China Bond Market Developments and Investment Environment
China Bond Market Developments and Investment Environment, and Entry Strategy
China’s bond market was up and running for a brief moment in the 1950s right after the foundation of the People’s Republic of China. But the market ceased to operate from 1958 to 1980. The bond market began operating again in 1981 when government bonds were issued to finance economic development and in 1984 and 1985 when state-owned companies issued corporate bonds and financial institution bonds. When China joined the World Trade Organization in 2001, it made a commitment to open up its financial service sector by 2006. Since then, China has accelerated its efforts to nurture the bond market to meet the commitment and now has a world-class bond market suitable for the economic scale of a G2 country. The market is the second largest after Japan in Asia in terms of issuance and larger than the Korean bond market. However, China’s bond market is lacking in some aspects. First, the market is oriented towards government bonds and inter-bank transactions only. Second, the market places a limit on market participants (issuers and investors). Third, the market is supervised by a dual-watchdog system. Fourth, its credit system and primary market efficiency have room for improvement.
China tried to maintain control over the financial markets by placing strict limits on foreign financial institutions issuing and trading yuan-denominated bonds with very few exceptions. But as the government felt the need to advance its bond market through foreign investors, it finally opened the corporate bond market and allowed foreign banks to issue and trade bonds in 2009. This shift is judged to be part of its policy objectives to nurture the bond market for better direct financing of the capital markets, as well as to develop the market to be a center of the Asian bond markets. In line with the trend, Korea and other foreign investors have turned more attention towards the Chinese bond market. This study closely looks into the structure, investment environment, and future prospects of China’s bond market. The data provided in this study will useful for Korean
investors to better understand China’s bond market and to seek investment opportunities. Also we try to proposed China bond market entry strategy for Korea's financial institutions.
China’s bond market has already surpassed Korea in issue volume, is the second largest in Asia after Japan, and fourth largest in the world. The market matches China’s growing clout as a G2 nation. At the end of 2012, the outstanding amount of Chinese bonds stood at $3.8 trillion, which was smaller than Japan’s $11.66 trillion but 2.71 times Korea’s $1.4 trillion.
The Chinese bond market is characterized by its rapid growth, product diversity, and high growth potential. Despite its short history, it benchmarked the experience of developed nations, and through several trials and errors, it has sustained the rapid growth.
The Chinese bonds outstanding rose 31.1% on annual average from 2001 to 2010, reaching about $3 trillion at end-2010. Government bonds ($1.6 trillion, 53.5%) exceeded half of the total bond issuance, while financial bonds and corporate bonds stood at $0.9 trillion (29.2%) and $0.5 trillion (17.2%). As the Chinese government accelerates its bond market reform and deregulation, bond products are being diversified. The bonds issued by the government and state-run organizations (government bonds, central bank notes, policy financing bonds) represented 98.3% of the total market at the end of 2000), but dramatically declined to 72.3% as of end-2012, while the proportion of other types bonds including corporate bonds has been on the rise. Last, China’s bond market has high growth potential. China’s share in global GDP is 14%, but its financial market accounts for only 8% of the global market, which creates an imbalance. Backed by the government efforts to nurture and facilitate the bond market, China’s capital markets are expected to grow in the future. As of end-2012, the outstanding amount of Chinese bonds relative to the global bond market was 4.9%, which was far lower than the US’s 37.6%.
Also, China’s bond market is small compared to its economic size: it is about 46% of the nations’GDP, which is far less than Korea’s 123% and Japan’s 213%. But this also attests to the high growth potential of the Chinese bond market.
The biggest merits from investing in Chinese bonds are perhaps the high yuan exchange gain and low return volatility. For the period between January 2004 and March 2011, portfolios composed of Chinese bonds recorded 62.9% accumulated return, while US and UK bond portfolios showed 42.3% and 25.2% returns, respectively, during the same period. The high return primarily stemmed from the high yuan exchange gain of 26.4%. As of end-2012, the average return of funds investing in Chinese bonds stood at 7.14%, which was higher than 4.55% from funds investing in Korean bonds. The volatility of Chinese government bond portfolios was 2.6% from April 2010 to March 2011, which is 6.8 percentage points lower than UK bonds’9.4%, and 0.1 percentage points lower than US bonds’ 2.7%.
