Euroweek RMB report: Quiet progress in the onshore market

Euroweek, November 2013

While the offshore RMB market captures the most headlines in the international financial press, the onshore market has quietly grown into by far the largest local currency bond market in ex-Japan Asia – larger, in fact, than all the others put together.

The statistics are already overwhelming. According to the Asian Development Bank’s Asia Bond Monitor for September 2013, by June 30 total Chinese local currency bonds outstanding stood at US$4.045 trillion ($2.875 billion government, $1.17 trillion corporate), compared to $2.716 trillion for the rest of Emerging East Asia combined. China’s local currency market is almost three Koreas, and getting on for 17 Singapores. And it’s certainly vastly greater than the dim sum bond market, whose outstandings stood at CNH288 billion at the end of June, or just US$47.26 billion, scarcely one hundredth of the size of its onshore counterpart.

Three more stats: it’s now the fourth largest domestic bond market in the world after the US, Japan and France; it is dramatically bigger than the Shanghai equity market, whose market capitalization is $2.4 trillion; and, according to HSBC, it is growing at about 30% a year.

The onshore market attracts less attention internationally, chiefly because there aren’t so many ways of accessing it from outside China, whether as an investor or an issuer. They are increasing, slowly: the recent announcements in London and Singapore that holders of RQFII licences can use offshore RMB to invest directly in domestic Chinese assets are examples. But still, the degree of access is relatively remote.

Nevertheless, it is important to understand this market because, given its scale, policy decisions there can have considerable knock-on effects on the funding methods of Chinese enterprises, and therefore the development of the offshore RMB market.

Onshore bonds are complicated, because the regulatory oversight of them is tangled. There are three different regulators looking after three segregated markets.

First, there are enterprise bonds. These are issued by institutions which usually have links with central or local governments, such as state-owned enterprises. “Their tenor tends to be between five and 10 years, and can be as long as 15,” says Crystal Zhao, fixed income analyst at HSBC. Issuance is subject to approval by the National Development and Reform Commission, which is a central economic planning body.

Then there are corporate bonds issued by listed companies, which are approved and regulated by the China Securities Regulatory Commission. These bonds are traded only on the exchange market, which is much smaller than the large and liquid inter-bank market upon which other bonds trade.

Then there is a third market for medium-term notes and commercial paper, which falls under the National Association of Financial Market Institutional Investors, which itself is under the supervision of the People’s Bank of China.

“The MTN market only took off in 2008,” says Zhao. “It hasn’t even been 10 years yet, but the overall size of the [entire Chinese local currency] bond market is RMB25 trillion already. It has expanded very fast, and we think it will continue to do so.” Part of the reason for this, she says, is because of policy towards subsidised housing and stable fixed asset investment, all of which needs financing. “Some of the finance is going to be met by bank loans, but once the banks reach their credit limits with borrowers, those borrowers are going to have to consider the bond market.”

The market’s potential size is clearly immense, but the disparate range of entities overseeing it is surely not desirable. “Ideally, it should be one regulator overlooking all these bond markets in one united market,” says Zhao. She notes that the PBOC did issue an announcement saying there would be more cooperation among the three regulators in order to build up and promote the domestic market just under a year ago.

At ANZ, Li Gang Liu, chief economist for Greater China, believes the number of regulators is impeding the market. “One of the reasons that the China debt securities market has been developing so slowly is that there are multiple regulators in the bond market,” he says, perhaps referring to the pace of sophistication rather than scale in asset terms. “There should be one regulator, and bond issuance should be taken in a form of underwriting rather than an approval process. Firms, depending on their needs, should go to the market themselves rather than first seeking approval from these regulators to issue a bond.” He notes that the PBOC is the strongest of the three. “The PBOC can take a lead role to help nurture and develop China’s bond market.”

Aside from the regulators, there are other idiosyncracies to the market. “It is quite unique: you need a credit rating before you can issue bonds in the domestic market,” explains Zhao. “Onshore regulators are not allowing foreign international credit agencies to work on their own in China, so we have four or five major domestic credit rating agencies which give ratings to all those who issue, regardless of whether they are CP, MTN, enterprise bonds or another.” This is in contrast to the offshore market, where a rating is not necessary, and in the market’s early days was even uncommon.

