member of the Bank for International Settlements (BIS) in 1996. The Asian financial crisis of 1997-98 added urgency to financial sector reform. Especially after the collapse of South Korea’s economy at the end of November 1997, the Chinese authorities became deeply concerned about weaknesses in their own banking system, poor financial performance of most SOEs and the undeveloped nature of domestic capital markets. The official “credit plan” was abolished in 1998, but de facto state influence over the allocation of financial resources is receding only slowly. Since banking reform moved center stage around the turn of the century, significant progress has been made. Capital market development became the next priority. The Third Plenum of the 16th CPC Central Committee (October 2003) called for “a greater role for direct financing through establishing a multi-tier capital market system and encouraging the growth of institutional investors” [6].

As result of these and other developments, China’s financial system has significantly broadened and deepened since the turn of the century. Many new instruments have entered the market and yield curves for government bonds, which were mostly flat until about five years ago, have become sloped as they normally typically are in mature capital markets [7]. Now is the time to liberalize and commercialize corporate bonds. The promotion of Tianjin as a new financial center and area for concentrated development offers a good opportunity to also promote the development of genuinely commercial corporate bond market.

Remaining Obstacles

Impressive as financial system development has been in recent years, a number of relatively serious obstacles to the development of capital markets, including corporate bond markets, remain:

Effective market discipline has yet to be established. The government continues to exercise considerable influence on the allocation and pricing of financial resources through administrative interventions. This affects the assessment of risk, reduces pricing flexibility and generally limits the beneficial effects of market discipline.

Market supervision is relatively weak; insider trading, price manipulation and inadequate disclosure remain serious problems.

Investor education remains limited. Although institutional investor participation has sharply increased, most individual investors continue to regard these markets as casinos.

The market for corporate bonds remains highly segmented. There are now at least three kinds of corporate bonds: (a) short-term bonds with a maturity of one year or less, issued under the auspices of PBC since May 2005 and traded OTC on the Interbank Market, (b) medium and long-term corporate bonds issued by major unlisted SOEs under the auspices of NDRC, fully guaranteed by a major state bank, traded on the exchanges, and (c) non-guaranteed medium and long-term bonds issues by listed companies under the auspices of CSRC, traded OTC on the Interbank Market. A fourth category of corporate bonds now seems to be emerging: in April 2008 NDRC approved the issue of non-guaranteed debenture bonds by two unlisted SOEs (China National Materials Group Corporation, SINOMA, and Dalian Port Corporation Ltd.) (Xinhua News Bulletin, April 8). There is a need for consolidation of the corporate bond market and its supervision.

China’s credit rating industry remains undeveloped. There are at present five licensed credit rating agencies (CRAs), but most are under (indirect) government control and not truly independent. Investors pay little attention to their ratings. China has not so far permitted wholly foreign-owned agencies to rate locally issued bonds, but several foreign CRAs, including Moody’s, have been given permission to increase their minority participations in JVs with Chinese CRAs to 49 percent.

Financial repression. The control of deposit rate ceilings by PBC tends to push some financial intermediation underground and retards the commercialization of official debt markets.

Notes

1. At present the total amount of corporate bonds outstanding accounts for only about 3 percent of China’s stock market capitalization. In developed market economies the corresponding ratio would typically range between 100-200 percent. Corporate bonds account for about 1.4 percent of funds external funds mobilized by China’s corporations (Hale).

2. Hale, G. (2007), ‘Prospects for China’s Corporate Bond Market’. Federal Reserve Bank of San Francisco Economic Letter.

3. Green, S. (April 2003), ‘China’s stock market. A guide to its progress, players and prospects.’ The Economist.

4.The overheating was due to excessive bank credit expansion, large-scale corporate bond issues sponsored by local governments and a general lack of discipline in the financial system

5. Bottelier, P. (2008), ‘China’s Emerging Domestic Debt Markets’, in Policy Reform and Chinese Markets, edited by Belton M. Fleisher et al. Edward Elgar.

6. Zhou, X. (2006), ‘China’s corporate bond market development: lessons learned.” BIS Papers No 26.

7. See for example https://eyield.chinabond.com.cn/cbweb/index.