Ironically, one month before the 327 Incident, Vice Premier Zhu Rongji, who was then responsible for the financial sector, had fiercely criticized the rampant speculation in the bond futures market “by a number of huge interest groups, taking funds of the state, the local governments and the enterprises to seek profits.” Zhu had identified a growing problem but was apparently unable to do anything about it. He could, however, eliminate the futures product. Given the political cost associated with this scandal, it should not be surprising that the Party prefers an orderly, controlled bond market, even if this is, after all, moribund. But by refusing to reform the market, the Party simply promotes the forces of speculation which, as China has become more prosperous, become all the stronger.
THE BASE OF THE PYRAMID: “PROTECTING” HOUSEHOLD DEPOSITORS
At the base of China’s bond and loan markets are China’s household savers. Today, banks hold more than 70 percent of all bonds in value terms, but this was not always the case. In the earliest days of the market in the 1980s, individuals became the dominant investors, annually snapping up 62 percent of all bond purchases. By 2009, however, they had nearly disappeared from the field, accounting for only one percent in outstanding bond value (see Figure 4.10). Foreign banks account for another seven percent, which means that state-controlled entities hold 92 percent of total bond investment. What’s more, many of these same state entities are the only issuers in the market.9
FIGURE 4.10 Change in types of bond investors, 1988 and 2009
Source: 1988, Gao Jian: 49–51; 2009, China Bond
This fact has profound implications for China’s financial system. If the markets today simply function as clearing houses that move money from one pocket of the state to another, then they have developed away from their more diverse origins in the 1980s into something resembling a pyramid scheme. This is exactly why Zhou Xiaochuan has described them as “distorted” and filled with “implicit risk.” Why has the role of the critically important non-state investor become so diminished?
As part of its effort to develop greater market capacity, in 1991 and 1992, the MOF experimented with different underwriting methods. Its own experience had clearly highlighted the problems limiting large-scale bond issuance. First of all, there was the pricing problem. But, secondly, the over-reliance on the retail market created major difficulties. As individuals purchased bonds in small amounts, simple logistics limited the total amount of bond issuance and offering periods were often up to six months before an issue could be closed. Even to access these investors, the MOF found itself having to pay close to market prices. The retail market also tended to buy and hold until maturity, thus inhibiting the emergence of a secondary market. Finally, maturities tended to be short as a result of both inflation and retail preference. Small issue sizes, high cost, shorter maturities and the fact that there was no secondary market prevented the development of benchmark interest rates and, ultimately, meaningful yield curves. All of these are legitimate reasons to seek to develop an institutional investor base.
The MOF had sought early on to develop institutional investors by seeking support from banks and non-bank financial institutions. However, banks in the 1980s had little excess liquidity and, therefore, little capacity to invest. Even if the State Council had allowed the MOF to develop a market-based pricing method, the retail nature of the investor base may have limited its ability to raise funds in line with its needs. It was at this point that the story of stock markets and bond markets came together. Having created stock exchanges to manage the “social unrest” associated with street trading, the government also brought bonds “inside the walls,” especially those of the Shanghai Stock Exchange.
The exchanges enabled demand to be sourced from both individual and institutional investors; all were members of the new markets. The banks also had much deeper pockets given rapidly growing retail deposits (see Table 4.4) and it was not long before the government began to lean on them for support as they discovered an interesting fact.
TABLE 4.4 Composition of Big 4 bank deposits, 1978–2005
Source: China Financial Statistics 1949–2005
Accessing funds from the banks had the effect of lowering the MOF’s interest expense. The Party could urge banks to buy bonds at levels just above the one-year rate they were paying retail depositors, while retail investors using the same bank deposits to buy bonds would require far higher returns. In other words, the banks provided the government with direct access to household deposits at government-imposed interest rates without even having to ask the depositor for permission: the banks simply disintermediated them. Unlike unruly retail investors seeking to maximize returns, banks had the pleasing aspect that their senior management (Party members) did as they were told. The Party was now easily able to direct funds where it wanted and in the amount it wanted without the need for excessive cajoling or paying market rates. Meanwhile, it could persuade itself that this was the right thing to do since it “protected” the household depositor from undue credit risk.
At first, there was no conflict of interest: individuals were crazy about shares, not bonds, and banks could not buy shares. But as China emerged from the major inflation of the mid-1990s, bonds suddenly offered a very attractive return in comparison to a collapsing stock index. The problem was that retail investors were unable to get their hands on them. In just a brief period of time, China’s banks had monopolized bond trading on the Shanghai exchange. The story goes that a feisty Shanghainese housewife complained about this de facto government-bond monopoly and her anger reached all the way to Zhu Rongji. Characteristically, Zhu took decisive action and in June 1997, he summarily kicked the banks and the bulk of government bond issuing and trading out of the exchanges and into what was then a small and inactive inter-bank market.10 Since then, individual investors have been limited to buying savings bonds through the retail bank networks and institutional investors have been largely limited to the inter-bank markets.11
This significant structural change meant that although the market continued to rely overwhelmingly on the state-owned banks, all other state-owned entities that could qualify as members could also participate (see Table 4.5).
