Growing China-US trade tensions and the increased number of defaults among Chinese companies and Local Government Financing Vehicles (LGFVs) will not put an end to foreign investment in China’s bond market, which has barely begun to scratch the surface.
If anything, it can only grow, say regional economists and credit market experts, as international funds are drawn to China by increased issuance, favourable policies and the onshore market's inclusion in key global benchmarks.
According to official government data, China’s onshore bond market was worth Rmb64.57 trillion ($9.4 trillion) at the end of last year. It is the world’s third-largest onshore bond market, and yet foreign ownership is estimated to be roughly 2% or less, so it has plenty of room to grow.
And grow it will, said Iris Pang, greater China economist at ING Bank.
“I expect even more foreign investors in China’s onshore market in 2019," Pang told FinanceAsia. "Foreign investors want to diversify into China despite the Sino-US trade war risks.”
Expert forecasts on the number of Chinese corporate defaults next year are mixed but some think there are good reasons to believe they will either be similar to this year's or, at worst, modestly higher.
Data from Bloomberg shows 107 bond issue defaults by Chinese companies so far this year, compared with 25 in the whole of last year. At around Rmb100 billion, the total value of these defaults is more than triple the defaults registered in 2017 and 2016.
Neeraj Seth, head of Asian credit at BlackRock, thinks defaults will increase but not reach crisis proportions.
“You can get good returns in the next one to two years from Chinese bonds despite potential defaults,” Seth said.
Pang predicted that the Chinese corporate default rate would be flat in 2019 relative to 2018.
Once investors realise private companies can again access funding from banks, the risk premium on Chinese corporate bonds will not increase, so foreign investor appetite for onshore bonds will increase, Pang said.
Private companies account for most of the bond defaults seen so far this in China, Christopher Lee, a Standard & Poor's analyst on Asia-Pacific corporates, said in a report published by the ratings agency on Wednesday.
And more defaults are likely, Lee said. Vulnerable sectors include capital goods, property, and LGFVs, which are local government entities that finance public projects like roads.
One of these LGFVs -- Xinjiang Production-Construction 6th Shi State-owned Assets Management -- defaulted on a Rmb500 million note in August.
Qinghai Provincial Investment is the guarantor of a $300 million bond of another local government company, Qinghai Province General Aviation Group, which is due for redemption on December 11. The market will be watching closely whether this bond is repaid.
That said, the backdrop for Chinese borrowers has recently turned more favourable, with Beijing announcing a slew of measures to boost the private sector.
For example, the People’s Bank of China said it would provide capital for credit mitigation purposes to assist bond issuance by private companies.
The Chinese government is encouraging the use of state capital to provide financial support to private companies, said Moody’s senior vice president Kai Hu. “Such actions will help [to] alleviate pressure in private corporate bonds in China’s onshore market.”
“Through 2018 we saw many private companies default, some of which were related to share pledges [made by] their large shareholders. Current measures to address share pledges and private companies’ access to liquidity will help reduce the funding pressure,” Hu said.
To mitigate listed company share pledge risks, the China Securities Regulatory Commission also announced in October a proposal to speed up the approval of special-purpose corporate bonds.
Next year, we expect that the Chinese government will continue to inject liquidity into the market to facilitate issuers’ debt refinancing. Having said that, the government will allow isolated defaults which do not threaten China’s financial stability or social stability,” Ivan Chung, head of Greater China research and analysis at Moody’s said at a press conference in Hong Kong on Monday.
The refinancing requirement of onshore Chinese bonds issued by non-financial corporates will total Rmb3.8 trillion in 2019 and Rmb3.1 trillion in 2020, according to Wind. This year, the total refinancing requirement of Chinese onshore bonds is Rmb3.7 trillion.
The government is also trying to attract more foreign investor participation.
On November 22, the Chinese Ministry of Finance announced that overseas institutional investors for the next three years would be exempt from paying certain taxes on any interest gains as a result of investments in the country's onshore bond market.
The aim of this policy is to further liberalise China’s bond market, the Finance Ministry said in a joint statement with the State Administration of Taxation.
“That will erase uncertainty over tax issues for foreign investors,” said Pang, who expects foreign investors to begin casting a wider net as a result of the changes.
To date, foreign investors have mostly been interested only in sovereign Chinese bonds, but they could increasingly also be drawn to onshore local government debt in the coming months.
“For 2019, we see a bigger fiscal deficit in the central and local governments of China, so they need to issue bonds in the onshore market to finance this deficit,” she said.
More than Rmb1 trillion of local government bonds could hit the Chinese onshore market this year, FinanceAsia reported on August 20.
Foreign investors will go from just investing in central government bonds and policy bank bonds to a broader sector in China over the next three to five years, BlackRock's Seth predicts.
In addition, there is the prospect of foreign funds flowing into China’s onshore bond market as a result of the market's looming benchmark index inclusion.
The Bloomberg Barclays Global Aggregate Index, widely tracked by many funds, will include Chinese yuan-denominated government and policy bank securities from next year, Bloomberg announced in March. In total, 386 Chinese securities representing 5.49% of the index, will be included, it said.
That could bring in $250 billion into the onshore bond market as passive funds tracking the index buy Chinese bonds in accordance with the index's changed composition, Pang said.
External factors could be another supportive influence.
“If the US continues to raise interest rates, global investors will find [more] attractive yields in the offshore market, but if the hikes stop, investors may seek value in China’s onshore market,” Gaetano Bassolino, Asia-Pacific head of global capital markets and solutions at UBS, told FinanceAsia.
But, in general, the underlying upward trend for foreign capital inflows into China’s onshore bond market is seen stayng intact, having surged to more than $80 billion since the beginning of this year, according to JP Morgan estimates. This contrasts with the outflows this year in the local currency debt markets of India, Malaysia and Indonesia.
Chinese bonds will be more significantly held by institutional investors in the next five years, said Hannah Anderson, global market strategist of JP Morgan.
She adds a proviso though: “Over the long run, we don’t think Chinese bonds will be core holdings; significantly more doesn’t mean significant holdings.”