AllianceBernstein's Hayden Briscoe explains how he sees China transforming global capital markets in the years ahead.
Q What is the biggest development now in Asian fixed income?
A From a structural point of view, our focus is on China’s bond market. It is now the world’s third largest, at Rmb48 trillion-Rmb49 trillion, or $7.2 trillion. China is going through a huge shift from being a loans market to becoming a bonds market. In the US, the split is about 30% bank loans to 70% bonds. In Europe, it’s more like 80% loans to 20% bonds. In China, it’s 90% loans to 10% bonds.
Q What is causing that ratio to change?
A The provinces, cities, local governments – whatever you call them – kicked off a municipal bond market last year. In the second half of 2015, they issued about $500 billion worth of bonds. Over the next four to five years, the Chinese muni market will become nearly as big as America’s. The US muni market is $3.7 trillion and China will reach north of $3 trillion.
This is part of Beijing’s recentralisation programme, as the central government takes control of how local governments finance infrastructure spending. From now on, these local entities must do so by borrowing in the municipal bond market, and they can do so only after they’ve received approval from the National Development and Reform Commission [NDRC, the central government’s planning agency]. This will reduce systemic risk and allow local governments to term out their debt: instead of relying on one-year rollover loans, they can borrow out to as far as 10 years.
Q There are concerns that local governments might struggle to place muni bonds because they yield rather less than bank loans, particularly shadow-bank loans.
A Yields have been an issue. When the muni market began last year, some local entities issued bonds at yields below government bonds. These securities were bought by local authorities’ investment arms, or by affiliated banks. That earned those banks a stern letter from Beijing that this cannot happen. It proved to be a flash in the pan. For new supply there is an understanding that implicit government guarantees need to be properly priced, and that is leading to the emergence of credit spreads and differentiation among borrowers. Credit spreads on munis are now as much as 35 basis points, and I see more way to go in this trend: many of them should trade at spreads above that of China Development Bank or the other policy banks.
Q The lack of international credit ratings on Chinese muni bonds is another impediment.
A There are no credit ratings and there is no secondary market trading. We are not recommending to clients to invest in munis yet. There is, however, a lot of data about these bonds, and it is going to become a meaningful market. We’ve done our own research, because there is no sell-side or rating-agency research yet.
Q What has your research unearthed?
A We examined provinces versus their local housing markets, their demographics, their dominant local industries, and we found that there are some second- and third-tier cities, 27 in fact, that we think will emerge as winners. They have the right demographics, the right number of migrants from rural areas, the right infrastructure – rail, roads, water; the right types of industries; and fewer legacy issues. These places are favoured by central policymakers for particular reasons. For the most part they are still found along the eastern seaboard.
Q What else is going to expand China’s fixed-income world?
A There is a growing municipal bond market. There is a government bond market. There are bonds from state-owned enterprises deemed not strategically important – the SOEs that will shift their financing to the equity market or be privatised, and which will form the basis of a credit market. Already China’s credit market is $1.8 trillion, which is bigger than the high-yield market in the US, which is $1.3 trillion. On top of this, China’s fiscal policy is expansionary and the NDRC is issuing $1.6 trillion or more in project bonds and other vehicles to support infrastructure.
When you add it all up, China’s bond market will double in size over the next four to five years, to become the world’s second largest, ahead of Japan’s. The US bond market today is about $36 trillion, and China will soon reach about half that size. This is happening because China is rebalancing its economy and it needs the rest of the world involved if it is to lower its systemic risk. Chinese banks don’t want to hold long-term bonds, so China needs insurance companies, mutual funds, pension funds and international banks to create a full yield curve.
Q How readily can international investors price different types of maturities or credits?
A Foreign institutional investors can’t buy loans from Chinese banks. It’s much easier for us to buy a bond. The equities market is going to open up as well, as they IPO the non-strategic SOEs – while the largest SOEs will consolidate. So credit selection is going to be vital. In 2012 we began to identify SOEs and classify them as strategic, partially strategic, and non-strategic. Today we are beginning to see prices among these differ, and that will continue. For those with a credit rating, there could be a multi-notch shift when terms of Sasac’s ownership are made clear. [The State-Owned Assets and Supervision Council is the State Council’s holding company.] If an SOE turns out to be less than 100% owned by Sasac, there should be a downgrade. We need more visibility around implicit and explicit guarantees.
