China's bond markets look finally to be getting off the ground. Already this year, the government has launched about 150 billion yuan (HK$140 billion) in treasury bonds, nearly as much as the entire amount that was outstanding to the end of last year. The combined total of about 300 billion yuan is minuscule compared with the bond markets of Japan or the United States. It is also dwarfed by the total amount of money held in bank deposits, which tops three trillion yuan. But the recent success of some domestic issues indicates that China's debt markets are set for rapid growth. Only last year, the bond markets were all but written off. In May 1995, wild speculation by Shanghai International Securities and other firms led to the collapse of the bond futures market, which in turn sapped the wider market. In addition, with inflation soaring and the government subsidising interest rates on bank deposits to stabilise a banking sector weakened by a deteriorating state sector, there was naturally little interest in bond issues. Even as recently as May of this year, despite much improved inflation expectations, a five-year treasury issue was still a resounding flop due to poor pricing. But in June, with inflation still falling and finally some attractive pricing, investors snapped up the first 10-year bond since 1981. So strong was the interest, especially from institutions, that the size was more than doubled from 12 billion yuan to 24.9 billion yuan. As a result, the beginnings of a proper yield-curve, by which inflation expectations can be judged, have been made, and there is every expectation that more long-dated issues will appear. China badly needs to develop its capital markets. Only then can the country's high savings - standing at about 40 per cent of gross domestic product - be used effectively to develop the economy and infrastructure. 'The highest priority for China is for the People's Bank of China (PBOC) to build a money market that can regulate the money supply through open-market activity,' Jack Wadsworth, chairman of Morgan Stanley Asia, said. There are still problems, of course. As a recent World Bank report pointed out: 'China's capital market suffers from distortions in pricing, access, and market development.' In particular, the debt and equity markets are part of an overall financial system that allocates credit in part for social and political ends. Many debt issues are never intended for the market, but to be forced on institutions to raise money for the government. Interest rates on the coupons can vary according to who the (involuntary) purchaser is, and maturities are decided solely to benefit the issuer - the government. Therefore, institutions have naturally shied away from engaging in market-based activity. This now looks to be changing. In April, the PBOC announced that it was considering abolishing the state credit plan, the most important legacy of the state planning system that was set up in 1949. Instead of assigning credit by quota, it would control credit, as in developed countries, via activities in the bond markets. 'To do this, it needs a large base of treasury bills and bonds,' Peregrine Brokerage's China economist Pan Ming said. 'With the inflation picture looking positive and with a budget deficit, we can therefore expect issues in sizeable amounts next year.' Increasing the base is just one aspect of widening and deepening the market. 'At the moment, the problem is that you can only be long,' Mr Wadsworth said. 'There is no repurchase (repo) system. You cannot short the market. The paper is also sold mostly retail through the Shanghai stock exchange.' But such aspects are being addressed. Regulations for the capital markets have now been put in place, and observers feel that the bond futures market, which will allow investors to hedge risk to the cash market, will be revived next year. As the market grows, in size, choice and liquidity, institutional investors should also invest in the market more. Furthermore, whereas now they tend to buy and hold bonds (sometimes under pressure from the government) turning them effectively into quasi-loans, they will also trade the instruments more readily. This will in turn reduce market volatility, further boosting confidence in the market. For the moment, foreign investment banks, which dominate the international bond markets, are shut out of all this promising activity. This is not only for legal reasons, but because the yuan is not yet convertible on the capital account. One firm that might soon become involved, however, is Morgan Stanley. The US investment banker has put a great deal of faith and capital into China International Capital Corporation (CICC), its US$100 million joint venture with China Construction Bank. Although it has been slow to get off the ground, CICC could give Morgan Stanley a decisive edge in China's debt markets. 'The whole idea of having CICC is to get into the domestic market,' Mr Wadsworth said. 'There will be a huge advantage of getting in early.' CICC formally began operations in August last year. It now has 40 staff, and intends to pursue the entire range of investment banking activities. Being a domestically incorporated company, unlike any of its rivals, this can also include yuan-based business. It makes possible underwriting A shares, managing assets and underwriting domestic bonds.
