Taiwan’s Kuomintang was once reputed to be the world’s richest political party. But since losing power last year, its assets have been frozen while a government committee decides whether they are owned by the party or the state. And this month investigators reported an unexpected find: a stash of Chinese sovereign bonds issued by the KMT government in 1947. The dollar-denominated notes carried a face value equivalent to $1.26 billion today, but the island’s government said they could not be redeemed “until the cross-Strait unification [with mainland China] was achieved”.
China was a prolific issuer of sovereign bonds until 1949 as the government relied on foreign debt to finance its expenditures. A large proportion of the later issuance funded the wars against Japan and the Communists. If Chiang Kai-shek had prevailed over Mao Zedong, the Taipei Times believes, he would have paid off the debt, including those dating back to the imperial era. But after losing the civil war in 1949, the Generalissimo had no alternative but to “put the bonds into hibernation”.
Unsurprisingly Mao’s Communist regime refused to pay off the KMT bonds too, even though successor governments are usually bound by their predecessors’ debts. For the Chinese this was not a default, technically-speaking. The matter was simply unresolved. In 1987 during talks over Hong Kong’s sovereignty, Beijing did settle some of the outstanding claims – at a steep discount – with British investors holding pre-war bonds. But the rest of the debt is mostly unpaid, despite occasional lawsuits or Congressional hearings with American bondholders pressing their case.
China’s creditworthiness for foreign investors has come to the fore again this month. But now the debate is much more forward-looking, with growing excitement about ‘Bond Connect’, a programme that will open mainland China’s bond market substantially to foreign investors this year.
What is the Bond Connect plan?
The Shanghai-Hong Kong Stock Connect was introduced in November 2014 to allow investors in Shanghai and Hong Kong to invest in each other’s equities. Another Stock Connect scheme commenced operation late last year to link Shenzhen’s stock exchange with Hong Kong’s. The Stock Connects are keystones of China’s plan to improve its capital markets and financial service industries. And the government is now prepared to take similar steps to expand cross-border investment into the bond market.
Last week Chinese Premier Li Keqiang gave the green light to the plan at the National People’s Congress. During his annual press conference with the media, Li was asked to give his opinion on his government’s relationship with Hong Kong (Li’s policy address included strong wording that any notion of Hong Kong independence would “lead nowhere”). He answered that his administration would continue its support for the city and, to drive home his point, he revealed that the State Council will establish Bond Connect on a trial basis this year, allowing overseas investors better access to the bond market via Hong Kong.
“This is a pioneering move. Hong Kong is the waterfront tower which is the first to see the moon,” Li said, in a local idiom that loses something in English translation.
But his point was clear enough – and other financial hubs around the world will soon be trying to get their own glimpse of the moon too.
How do foreign investors buy Chinese bonds currently?
As things stand, qualified institutional investors approved by the government are able to invest in the bond market via schemes known as QFII and RQFII. However, their exposures are capped by a quota allocated by regulators.
(Foreign institutions with long-term investments are allowed to invest in China’s interbank bond market without pre-approval requirements and individual quotas – more of which later.)
The Mainland-Hong Kong Mutual Recognition of Funds (MRF) scheme was also introduced in 2015 as another channel to invest in Chinese bonds. A net quota of Rmb300 billion ($43 billion) was imposed for mainland-bound bondholders but interest in the scheme has been tepid. As of the end of June, there were only 12 funds investing in China’s bond market via the MRF, and only four of them were purely bond funds.
QFII nor RQFII investors haven’t been too enthused either. According to figures from Hong Kong’s Financial Services Development Council (FSDC), only 10% of QFII’s overall portfolio was invested in the Chinese bond market by the end of 2014. The complex approval process has been blamed, although the FSDC reckons that interest has been further dampened by the recent depreciation in the renminbi.
In the opposite direction, Chinese investors have been allowed to invest in Hong Kong’s bond market through their own QDII and RQDII programmes, or in Hong Kong bond funds that are sold in the mainland under the MRF scheme.
All the same, the share of bond-only funds available to mainland investors (under the QDII programme) is small, or less than 3% of the total $90 billion quota established by June 2016.
According to the China Securities Journal, that is because Chinese investors are still more interested in the stock markets, even though fixed-income products would often better serve the needs of retail investors.
How big is China’s bond market?
In a developed economy, the bond market is typically much bigger than the stock market. China is a latecomer in this regard (a primary market for sovereign debt was only established in the early 1980s) and perhaps that helps to explain why local investors are still more familiar with equities too.
That said, the Chinese bond market is now the third biggest in the world after the US and Japan, with total outstandings of $8.7 trillion by June 2016 (the Financial Times says the market has grown to $9.3 trillion since then), or roughly 75% the size of the Chinese economy.
That is a major development from 2001, when the ratio stood at 18%. In comparison, the bond market in the US is almost twice the size of American GDP, and 240% in the case of Japan, as of 2014.
There are actually two bond markets in China: the interbank bond market (CIBM) and an exchange-traded bond market. The CIBM is essentially an over-the-counter wholesale market. This is where the bonds of the policy banks, central bank paper and local government debt is being traded. According to the People’s Bank of China, it accounts for 90% of outstanding bond value in the country.