TABLE 4.5 Number of investors, October 31, 2009
Source: China Bond
Note: Members include individual branches in the case of institutions.
Member type Number
Special members (PBOC, and other government agencies) 16
Commercial banks 382
Credit cooperatives 830
Non-bank financial institutions 163
Securities companies 122
Insurance organizations 131
Funds 1,502
Non-financial organizations 5,908
Total inter-bank market members 9,054
Individuals (not members of the inter-bank market) 7,334,832
In short, bonds returned to their earliest stage, when the state was its own investor. But the principal difference was that banks and all other non-bank financial institutions replaced SOEs, which meant that household savings would be channeled directly by the Party. This explains how the banks came to hold over 70 percent of all fixed-income securities in China, including 50 percent of all CGBs, 70 percent of policy-bank bonds, and nearly 50 percent of commercial paper and medium-term notes issued (see Figure 4.11). Only in the case of the NDRC’s enterprise bonds do insurance companies (NBFI) displace the banks as the principal investors, holding some 46 percent of these securities.
FIGURE 4.11 Investor holdings of debt securities, by issuer, October 31, 2009
Source: China Bond
Note: Non-state investors include foreign banks, mutual funds, and individuals.
In the international markets, banks also dominate underwriting and trading, but investors and their beneficial owners are, of course, far more diverse, with large roles being played by mutual and pension funds as well as insurance companies. In China, such diversity is beside the point since all institutional invest
ors, whether banks or non-banks, are controlled by the state. In such circumstances credit and market risk cannot be diversified. This is why China’s markets remain primitive and why there is the “implicit risk” alluded to by Zhou Xiaochuan.
In late 2009, the CBRC suddenly became aware of this inevitable reality when it stopped all issuance of bank-subordinated debt. Why had it been oblivious to this risk from the beginning? If the state owns China’s major banks outright, as it does, what is the significance of Bank of China issuing subordinated debt to investors that are largely other state banks? The state is simply fooling itself by subordinating its own capital to its own capital. The level of risk in the system has not changed one bit, even if the financial landscape seems the richer for adding this new product.
All of this raises the question of why it has been so difficult for foreign banks and other financial institutions to become involved in this market. Over the past 15 years, China’s leaders have witnessed the Mexican debt crisis of 1994, Argentina’s peso crisis of 1999 and the ongoing sovereign-debt crises of Greece and Spain. They have seen the huge ramp-up of their own stock index in 2007 and its collapse in 2008. Local newspapers and other media commentary are rife with talk of hedge funds, hot money and unscrupulous investment bankers. An inherently conservative political class, whose natural instinct is to control, will not easily invite those it cannot easily control to participate actively in its domestic debt markets. But, as appearances have to be preserved, there will always be slight movements toward market opening. But there will be no true opening.
What would happen to bank and insurance company holdings of CGBs or other corporate and financial bonds in an inflationary environment? As mentioned, China’s central bank manages interest rates in order to contain change because change is risk. No matter that these state institutions hold fixed-income securities as long-term investments to avoid marking their value to market, in an inflationary environment their value will inevitably decrease as funding costs rise. The inevitable result would be a growing drag on bank income even if valuation reserves are not taken. This problem can be seen clearly in bank financial statements. For example, the auditors for ICBC’s 2009 financial statements usefully show separately the yields on the bank’s loan, investment-bond, and restructuring-bond portfolios (see Table 4.6).
TABLE 4.6 Yields on loans, investment and restructuring bonds, 2008–2009
Source: Bank FY2008 financial statements
Note: * CCB and BOC bond rates are calculated on portfolios that include the restructuring securities; hence returns are pulled down. ICBC rates have been separately calculated.
The restructuring bonds yield on average almost exactly the one-year bank-deposit rate and are fixed. In other words, in a low-inflation environment, they will nearly break even, whereas the bonds held as investments yield 3.34 percent, around 1.1 percent over the one-year deposit rate. This is somewhat better, but raises the question: why hold such huge bonds portfolios when loans yield on average nearly seven percent? Banks hold these portfolios partly for liquidity reasons, but largely because they are required to do so by the Party. If the ultimate objective of bank management were to maximize profit, would such low-yielding bonds make up 20–30 percent of their total assets (see Figure 4.12)?
FIGURE 4.12 Composition of total assets of Big 4 banks, FY2009
Source: Bank 2009 annual reports
Interest-rate risk holds true for all bonds, but corporate bonds also have a credit aspect. In the event of their inability to pay interest, banks will experience a drag on income and, sooner or later, would be compelled to re-categorize their internal credit ratings and make provisions as the bond becomes, in effect, a problem loan. Even if the bank could sell the bond into the market under such circumstances, it would be forced to take an outright loss. China’s major financial institutions, banks and insurance companies are all listed on overseas exchanges and audited by international firms. The need to take reserves should be unavoidable in such circumstances. China has not been, and will not be, exempt from such circumstances.