Q Is China’s bond market open for business?
A The providers of global bond indices, such as Citi, have laid out three criteria to include China: high-grade bonds need a credit rating, there must be sufficient size, and the currency must be open. From our perspective, that openness now exists. The People’s Bank of China now recognises both the CNH and the CNY as the same currency. [CNH refers to offshore renminbi circulating in Hong Kong and elsewhere; CNY is the onshore yuan.] We can get CNH, get a China interbank licence, and start investing. This measure opened last year to central banks, sovereign wealth funds and supranational organisations.
Q Do you expect big inflows to China?
A This is the single biggest change to the capital markets in our lifetime. We estimate this could result in an inflow to China of $2.5 trillion, assuming global institutions allocate 7% of their bond portfolios to obtain a neutral index weighting. Central banks are already allocating 5% to 25%, usually just to Chinese government bonds. That $2.5 trillion figure assumes the Chinese bond market doubles in size.
Q What about the lack of a reliable legal system and domestic auditors’ reports?
A The corporate credit market in China is only open to domestic rating agencies. Global investors will need acknowledgement that global credit rating agencies can provide ratings. Some are beginning to enter the market, but they are limited by a lack of resources. They don’t have enough people to cover the level of issuance and the number of borrowers in the market. Other weak points will be auditors and the legal system. How will a default play out in China? The documentation isn’t standardised. And investors still want to know if, once we put our money in, we can get it back. There remain a lot of issues regarding confidence.
We suggest clients stick to government bonds and policy-bank bonds. There are also globally rated SOE issuers, plus the five major commercial banks’ bonds, but at this point, the most conservative investors don’t need to access those.
Q And global investors want access to Chinese bonds?
A Today there is a need for income, especially in Europe and Japan, where interest rates are now negative. China 10-year government bonds today yield 2.8% to 3%. That’s the lowest yield in its history; it used to be around 3.5%, but yields have fallen as the PBoC has cut interest rates. But the real yield is still relatively high because inflation has also come down, closer to developed-market levels.
Our research shows that China’s government bonds correlate negatively with risk assets. They have the same characteristics as US Treasuries, and give a total positive return. They provide a positive real yield. The country enjoys a double-A rating. It’s a net creditor nation. It has all the things you’d seek in a bond market. Global investors have held a negative bias toward China for 20 years. But if you’re just looking at the assets, they are attractive, liquid and offer a full yield curve.
Q What other steps need to take place?
A I’d like to see the government to shift policy-bank debt into government debt. There are three main policy banks: the Agricultural Development Bank, the Export-Import Bank, and most importantly, China Development Bank. In most countries, this sort of entity is a small-scale issuer, but in China they have $1.5 trillion of debt outstanding – the same amount as government bonds. CDB is the most liquid security in the market, partly because it is not a deposit-taking institution, so it has no short-term liabilities.
Today, global investors make up no more than 2% of the Chinese interbank bond market. If China received $2.5 trillion of inflows from global investors, most would seek to go into government bonds, but there’s not enough supply. The government has declared plans to double its bond issuance, which will help, but it could also retire policy-bank debt and switch new issuance to the central government. If international money marched in, it would create some major pricing dislocations.
Q This would cause a rebalancing across emerging markets?
A It implies everything you own today will be sold to reweigh into this new market.
I think emerging markets generally will still enjoy net inflows, as investors continue to chase returns. But why invest in government bonds from Thailand, the Philippines, Malaysia or Singapore if we can get the same or better yields from China, along with all the defensive characteristics of Chinese government bonds? In China, portfolio outflows wouldn’t impact the currency much. It’s better rated. It has deeper liquidity. But if global investors de-risk from Asean or other emerging markets, there will be a corresponding rise in Chinese capital flows to them. China is going from being the world’s manufacturer to being the world’s banker, as a major net creditor. It will become the new liquidity provider to the region. Asia will become more reliant on the PBoC and China’s banking sector.
