China: Capital Account Liberalization and the Corporate Bond Market
The People’s Bank of China (PBoC) released a report (Chinese language) this week that focused on prospects for capital account liberalization. Opening up the capital account would be a major reform, perhaps the most significant in a more than a decade. It would give Chinese savers an escape hatch from financial repression and force the reform of the financial sector.
The report identifies four necessary, but insufficient factors for capital account liberalization to be successful: macroeconomic stability, competent financial regulation, adequate foreign exchange reserves, and stable financial institutions. The report argues that these factors are beneficial to capital account liberalization, but do not explain the entirety of why liberalization has been a success for some countries and a failure for others.
Instead, it’s important to look at the risks that come from capital account liberalization and where China stacks up. On all four of the risk factors identified by the report—commercial bank debts denominated in foreign currencies, foreign currency reserves subject to large drops in value, a high proportion of short-term foreign debt, and unmanageable risks in the property and capital markets—China faces comparatively little danger.
Given that China is in a relatively good position to move ahead with capital account liberalization, the report suggests a medium-term plan of action:
1 to 3 Years: Relax controls on investment directly related to trade and encourage Chinese enterprises to increase overseas foreign direct investment.
3 to 5 Years: Relax trade-related commercial credit controls and push forward renminbi internationalization.
5 to 10 Years: Strengthen financial sector development, open channels for credit to flow in and out of China, open in succession the property, stock, and bond markets, and move from quantity-based to price-based approaches to monetary management.
The Chinese Corporate Bond Market
Focusing in on the development of the bond market, the report makes several interesting points. It attributes the small size of the bond market to the absence of market-determined interest rates, the lack of a unified corporate bond market and a relatively undeveloped government debt market. Creating a thriving corporate bond market will be an important component of building a deep and liquid bond market to absorb financial inflows once China opens its capital account.
The corporate bond market appears to have grown relatively quickly over the past several years.
However, the growth is actually less significant than it initially seems. Non-financial corporate bonds outstanding were less than 10 percent of the loans to enterprises in 2011, a percentage that is far below many more developed financial markets. Moreover, issuances were dominated by state-owned enterprises, rather than the more dynamic private companies.
There are several lingering problems that continue to act as a drag on the corporate bond market.
Lack of a Unified Market: The bond market right now is a bit of a regulatory mishmash. The China Securities Regulatory Commission (CSRC) approves bond issuances by listed companies. The National Development and Reform Commission (NDRC) approves enterprise bonds issued by unlisted state-owned enterprises. Commercial paper, medium-term notes, and Small- and Medium-Sized Enterprise (SME) Collective Bonds are approved by the PBoC through the National Association of Financial Market Institutional Investors (NAFMII). The PBoC regulates bond trading that occurs in the interbank market while the CSRC regulates trading occurring on the Shanghai and Shenzhen exchanges. This confusing regulatory structure has added an unnecessary layer of complexity to the corporate bond market.
Distorted Interest Rates: As the PBoC article points out, the current interest rate environment has hindered the development of a deep corporate bond market. In developed financial systems, the growth of the bond market is spurred by the fact that for companies with good credit ratings, bonds are generally cheaper and have fewer strings attached than bank loans. Given the low interest rate environment in China created by financial repression, bonds have failed to emerge as a low cost alternative.
State-Firm Dominated: As it exists now, the corporate bond market is largely a financial merry-go-round of state-owned firms buying the bonds of other state-owned firms. Large state-owned companies issue debt in the corporate bond market, the vast majority of which is purchased by state-owned insurance companies and banks. Of the top 30 issuers of corporate bonds as of Q3 2011, all but one (Merchants Bank at number 30) is a state-owned enterprise. The dominance of state-owned issuers and buyers is clear even in the fast growing and less regulated medium-term notes market.
There have been several articles over the past couple weeks hinting at the creation of a high-risk, i.e., junk bond, market in China. The CSRC has reportedly met with key brokerage houses to brief them on its plans to create a new market for higher yielding bonds. The move is aimed at helping small and medium enterprises increase their access to credit. Whether this proves to be the catalyst the bond market needs is still unclear. The much-heralded SME collective bonds program, another tool used diversify bond issuances away from large state-owned enterprises, has been relatively lackluster, raising around 10 billion renminbi since its creation in 2009.
The PBoC report has laid out the development of the bond market as a key aspect of capital account liberalization. If the bond market is to be ready according to the timeline suggested by the report, China will need to rapidly grow the size of the corporate bond market and move away from overreliance on state-owned issuers and buyers.
This post originally appeared at the Peterson Institute.
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