China liquidity trap deters funds

Onshore bond market hampered by secondary trading that is less than a quarter of levels seen in the US

PUBLISHED : Sunday, 18 October, 2015, 11:00pm
UPDATED : Sunday, 18 October, 2015, 11:00pm

China’s efforts to open its US$5.9 trillion onshore bond market are being hampered by secondary trading that is less than a quarter of levels seen in the US, making global funds wary of being trapped in riskier bonds.

While the market is the world’s third-largest, annual trading as a ratio of total outstanding debt is 1.1, compared with 4.7 in the US, calculations based on official data show. Overseas investors currently hold just 2 per cent of onshore notes, with 82 per cent of their money limited to sovereign and policy bank securities, according to China Central Depository & Clearing.

Overseas investors are focusing mainly on issuers that are likely to be bailed out in the event of a crisis, and show little confidence in the ability of domestic rating companies to warn them of defaults in advance.

Baoding Tianwei Group, the first state-owned company to renege on a domestic bond in April, was rated investment grade by China Lianhe Credit Rating less than five months before the failure. The number of upgrades handed out by three of the largest rankers was four times that of downgrades this year, even as the economy grows at the slowest pace since 1990.

“There are very few market makers in China,” said James Yip, a fund manager at Shenwan Hongyuan Asset Management (Asia). “Efficiency is low when you need to find a keen buyer and a keen seller at the same time.”

The People’s Bank of China stepped up moves to open its capital account this year as it pushes the yuan’s case for inclusion in the International Monetary Fund’s special drawing rights at a November review. It allowed foreign central banks and sovereign wealth funds to trade in the interbank bond market without seeking pre-approval, while clearances for overseas institutions including Pictet Asset Management and ING Bank rose to 54 so far this year, from 34 last year.

Quotas granted through the qualified foreign institutional investor programme, which allows access to mainland markets, climbed 18 per cent this year to US$78.77 billion last month. Fidelity Investments Management (Hong Kong) and Fubon Life Insurance obtained more than US$1 billion each in allocations.

While these moves widened access and have been lauded by the IMF, capital controls still cramp activity by foreign investors. 

Standard & Poor’s and Moody’s Investors Service say that corporate outlooks can only worsen as the economy falters, yet pessimism is not reflected in local ratings. Three of the largest local ranking firms handed out 190 upgrades and 46 cuts to local companies this year. By contrast, the big three overseas institutions have raised 36 ratings and lowered 62.

State-owned Sinosteel, whose parent warned of financial stress last year, may have to honour two billion yuan of principal tomorrow when bondholders can exercise an option forcing the notes’ redemption two years before they mature. If that should happen, China Merchants Securities thinks the firm will struggle to repay.

Parent Sinosteel Corp asked the bond investors to withdraw registrations to redeem the debt because the company may not be able to pay, the 21st Century Business Herald reported on Thursday, citing a letter to bondholders.

China’s economy will grow 6.8 per cent this year, the slowest pace in 25 years and short of the government’s target of 7 per cent, according to a survey. Factory gate deflation extended to a 43rd month in September, imports declined for the 11th month and exports fell. The central bank will lower its benchmark interest rate by 25 basis points and cut the amount of cash lenders need to set aside by 50 basis points at least once in the fourth quarter, Barclays economists led by Hong Kong-based Jian Chang wrote in a note.

“Most investors are biased toward a buy and hold strategy,” said Edmund Goh, Kuala Lumpur-based investment manager at Aberdeen Asset Management. The immature rating system is one of the main reasons for the illiquidity, and there is very little incentive for foreigners to buy anything less than AAA-rated papers, he said.

Overseas institutions held 735.2 billion yuan of Chinese debt as of April 30, compared with the 37.3 trillion yuan of outstanding notes, official data show. That is about 2 per cent, compared with 6.4 per cent in South Korea and 30 per cent in Malaysia. JP Morgan Chase predicted in June that foreign holdings of China’s onshore local-currency bonds will reach US$500 billion in five years, while Bank of America forecast in May that it could touch 20 per cent in 10 years.

Offshore funds often find it difficult to find counterparties to trade with in the interbank market because of the large size of deals, according to Becky Liu, a senior rates strategist at Standard Chartered.

“When international funds get into China, they think they are too big for the market,“ she said. “When they actually get into the interbank market, they feel they are too small to find any counterparties to trade with them. Anything below US$30 million is not easy to trade.”