Most Asian economies long have depended on bank financing, and to a lesser extent, on the equity markets, to fund investments. Except for countries like Singapore, Malaysia and a few other more developed Asian economies, corporate bonds are almost unheard of in the region. But bonds and bond markets are at least as important, if not more so, than stock markets, for the efficient allocation of a nation’s resources. In major economies, it is not uncommon for bond markets to be substantially larger than equity markets. But that’s not always the case in Asia. And certainly not in China. Yet if any economy in Asia needs to develop a bond market, it is China’s.
To give credit where credit is due, the Chinese government historically has shown a good measure of fiscal responsibility, and this has helped the nation gain an A2 rating on its sovereign debt. The bad news is that the government borrows little from outside sources. This in turn means a limited amount of government debt is available for trading on secondary markets. So don’t go looking for a deep and liquid secondary market for Chinese debt. For businesses trying to issue bonds, this is a problem because it is just such a government-bond market that sets interest rate benchmarks for corporate bonds. (Which is why some countries issue sovereign bonds to replace maturing ones–even when the funds aren’t needed–to maintain benchmarks across the yield curve.)
Yet of course, to have a corporate bond market, you need companies that want to issue bonds. In China, companies have traditionally relied on bank-loan financing. It will take some persuasion to change that. Today, even if a corporate bond option existed, Chinese companies would still head for the bank. Why? In a phrase: Cheap money. Companies can borrow at low, government determined interest rates, irrespective of the risk of the loans. The risk is assumed by the government, which must periodically bail out banks by taking over their nonperforming loans. Indeed, companies are further encouraged to seek bank financing by the fact that state controlled banks almost always automatically roll over maturing loans at low rates. This is of course a classic case of moral hazard. Costs and risks are absorbed by state owned banks, which ultimately pass them on to the government.
For now, the burden of debt servicing is manageable. But government bailouts can only be a temporary solution for clearing the balance sheets of state owned banks. Nonperforming loans are becoming unsustainably large. The national debt as a percentage of GDP is estimated to be around 20 percent. But if you add implicit debts to this figure, it rises to over 130 percent of GDP–which would likely cause the government to lose its current sovereign risk rating. It is unclear how much longer China can afford to keep bailing out its banks.
All of the above makes a convincing argument for the development of a Chinese corporate bond market. Such a market would serve several functions. First, it would enable companies to raise funds even if they are not favored customers of the banks. China has one of the world’s most entrepreneurial economies. But entrepreneurs aren’t usually well connected. So even as new companies are constantly being established, and many succeed and create jobs, they tend to be small and to stay small because they lack access to funding to grow. A corporate bond market could remove this constraint and enable China to create world class companies and, even more importantly, jobs for tens of millions of people.
Second, it allows for fewer systemic risks. Bank loans typically are of short to medium term, and therefore need to be rolled over to cover the life of the project funded. This lends an air of uncertainty to business planning. Worse, loans can be called in before schedule, leaving companies in dire financial predicaments, of the sort that Southeast Asia witnessed during the Asian Crisis. Recourse to bond financing would eliminate any mismatch between the lifetime of assets and the duration of liabilities.
Third, as the number of Chinese pension funds, social security funds and insurance funds proliferate, bond markets are key to ensuring that these funds can match their future payment obligations with assured future income. Without a long term bond market, such funds, increasingly important to China, will be at risk.
Given the size of China’s economy and its government’s history of fiscal discipline, the country has the potential to develop a sophisticated government bond market that could lay the foundation for a large Chinese corporate bond market. And once the renminbi is fully convertible, such a market could be the seed for a regional local currency Asian bond market. A well regulated corporate bond market open to private companies can fund the jobs China needs for social stability. Together, government and corporate bond markets can stabilize China’s financial landscape by properly matching assets to liabilities.