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China’s efforts to liberalise its bond market could spell the end of the country's qualified foreign institutional investor programmes and of the offshore renminbi bond market too, speakers predicted at FinanceAsia’s 7th annual Borrowers & Investors Forum in Hong Kong on Wednesday.
“Going forward there could perhaps be one China bond market and everyone could easily access into this market,” Sean Chang, head of Asian debt at Baring Asset Management, said before a packed ballroom at The Ritz-Carlton. “However the tax environment is something to look at, as the onshore market has withholding and capital gains tax, while the offshore market has no such thing.
“For QFII and [its offshore renminbi version] RQFII it’s a matter of time before they become obsolete,” he said. “If you can fine-tune the tax differences there is nothing left [to keep offshore and onshore renminbi investing apart].”
QFII quotas were introduced in 2002 to enable select foreign investors to circumvent China's strict capital controls and buy renminbi-denominated shares listed on the Shanghai and Shenzen stock markets. They have since evolved to include a wider array of financial investments, including bonds.
But on February 27 the Chinese government opened up its local interbank bond market to foreign commercial banks and institutional investors, meaning they would no longer have to rely on QFII or RQFII schemes to invest in local bonds.
“Since 2005, when China’s financial markets opened up, people had needed QFII or RQFII to invest into China’s bond market but now they can directly invest onshore,” Chang said. “We still need to clarify how bonds that are invested in onshore are settled through clearing houses, and whether we should conduct a dollar exchange onshore with CNY or if people can bring CNH. There are still developing opportunities.”
CNY is the international currency code for the onshore renminbi and CNH is its offshore version.
The broadening of China’s onshore debt market has been a boon for the country’s private corporate borrowers, many of which had previously had to source more expensive funding offshore.
“The opening of the domestic bond market is a positive step from a credit-risk perspective, especially for property developers that require a lot of capital to fund their expansion,” said Christopher Lee, chief ratings officer for Greater China at Standard & Poor’s. “Having funding in the domestic market has changed the game for them. Their funding costs are much lower and it's in renminbi, so they have no exchange currency risk.”
Rating risks
Yet while speakers were happy to talk up the opportunities of China’s burgeoning bond market, many also struck a cautious tone about the trading trends on display.
Onshore bonds in China have seen yields drop markedly, as more money has been put to work into these instruments due to a combination of aggressive interest rate cuts by the People’s Bank of China, local banks seeking higher returns than loans, and investors disappointed by collapsing equity valuations.
“Looking at the onshore bond market in general, we see valuations are rich and getting richer. The onshore market is flush with liquidity and the PBoC has cut rates multiple times and injected liquidity,” said Chang. “All of this has made bond valuations rich versus the offshore market.”
That is a worry given the rapid rise in corporate debt levels, which has left many Chinese company balance sheets looking weaker at a time of slowing economic growth.
Property developers, among China’s most frequent borrowers, face particular issues.
“During each down cycle over the past five to six years, several property developers took the opportunity to expand by taking on more leverage,” S&P's Lee said. “This cycle has been smaller and weaker developers are finally beginning to merge but big companies aren’t slowing their land acquisitions by taking on more leverage. So leverage has been rising more than we expected.”
Added to this are sectors that have well-documented over-capacity, such as iron, steel, shipping, cement, and related services industries. In each one many, predominantly state-owned companies are outright losing money or struggling to remain profitable, while sitting on large debt loads.
Baring's Chang nonetheless believes the onshore market offers selective credit-buying opportunities. “In some cases onshore issuers don’t have a good track record yet but they have good financial matrices and so their [valuations] are dislocated,” he said. “They have yield pickup and investment opportunities. Some of these dis-allocated opportunities will arise in such a big market.”
But for many investors, Chinese names are riskier bets. This is particularly evident from the bifurcated pricing levels between their international and local debt. “We’ve seen a steady deterioration in leverage and cash flows across many sectors in China, yet bond yields are compressed,” he said.
Florian Schmidt, head of debt capital markets for SC Lowy, underlined the point later in the day.
“The domestic market is accommodating issuers; Evergrande previously paid [a coupon of] over 12% for an offshore bond and under 6% for an onshore bond,” he said. “On the one hand, this is good for international investors who chase real estate companies, because Chinese investors they’ve never heard of will pay for the maturity of their dollar debt.”
Awry ratings
While the marked disparity in offshore versus onshore bond yields is a relatively recent phenomenon, it reflects a longstanding disparity between the local and international credit ratings of many Chinese companies.
Lee noted that China’s domestic credit rating agencies have long been far more bullish than their international counterparts when it comes to rating corporate debt.
“Their ratings are very narrow, typically AA to AAA,” he said. “You rarely see a bond come to market with a BBB rating for example. That’s a narrow rating band and doesn’t correspond with the ratings we have.”
He offered the example of Chinese property developer Evergrande, which S&P rates as a B+ junk-rated company, yet is deemed a tip-top AAA credit by some local credit agencies. “There are clearly differences about how we rate credit risk versus the onshore credit rating agencies,” Lee said.
One key issue is the fact there have been relatively few defaults in public bonds in China, which means there is no history from which to assess default rates.
Schmidt was even more sceptical, questioning the accuracy of such high onshore ratings for heavily indebted companies.
“Evergrande’s B rating means it’s a highly leveraged credit, it can issue onshore and the onshore credit rating agencies say it’s AAA, which means it’s risk free,” he said. “If Chinese rating agencies say it’s AAA we should be very careful what that means. We will see where we are in five years’ time.”
Super-regulator
The other aspect of China’s markets that the panel agreed would assist foreign issuance into China’s onshore renminbi market would be a unification of the country’s myriad bond market regulators under one roof.
Currently the PBoC, its associated unit the National Association of Financial Market Institutional Investors, the China Securities Regulatory Commission, and the Shanghai Stock Exchange each monitor different parts of the country’s bond markets.
There has been discussion in China about bringing the various regulators together, to better coordinate the development of the departments. “It’s a lot more efficient to have one regulator than five regulators,” said Lee. “Otherwise the regulators change the rules to make their part of the market more appealing. One reason the exchange bond market has done so well is because it has created different rules to attract issuers.”
“It’s definitely a good initiative as we know the Chinese regulatory regime is super fragmented and needs coordination,” said Ricco Zhang, chief executive officer of the International Capital Markets Association. “Sometimes we find people in the same organisation, or even the same department don’t talk to each other, because they are working on different work streams.”