Liu believes the market should be opened to foreign credit rating agencies. “That will improve informational transparency and will enhance the development of the bond market,” he says.

So what next? “The policy direction is to further develop the onshore bond market, in terms of the variety of, and opening up to, both issuers and investors,” says Frances Cheung, senior strategist for Asia ex-Japan at Credit Agricole CIB. That’s an important policy, he says. “The external financing structure is highly skewed towards bank loans in China – more skewed than key markets in the region,” he says. “China depends much less on bonds, and minimally on equities.” He says policymakers have set about moving things in the right direction, with bonds’ share in external financing rising.

And it’s not just about access to capital. Cheung argues that bond market liberalization could facilitate interest rate liberalization. “If more entities are allowed to raise funds in the bond market, more curves could be developed,” he says. “A high yield bond market could help those smaller companies to raise funds, without the needs to go for informal banking. Bond market activity could help banks to gauge the level of interest rates they would like to charge their clients on their loans.”

High yield is one approach, but there’s also scope for development at the municipal level. Liu suggests that China needs to decide whether to allow local governments in China to issue bonds directly. “We think this is very important, because if China can have a US municipal-type bond market, Chinese indebtedness will not look so dangerous.” The health of local governments in China has been a subject of mounting concern, and a greater range of fund-raising options – particularly ones that allows longer maturities to match liabilities – would improve the situation.

In the wings of the onshore market is the Shanghai Free Trade Zone, which, in the long-standing tradition of Chinese financial market development, is a testing ground for new ideas. In essence, it seeks to create an offshore-styled financial centre within mainland China itself. “China wants to build Shanghai as an international financial centre and is trying to bring more international players here,” notes Zhao.

While that suggests urgency, there is still a lot we don’t know about the zone. “We are still expecting details in terms of what they want to do: how they are going to open the onshore markets more, or how they want foreign banks or corporates to register in the free trade zone,” she says. She notes, though, that it has support and involvement from the State Council, CSRC, CBRC and PBOC, and is “a very high profile project. In the long term, it should be promising.”

At ANZ, Liu agrees there is little detail yet, but is wondering about the consequences when those details are announced. “The offshore market does not have any capital controls, and not much interest rate controls. Onshore regulation is strenuous: banks have to maintain adequate capital ratios, they have to abide by a loan to deposit ratio at 75%, and there are reserve and deposits requirements,” he says. “People are curious about whether current onshore regulations will apply in the Shanghai Free Trade Zone. If those regulations continue to be imposed upon offshore financial institutions, the attraction of Shanghai will be less. If they use different regulation, a framework that is similar to Hong Kong and international standards, I’m sure a lot of financial institutions, both domestic and international, will want to open operations in Shanghai.”

If that happens, “then a lot of offshore RMB transactions currently done in the Hong Kong market could be done in the Shanghai Free Trade Zone. In that sense, Shanghai could grab business away from Hong Kong.”

With or without the Shanghai initiative taking that course, liberalization of the onshore market will eventually provide competition for the offshore. “If more investors are allowed to tap the onshore market, I believe the offshore market will still have a niche, which is providing more choices of issuer names,” says Cheung. “But if more issuers are allowed to issue in the onshore market, while foreign investors can bid, then the competition will be more obvious.” Not that this necessarily constitutes the death knell of the dim sum market: there are many examples of currencies which support vibrant markets both onshore and offshore, most obviously the dollar.

As the Chinese currency becomes more international and moves to full convertibility, one would expect a degree of convergence between the way that onshore and offshore bonds behave, as is the case in the dollar bond markets, for example. “Eventually, once China opens the capital account, and once there are free cross-border flows, offshore yields are going to converge with onshore,” says Zhao. “But that is mid to long term from now.” Bonds did begin to converge earlier this year, but since mid-year the gap has widened again as liquidity has fallen in the onshore markets. “Onshore, yields have been rising, but offshore, the yield curve has been stabilising,” Zhao says. True convergence, like full currency liberalisation, is a while away yet.