Finally, there is the foreign banking presence. International banks were very active in the negotiations leading to China’s accession to the World Trade Organization, producing a detailed schedule that opened China’s domestic banking markets. China has largely abided by the agreement and, over the past eight years, foreign banks have invested heavily in developing networks and new banking products. With a focus primarily on domestic consumers, new branch networks and the brand advertising of the major American and European banks have become common in China’s major cities and media. Foreign banks have also been quick to engage in the development of a market for local-currency risk-management products.
These banks understand that China and its financial system are in transition and most are prepared to persist in the expectation that at some time in the not-too-distant future, the market will be open fully to them. This was the commonly held position prior to 2008. But the conclusions about the global financial crisis now being drawn by the Chinese government suggest that opening and reform along the lines of the now apparently discredited international financial model will no longer continue. This is not to say there is another model . . . except for the prolongation of the status quo, and this is the direction to which recent events point. What future, then, is there for foreign banks in China?
In summary, China’s banks operate within a comfortable cocoon woven by the Party and produce vast, artificially induced, profits that redound handsomely to the same Party. As demonstrated by the 2008 Olympics or the wild celebrations of the country’s sixtieth anniversary, the Party excels in managing the symbolism of economic reform and modernization. Ironically, however, if the Asian Financial Crisis in 1997 caused one set of Chinese leaders to see the need for true transformational reform of the financial system, the global crisis of 2008 has had the opposite effect on the current generation of leadership. Their call for a massive stimulus package reliant on bank loans may have washed away for good the fruits of the previous 10 years of reform. Even more ironic, while the “good” banks have been weakened, the “bad” banks created for the earlier reform effort are being strengthened, perhaps in preparation for the next inevitable wave of “reform.” If emerging markets are so defined because their institutions are always “in play,” buffeted by the prevailing political needs of the government, then real change depends on the next major crisis and a Party leadership willing to accept that today’s symbols do not reflect underlying reality and that the true needs of China’s economy are not being met.
ENDNOTES
1 China Daily, August 25, 2010: 9.
2 The bonds originally had a 10-year maturity, but this, as well as the coupon, changed in 2005. The new coupon is a more manageable 2.25 percent despite its much longer tenor, which was extended to 2028.
3 In ABC’s case, this bond was just replaced by an MOF IOU.
4 The RMB93 billion noted is the amount injected into the two banks in 1998 by the MOF’s arrangements as part of the RMB270 billion Special Bond. As the total NPL ratio for the banks stood at 40 percent at that time, it cannot be the case that any of the banks had any real retained earnings.
5 In fact, the PBOC slightly diversified CCB’s shareholders by allowing a number of central SOEs, as well as the National Social Security Fund, to hold shares. Hence, the PBOC held only a little more than 95 percent of CCB at this point.
6 The original AMC bond, totaling RMB138 billion, owed to ABC from 1999 was replaced by the IOU; RMB150.6 billion in NPL assets was used to offset a PBOC loan of the same amount.
7 See The Economic Observer, December 26, 2005: 34. This number may be even larger. The PBOC, in its Financial Stability Report 2005, has also reported a figure of RMB3.24 trillion or US$390 billion.
8 Keith Bradsher, “Main Bank of China is in Need of Capital,” New York Times, September 5, 2008.
9 Yu Ning, “Huida deng chang (Huida takes the stage),” Caijing , July 25, 2005: 65.
10 See “Huida zichan tuoguan fuchu shuimian Zhan Hanqiao huoren rending shizhang (Huida Asset Management surfaces; Zhang Hanqiao likely appointed as Chairman),” China Business News, August 3, 2005: 1.
11 The absence of the Hainan and Guangdong figures makes one wonder about the fate of the huge amounts of “triangle debt” Zhu Rongji untangled in the early 1990s that were left over from the 1980s banking debacle.
12 Caijing , May 12, 2008: 79.
13 www.caijing.com.cn/2009-09-23/110258742.html
14 The bond owed to Bank of China by its related AMC, Orient, was also extended as it came due in 2010; without question the similar Huarong bond held by ICBC can also be expected to see its life extended later in 2010.
15 CEO and Chairman of JPMorgan Chase & Co.
CHAPTER 4
China’s Captive Bond Market
“Compared with other financial instruments and against the backdrop of a high savings rate and high ratio of M2 to GDP, China’s corporate bond market has been developing very slowly and its role in economic growth has been rather limited. Such lack of development has also distorted the financing structure and produced considerable implicit risks, whose consequences may be grave for social and economic development.”
Zhou Xiaochuan
Speech at China Bond Market Development Summit
October 20, 2005
The demand from corporations and other issuers for cheaper capital than banks were willing or able to provide gave rise to the debt-capital markets in the developed economies. The basic assumption of issuers is that banks do not have a monopoly on understanding and valuing risk; large institutional investors, such as insurance companies and pension funds, also have the capacity to make investment judgments independently. So why rely only on banks for capital if you can get money more cheaply from other investors? Why not use markets to press the banks for cheaper funds? In China, over the past several years, a similar process appears to be happening. Its bond markets have enjoyed record issuance volumes, developed standardized underwriting procedures and allowed some foreign participation. Is it possible that in the not-distant future, investors in this market will compete with banks for corporate issuers and so take some of the credit- and market-risk burden from them, as has been one of the explicit reform objectives of the central bank?
