China bond market becomes an imperative
CHINA'S FINANCIAL MARKETS are at a crossroads. As of last year, the country has surpassed France as the fourth largest economy in the world. Given the size of the economy and large imbalances inherent in the system, increasingly the government focus needs to shift to developing the bond market.
Most Asian economies have always focused on bank loans and to a lesser extent on equity markets at the expense of bond markets. But bond markets are as important as - or more important than - equity markets for the efficient allocation of a nation's resources. In all major economies, it is common for the bond markets to be substantially larger than the equity markets.
China's fiscal responsibility has helped the country gain an A2 sovereign credit rating. The bad news is that its limited government borrowing has also inhibited the development of deep, liquid, sophisticated bond markets.
A highly liquid government bond market usually sets the standards and the interest rate benchmarks for an economy's corporate bond market.
The absence of such a government market has, for instance, inhibited the emergence of a sophisticated bond market in Hong Kong.
Because China has significant government debt, combined with a history of not letting that debt get out of control, the city has the potential to develop a sophisticated government bond market that could become the foundation both for a large Chinese corporate bond market and, when the yuan is fully convertible, for a local currency Asian bond market.
The 1990s restrictions of China's government guarantees, both explicit and implicit, mean that the country's principal financial risks are focused on companies and banks, not the government, or at least not directly on the government, and on domestic loans rather than foreign loans. These corporate risks can, if not properly managed, accumulate into a 1997 Asian-style crisis, hence the need to develop the corporate bond market.
In China, most companies would rely primarily on bank loans even if they had the option of corporate bonds. They are able to borrow at low, government-determined interest rates that do not reflect the risk of the loans.
The government absorbs the cost of the extra risk by bailing out the banks' non-performing loans.
Companies mostly do not worry about the risk of rolling over their loans, because they are confident that state banks will almost automatically roll them over at low rates.
A classic moral hazard problem. State banks absorb the cost of this system and ultimately pass it on to the government. Although the burden of the debt service is still manageable, concerns exist about the government's implicit liabilities.
Government bailouts are only a temporary solution for clearing up the state-owned banks' balance sheets.
Non-performing loans are becoming unsustainably large. National debt outstanding as a percentage of gross domestic product is about 20 per cent; if one adds implicit debts, it rises to more than 130 per cent of GDP.
In comparison, the United States national debt to GDP is 60 per cent and in Japan, it is more than 120 per cent. In China, a corporate bond market would serve several functions.
First, it would enable companies to raise funds even if they are not favoured bank customers.
Today, China has one of the world's most entrepreneurial economies. New companies are formed, and many succeed and create jobs, but they tend to stay small and not expand rapidly like many US firms, because they lack appropriate funding. The corporate bond markets can potentially remove this constraint and enable China to create world-class companies and, even more importantly, jobs for tens of millions of people who need them.
Second, it would allow matching the duration of assets with the duration of liabilities. This would give investors with longer-term liabilities - such as life insurance companies - a greater range of longer-term assets to choose from.
China would avert the risk of an Asian crisis in its corporate world by ensuring that difficulties in obtaining bank funding would not endanger most of the country's major companies.
Third, with the rise of pension funds, social security funds and insurance funds, the bond markets are the key to ensuring that these funds can match their future payment obligations with assured future income.
Without a long-term bond market, pension funds, social security funds and insurance companies will always be at risk.
China has the potential liquidity to create Asia's greatest bond market. It has the momentum of fiscal discipline and financial reform to create a stable, confident government bond market. A well-regulated corporate bond market open to private companies can fund the jobs that China requires for social stability.
Government and corporate bond markets together can stabilise the financial situations of the country by properly matching assets to liabilities.
Michael Preiss is the chief investment strategist for CFC Securities