When investing in Chinese bonds, however, investors should be wary of policy risk, credit risk, liquidity risk, and information asymmetry risk. In terms of policy risk, two factors should be considered: first, the tapering of the US quantitative easing is expected to impact the financial market, and second, China’s shift of its growth engine toward domestic demand will affect its financial markets.
Next, the risk of corporate default is rising amid the delay in economic recovery, and the rising debt levels of Chinese municipal governments may affect the likelihood of a national credit crunch. As of end-September 2012, China’s yuan-denominated outstanding bonds was 23 trillion yuan (approximately KRW 4,025 trillion), which is about 50% of the 2011 GDP.
Also increasing is liquidity risk: China’s tightening monetary policy will likely decrease the central bank’s liquidity provision, which may put a squeeze on interbank market liquidity. Last, the Chinese bond market has low market transparency and lacks a corporate bond market operation system that provides sufficient market data.
Currently, qualified foreign institutional investors (QFIIs), joint securities firms, foreign banks, and other foreign firms operating in China can trade government bonds, central bank notes, financial bonds, municipal bonds, and some derivatives in the interbank bond market. Some foreign banks headquartered outside China such as central banks that have a currency swap agreements with China, the banks in Hong Kong and Macau providing yuan clearing, and the banks providing yuan cross-border trade settlement can access China’s interbank bond market.
QFIIs and Renminbi Qualified Foreign Institutional Investors (RQFIIs) are allowed to invest within an approved amount in government bonds, convertible bonds, and corporate bonds listed on China’s securities exchanges as well as other financial products approved by the China Securities Regulatory Commission. Foreign retail investors cannot open accounts to trade A-shares on China’s securities exchanges, and therefore cannot trade on the regular exchanges. But they can purchase a certain amount of government bonds by bringing proper identification (e.g., passport) to commercial bank counters. Taken together, the following implications are worth considering. First, although foreign investments in the Chinese stock market have been allowed only to a limited extent, China has been opening its bond market more aggressively. Korean financial firms need to break away from their stock-focused investments and expand their investments in the Chinese bond market. This is especially necessary in terms of investor protection. Stocks listed on the Chinese exchanges are mostly state-owned, and their objective is often to maximize government profits, rather than shareholder value. In China, it is difficult to demand higher shareholder rights, e.g., dividend increases, compared to other nations that have well-established shareholder protection mechanisms. Under this structure, it may be hard to recover high investment values from Chinese stocks.
This is the primary reason why the Chinese stock market degenerated into a speculative market. In this vein, investing in Chinese bonds may be easier for realizing investment values because bonds’principals and interest payments are legally protected unless the
issuers default. Hence, under the current status of China’s capital markets, bonds offer more benefits than stocks as an investment product.
The Korean government and other related organizations need to pay close attention to the fact that the development of China’s bond market is important for Korea’s capital markets to grow and advance, and for Korean financial firms to expand overseas.
Based on aggressive marketing activity, Korean securities firms need to expand their strategic alliance with Chinese securities firms and asset management companies and design diversified IB products associated with Chinese bonds. Furthermore, it is time for them to consider when to start selling Chinese government bonds in Korea. Also necessary is providing Korean firms operating in China more advanced corporate financing services, e.g., issuing yuan-denominated bonds, as seen from the cases of Eland and Hyundai Wia.
Finally, it is noteworthy that yuan internationalization will accelerate significantly by 2020. China’s bond market still has a long way to go in terms of openness, but this will definitely become a crucial part of Korea’s and global capital markets.
Therefore, Korea should be prepared for this. First, foreign investors will become major participants in the Chinese bond market, and Chinese government bonds will be included in foreign reserves of other central banks, and Chinese government bonds and corporate bonds in global asset portfolios of large global financial firms. Second, yuan-denominated bonds issued by foreign players will constitute an important market. More foreign governments and global firms are forecast to issue yuan-denominated bonds in China. Third, due to yuan internationalization, a large yuan-denominated Eurobond market will emerge. It is expected that Shanghai will provide offshore services for yuan-denominated Eurobond transactions and Hong Kong will be the most important marketplace for these Eurobonds.
Hence, government-level efforts are necessary to strengthen cooperation in terms of bond issuance and trading as well as credit assessment. Korea and China should solidify their cooperation to facilitate the issuance and trading of the two nations’government
bonds and corporate bonds. Especially, they need to cooperate more closely on credit assessment. It is desirable for the two governments to provide credit enhancement to the issuers without solid credit ratings. This will facilitate the development of the regional bond market.