In China, nothing is as it appears; words similar to those used internationally can have different meanings. Here, the markets were created by the same group of reformers who promoted bank reform. Beginning in 2005, with the aim of reducing excessive risk concentration in the banking system, they took over the largely moribund inter-bank market for government debt and introduced products modeled after those available to corporations internationally. On the surface, their efforts appear to have paid off. But huge issuance volumes, thousands of market participants and a growing product range do not alter the fact that China’s debt markets remain at a very primitive stage—an assessment with which no market participant in China would disagree, as Zhou Xiaochuan’s comments above attest. China’s debt markets are captive both to a controlled interest-rate framework on the one hand, and, on the other, to investors that, in the end, are predominantly banks. To understand why China’s bond markets are moribund requires digging into the technical details. But seeing how these markets are controlled is a key part of understanding how the Party manages China’s financial system: the symbols of a modern market are there, but the market itself is not.
Normally, the word “primitive” is used to indicate that the necessary market infrastructure is missing, but in China, all such infrastructure is in place. Like highways, new airport terminals or CCTV’s ultra-modern office building in Beijing, it exists because the Party believes bond markets are a necessary symbol of economic modernity. So there are ratings agencies (five), regulators (at least seven) and industry associations (at least two) with overlapping authorities and little respect for one another. There are now many of the same products that can be found in more developed markets, including government bonds, commercial paper (CP), medi
um-term notes (MTN), corporate bonds, bank-subordinated and straight debt, some asset-backed securities, and so on. These products are traded for cash, repo-ed1 out, or sold forward, and interest risk is hedged through swaps: all as might be expected.
What makes China’s bond markets “primitive,” however, is their lack of the engine that drives all major international markets. That engine is risk and the market’s ability to measure and price different levels of it. Risk, in market terms, means price; like everything else, capital has a price attached to it. In China, however, the Party has made sure that it alone, and not a market-driven yield curve, provides the definitive measure of risk-free cost of capital and this measure is based ultimately on the funding cost for bank loans, the one-year deposit rate. Consequently, in the primary (issuing) market for corporate debt, it is common practice that underwriting fees and bond prices are set with reference to bank loans, and not to true demand. Artificially low prices are then compensated for by the issuer’s agreement to an exchange of additional value outside of the market through, for example, conducting a certain amount of foreign-exchange transactions. In other words, bond-price setting is bundled with other business not in the market and the underwriter then holds the bond to maturity. Why? In the secondary (trading) market, investor demand is free to price capital, but the low issuing prices in the primary market mean that the bond underwriter will take a loss if he sells. Thus, the number of Chinese government bonds (CGB) and other bonds traded daily is in the hundreds at best. To the extent that bonds change hands, they do so at prices reflecting the premium that holders must pay to buyers to unload the security. If there is no active trading, there can be no accurate market pricing standards, only a price that might be called a “liquidity premium.”
There is an additional, historical, reason explaining the weakness of China’s bond markets. China is a country where the state—that is, the Party—owns everything and there is no tradition of private property. It might be expected, therefore, that the debt markets would have grown into the most developed market for capital. Unlike stock, debt does not touch directly on the sensitive issue of ownership. As even the most casual observer cannot help but note, however, everyone in China—from retail mom-and-pop investors to provincial governors and Communist Party leaders—is infatuated with stock markets. This has been true since the early 1980s when shares were “discovered” and is one of the main explanations for why observers believe that China is evolving along the path traced by developed economies.
So why not debt? The reason is simple: the government and SOE bosses quickly figured out that stock markets provide enterprises with “free” capital in the sense that it need not be repaid. In contrast, like a loan, bond principal must be paid back at some point and in the past, this often has proved to be “inconvenient.” Even better, a public listing provides an SOE with a “modern” corporate veneer (plus higher compensation levels for senior staff if the company is listed overseas) that issuing debt does not. Again, it’s the great attraction of symbols. Selling shares is a game-changer in these and many other ways, while issuing more debt is just business as usual. No Chinese CEO was ever lauded in the financial press for borrowing money from a bank.
China’s beautiful market infrastructure is necessary, but insufficient to raise the bond market above its primitive stage. As a result of manipulated pricing, corporate issuers are indifferent to the choice of debt instruments; bonds or loans are the same to them. More importantly, underwriters and investors are also indifferent to this market because they cannot make money. This chapter explains why this is so. Caught up in guidelines left over from the Soviet central-planning era, interest rates do not reflect true market forces, so debt valuations are distorted. But this is how the “system” likes it; the Party’s urge is to control. Party leaders believe they are better positioned than any market to value and price risk. The near-collapse of the international banking system in 2008 has only confirmed them in this belief.
