The Asia Securities Industry and Financial Markets Association (ASIFMA), a sell-side trade association, believes that in numerous respects, China’s bond markets fall short of international norms, and as such, are failing to realise their potential.
It is a timely reminder for a market that has come under particular pressure this week, as short term interest rates have shot up. Overnight bond repurchase rates are still at twice their normal levels as the Chinese central bank has been sluggish in keeping the liquidity tap turned on.
In a new publication titled ‘China bond market roadmap’, pointers are provided to help boost China’s bond markets, which, despite being the fourth largest in the world are a sixth of the size of the US bond market and four times smaller than Japan’s.
The amount of outstanding local currency bonds in Chinese markets was US$3.8 trillion at the end of December 2012, an annual increase of 11.2%, largely driven by growth in bank and corporate bonds. The Chinese corporate bond market demonstrated especially strong growth in 2012, with 20.8% annual growth.
Quotas for accessing the bond markets
However, China’s bond market is closed to most foreign institutions unless they have one of two types of quota. The first is QFII (qualified foreign institutional investor), which allows firms which obtain a quota to transfer US dollars and receive renminbi, which can be used to buy local stocks or bonds, although a minimum of 50% must be invested in equities.
The second is RQFII (renminbi qualified foreign institutional investor). This is more flexible and does not restrict investors to a minimum equity exposure but is only open to firms with a Hong Kong presence. This allows investors to get access to Chinese stock and bond markets but investors have to already hold the renminbi offshore (CNH).
ASIFMA says that the first step to fostering a vibrant bond market is interest rate liberalisation. The Chinese authorities recently said that they plan to make further steps in this direction before the end of this year. Their paper also advocates a more developed interest rate swap market.
ASIFMA also believes that it could be time for Chinese authorities to look again the mandatory cap on banks’ loan-deposit ratios, currently set at 75%, as it says it holds back the further growth of the corporate bond market. However, some commentators have said they feel this conservative level is a distinct aid in controlling possible exuberance in the banking sector.
Uneven taxation rules
China’s state-owned banks receive preferential tax treatment when they purchase and hold government bonds. Market participants have expressed concern that this makes the yield curve meaningless, because the yield on these bonds does not reflect market conditions.
ASIFMA therefore advises regulators to eliminate the preferential tax treatment granted to state-owned banks when they hold government bonds. It would also like to see the establishment of a liquid secondary market for government bonds and a more stable repurchase (repo) rate.
Taxation is an issue that impacts the buy-side in other ways.
“Firstly, there is withholding tax on capital gains of 10%,” says Andy Seaman, portfolio manager of Stratton Street Capital, a fixed income manager operating a renminbi bond fund. “This is a significant disadvantage for a fund manager running a portfolio of Chinese government bonds as gains on one bond cannot be offset against losses on other holdings. Secondly, it is the wrong stage in the cycle to be investing in local bonds as the People’s Bank of China is currently tightening policy to curb inflation and as it tries to impose more discipline in the lending policies of local banks.
This has seen a sharp rise in money market rates in China which has caused a sharp sell-off in bonds too, seeing yields rise from 3.32% at the beginning of the year to 3.59% today, with most of the rise happening in the past few days. That is not too bad by global standards, but according to Stratton Street, there may further yield rises to come, until inflationary pressures come under control.
Once the cash market is improved and liquidity present, ASIFMA says the next target is to develop the government bond futures market for hedging and risk management purposes. With an illiquid cash market, it is not feasible to develop liquid bond futures.
Stronger regulation is needed
On the legal side, ASIFMA wants to see a strengthening of creditors’ rights and better arrangements for netting. There is no netting law in China and the closest concept to “netting” is “set-off,” which is allowed under Chinese Contract Law.
ASIFMA talks tough on the subject of regulation, challenging China’s regulators to improve.
“China’s regulatory and jurisdictional uncertainty is a serious impediment for foreign-invested financial institutions, effectively serving as a non-tariff trade barrier. To make matters worse, rules are often unclear, reasons for denial or approval are not widely disclosed, and in some cases the rules themselves are not publicly available. At times it is not even clear which regulator’s approval is required, and sometimes regulators themselves disagree about approval processes or procedures.”
On a brighter note, ASIFMA credits China for allowing foreign banks to trade and underwrite corporate bonds in the interbank market without the approval of the China Banking Regulatory Commission, (CBRC), and it approves of the elimination of a
rule which previously prevented bond issues below RMB 500 million, which as a result increases access for small and medium-sized businesses.