In the past only major domestic institutions such as the state banks and pension funds were allowed to participate in the CIBM. But in January 2016 the market was opened to more types of overseas financial firms (although not hedge funds). In January, the People’s Bank of China said 230 foreign central banks, commercial lenders and fund houses were now active in the CIBM. Yield-seeking retail investors are also showing more interest via wealth management products issued by Chinese financial firms.
Corporate bonds and convertible notes issued by Chinese corporates are typically listed on the stock exchanges of Shanghai and Shenzhen instead. Here retail investors are taking part too, although they are only allowed to invest in the offerings of bigger firms, which are subject to more stringent listing requirements.
Why is Bond Connect happening now?
The Chinese premier said the scheme is a supportive policy designed to boost Hong Kong’s financial services industry, although he added that China would also benefit from the reform.
Traditionally Chinese economic planners have been unreceptive to the idea of relying on more foreign capital. Part of the stigma is historical – memories persist of an inglorious past when imperial China was forced to borrow from foreign powers virtually at gunpoint.
Some of the current leaders may even recall the pitiful days of the early 1960s when the Soviet Union allegedly forced China to repay its debts while the country was mired in economic depression and famine.
China Securities Journal also notes that local regulators see the bond market as the fundamental core of their financial system. There have been concerns that too much foreign holding of domestic debt would exacerbate systemic risk at times of crisis.
However, the newspaper says Beijing is now more confident that periods of stress can be contained. Hence the loosening of longstanding restrictions on foreign involvement, including the opening up of the foreign-exchange derivatives market last month, allowing international entities that invest in the CIBM to hedge their positions with forwards, swaps and options with domestic agents.
These reforms come at a time when the government is focused on attracting long-term capital inflows, after a weakening economic outlook and a cash exodus that pushed the Chinese currency to a five-year low. Tighter capital controls have made foreign fund managers more wary of holding yuan assets in general, but according to research by the brokerage Haitong Securities, fixed income inflows from foreign institutions have climbed 53% to Rmb732 billion since January last year, when the CIBM became more accessible.
That is still a tiny fraction of the overall market. But rather than serving simply as an extension to the Stock Connect schemes, the Bond Connect is better understood as a pilot programme, opening up the more volatile exchange-traded bond market where most of the corporate debt is traded.
Will foreign investors be interested?
International investors account for less than 2% of the Chinese bond market, so Bond Connect will help the proportion to increase. According to the Financial Times, the significance of the scheme is that foreign investors won’t have to open accounts onshore, but trade Chinese bonds via accounts in Hong Kong, where the movement of capital is much freer.
The prospect has prompted the more bullish analysts to predict that foreign holdings in the Chinese bond market will increase to up to 10% in the next few years. By further liberalising its debt markets China will also stake more of a claim to be included in global bond market indices, although as Hong Kong’s Apple Daily notes, trading in shares through the Stock Connect schemes hasn’t been sufficient to convince index compiler MSCI to include A-shares in its benchmark index for emerging markets.
Others have been calling for context too, including HSBC, which points out that foreign investors have had the option of investing in onshore debt since the CIBM’s opening up last year. But HSBC adds that the Bond Connect does bring something different, especially in being “more suitable for retail investors and investors who want to have a small exposure to the market as a testing first step”.
Is credit risk priced properly?
The Chinese bond market has been plagued by what might be termed ‘the Beijing Put’ – the belief that the government will step in to prevent major state firms from failing.
This notion has weakened since last year, following a slew of defaults by state firms (see WiC322). In the past when bondholders were predominantly Chinese and often backed by the state, the Beijing Put served to hold the financial system together. Now it seems to be holding the debt capital markets back, and a columnist on Sina Finance has written that the introduction of Bond Connect is another move to lessen moral hazard.
Indeed it’s something of a paradox that the bond market may need to get riskier before foreign interest starts to become more substantial. And Bond Connect is getting greater billing after one of the worst sell-offs in the Chinese bond markets for a while. The slump late last year was triggered by a scandal related to Shenzhen-listed brokerage Sealand Securities, which refused to buy back Rmb16.5 billion of notes held by counterparties, saying that the contracts were forged. (It would later take responsibility, following a prod from the government.)
Fuelled by China’s own version of quantitative easing, 10-year government bonds had enjoyed a major rally since 2013, with yields falling. Spooked by the Sealand scandal, the benchmark counter then crashed. Borrowing costs spiked and 20 bond issuances worth a combined Rmb18 billion were cancelled.
As of this week, the government’s 10-year bond was trading at about 3.31%, versus 2.41% for 10-year Treasuries in the US (German 10-years yield 0.41%, while the Japanese 10-year yield is barely positive). This makes Chinese debt relatively attractive in the fixed income world, although the deeper question is whether the explosion of bond issuance in recent years is going to lead to a damaging run of defaults.
Given the lingering concerns (see WiC340), Bond Connect will serve as a litmus test for foreign appetite for Chinese corporate credit. Fixed income investors may fear that some outstanding bonds could prove as risky as those pre-1949 debts.
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