What does bond market “development” mean, however, if not establishing over time a finely tuned understanding of the price of risk? Part of the notion of risk is that of change. But China’s debt-capital markets have from their inception been founded on the expectation that there will be no change, whether in the quality of issuer or in supply and demand as understood by developed markets. Zhou Xiaochuan’s remarks, therefore, are an almost-unique public indication that at least some senior officials are aware of the real systemic dangers being created by this suppression of risk. Given his expertise, his remarks on the consequences for social and economic development are not entirely surprising. If all this is true—that the market is creating risk—why does China need a bond market or, in any case, the one it has currently?
WHY DOES CHINA HAVE A BOND MARKET?
The fact that banks hold over 70 percent of all bonds highlights the importance of this question. For the group of market reformers surrounding Zhu Rongji and Zhou Xiaochuan, developing the bond market was a basic part of the bank-reform process that began in 1998. A strong bond market would encourage institutions other than banks to hold corporate debt, and risk could be diversified. But if the markets are not wholly opened to the participation of investors not controlled by the state, this cannot happen. The reality is that China’s bond markets has evolved over the past 30 years because the national budget needs to be financed; however, its tax-collecting capacity was, and remains, too weak. If corporate investors could rely on bank lending, the MOF cannot, not if it follows in the model of state treasuries elsewhere in the world. What would a minister of finance be if he could not issue government bonds? What would a modern economy be if it didn’t have a government-bond yield curve to measure risk? The MOF’s growing demand for funds from the early 1980s led to the creation of a narrow market, which reformers 20 years later would seek to broaden.
In the early 1980s, markets for securities of any kind did not exist in China. The last bond the country had issued was in 1959 and all knowledge associated with it had long since been lost to the Cultural Revolution. But ambitious national budgets in the early 1980s began to create small deficits (see Figure 4.1). Confronting the question of how to deal with increasing amounts of red ink, the idea of issuing bonds was voiced by a courageous person at the MOF. This raised questions about the identity of the investor base and what price to pay them. At the start, only SOEs had money (of course, all borrowed from the banks), so by default, they were compelled to fund the government budget as a political duty. As for price, bond interest was set administratively with reference to the one-year bank-deposit rate set by central bank fiat to which was added a small spread. As the data in Table 4.1 indicate, individuals received a higher interest rate than SOEs, which reflected both the MOF’s need for third-party funding as well as the demand of retail investors for a reasonable yield. This was a real market situation and the MOF had yet to find a way to minimize its funding costs. As for a secondary market for debt, there was none. SOE investors were forbidden to sell bonds based on logic relating to the MOF’s “face”: selling a bond was seen as a lack of confidence in the state’s creditworthiness.
TABLE 4.1 Composition of national savings and sales of bonds, 1978–1989
Source: Gao Jian: 47–9; China Statistical Yearbook, various
Note: All coupons for maturities of minimum 5 years
FIGURE 4.1 National budget deficits vs. MOF issuance, 1978–1991
Source: China Statistical Yearbook; Wang Nianyong, p. 53
Note: Includes central and local government budgets; excludes maturing bonds rolled over in 1989–1991.
Over the course of the 1980s, successful agricultural reforms and the growth of small enterprises in the cities rapidly enriched the general population. By 1988, nearly two-thirds of all bonds were sold directly to household investors. Then, from 1987, the real market turned as inflation boomed and banks were ordered to stop lending. SOEs and individuals, strapped for cash and seeing yields turning negative, discovered they
could sell off their bond portfolios, although at deep discounts, to “speculators”. Suddenly a wholly unregulated over-the-counter (OTC) secondary market sprang into existence just as the craze for shares hit its peak in 1989 and 1990. Here were China’s first (and still only) true markets for equity and debt capital! They were rapidly closed down.
When the political dust from June 4 had settled, China in 1991 had the beginnings of regularized bond and stock markets, but they were ensconced safely inside the walls of the new Shanghai and Shenzhen exchanges. The new infrastructure suggested that market reformers had prevailed, but the truth is they had been forced to compromise away the heart of the markets. The two exchanges existed only to provide controlled trading environments where prices and investors could be managed to suit the government’s own interests. For its part, the MOF had also realized by this time that its fund-raising difficulties in part reflected investors’ fear of locking up their cash with no legal way to recover it until their bonds matured. To expand its own funding sources, therefore, from the early 1990s, the MOF began to develop a secondary market on the exchanges.
Proper pricing of the bonds remained a problem, however, and it wasn’t until 1994 that the MOF stumbled on a workable combination of underwriting structures and market-based bidding within the strictures of PBOC interest rates that allowed CGB issue amounts to increase (see Figure 4.2). The innovator at the MOF, Gao Jian, loves to recount the story of how he created a Dutch auction-based bidding system for a loose group of primary dealers using a Red Tower Mountain cigarette carton to hold their bids.2 Someone’s smoking habit and an equitable way to distribute the obligation to underwrite government debt largely solved the MOF’s fund-raising difficulties and created the market infrastructure that could be used a decade later.
Red Capitalism: The Fragile Financial Foundation of China's Extraordinary Rise Page 10