In short, China’s banks face severe challenges on three fronts. In addition to their structural exposures to the old NPL portfolios of the 1990s, there will inevitably be new NPLs arising out of their lending spree of 2009. Thirdly, the banks are fully exposed to both interest rate-related and credit-induced write-downs in the value of their fixed-income securities portfolios. In 2009, securities investments constituted 30 percent of the total assets of China’s Big 4 banks, or RMB7.2 trillion. While the interest risk of these portfolios can now be hedged somewhat as a result of the very recent emergence of a local-currency interest-rate swap market, for the state, it is a zero-sum game: BOC may effectively hedge, but its counterparty will almost inevitably be another state-owned bank. The effect of mark-downs, credit losses or even simply negative yields on bank capital would obviously be significant. From the viewpoint of the issuer, too, they seem to make little difference. In the international markets, corporations can source cheaper funds from other classes of investor; but in China, the banks remain the investor and the all-in cost to the issuer will be the same as a loan. So the question again presents itself: why did China build its fixed-income market?
ENDNOTES
1 A “repo” or “repossession” contract is a kind of financing transaction in which a party holding, most commonly, government bonds provides the bond as collateral to a second party who then lends money to the first party. This is a cheap way of funding a large bond portfolio.
2 For the only authoritative history of China’s government bond markets, see Jian Gao 2007.
3 This group is not the same as the primary-dealer group authorized by the MOF for CGB underwriting. The two non-banks are CITIC Securities and China International Capital Corporation. In late 2009, some foreign banks received licenses to underwrite financial bonds only to be told that “circumstances are not yet mature” for their active participation.
4 Of course, underwriters are free to set higher interest rates (known as coupons) on enterprise bonds if their issuer clients agree.
5 From January 2004, the cap on maximum interest rates on loans was eliminated, but banks are still subject to a minimum rate charged, which is 90 percent of the PBOC set rate for the relevant tenor.
6 Figures from US Department of Treasury, Office of Debt Management, June 2008.
7 There is, however, now a stock index future product.
8 Foo Choy Peng, “China Economic Rated Top Broker,” Bloomberg, January 13, 1996.
9 The Asian Development Bank and the International Financial Corporation, a part of the World Bank, have been the only foreign issuers in the domestic bond market to date.
10 The inter-bank market in China was established in 1986 as a funding mechanism for banks in which those with surplus funds place them with others needing additional funding in order to balance their books.
11 A small number of bonds remained listed on the Shanghai exchange to enable securities firms to finance themselves through repo transactions. Until recently, banks were excluded from this market. Their reintroduction is largely an effort to merge what has become two separate markets: the exchange-based and the inter-bank.
CHAPTER 5
The Struggle over China’s Bond Markets
“If it doesn’t have access to a stable and sufficient source of capital, the China Development Bank will be unable to operate normally.”
Unnamed staff member, Treasury Department, China Development Bank
January 11, 20101
The combination of bank restructuring and the stock market’s collapse from mid-2001 catalyzed dynamic growth in China’s bond markets. This period began with the appointment of Zhou Xiaochuan to the governorship of the PBOC in early 2002. That year, a total of RMB933 billion (US$113 billion) in bonds, largely Chinese government bonds (CGB) and policy-bank bonds, was issued. By 2009 new issuance had nearly tripled, to RMB2.8 trillion (US$350 billion), and included a large chunk of corpora
te and bank bonds. As of year-end 2009, the total value of China’s outstanding stock of debt securities had reached RMB 17.5 trillion (US$2.6 trillion), with a mix of products that included government bonds (US$841.8 billion), PBOC notes (US$620.6 billion), bank bonds (US$747.1 billion) and a variety of corporate debt (US$354.1 billion) being traded between more than 9,000 institutional investors.
Many issuers struggled to get a piece of this market, none more significant than the China Development Bank (CDB). As the trends in Figure 4.2 illustrate, the CDB has begun to challenge for the dominant position, becoming, in effect, the country’s second Ministry of Finance. The bank’s RMB620 billion (US$912 billion) in issuance in 2009 was nearly on a par with the MOF’s RMB666.5 billion (excluding savings bonds) and represented nearly 30 percent of the total market. Equally significant, driven by the need to finance the stimulus package, Beijing at last recognized the legitimate funding needs of local governments and allowed certain poor provinces to issue bonds. In addition, all levels of local government made aggressive use of the bond markets, raising RMB423 billion (US$62 billion) via their own enterprises on top of massive levels of bank borrowing.
Red Capitalism: The Fragile Financial Foundation of China's Extraordinary Rise Page 12