For yield-starved global asset owners, China's opening of its interbank bond market appears a very appetising development. This is, after all, a country that has a benchmark one-year lending rate of 4.35%.
In February, the People’s Bank of China said foreign commercial banks, insurance companies and investment funds would be able to buy into its $6.7 trillion interbank bond market (CIBM), subject to certain restrictions. And yesterday it emerged that the UK's Insight Investment had become the first overseas institution to register for access to the market, with HSBC as its custodian and settlement agent.
Many more will follow, attracted by being able to access some 90% of the world's third largest bond market.
It’s hard to underestimate the size of this opportunity for international investors. When AsianInvestor asked Ashley Perrott, head of pan-Asia fixed income at UBS Asset Management, whether this represented a once-in-a-generation investment development, he agreed: “I’d say that’s a fair assumption.”
At a time when one-year US Treasuries are yielding 70 basis points, German 10-year bund yields have just turned negative for the first time ever and Japan’s interest rates are also in negative territory, it’s understandable why China’s market is so appealing.
Unforunately, it’s also uniquely risky.
China’s bond market may be big, but it’s far from highly evolved. Local commercial banks hold around 60% of all bonds, while the level of debt in the hands of fund managers is relatively small. And while portions of these bonds are traded, others are largely kept and held. That leaves large liquidity risks.
There are also questions over the ease with which foreign fund managers can enter China’s market, invest in local bonds, realise capital gains and withdraw these funds from the country.
The greatest risk of all, however, is the country’s mounting defaults.
Fears about China’s overall debt burden continue to mount. Total debt is estimated to have risen to 237% of gross domestic product as of the end of March, while corporate debt was around 145%, both the consequence of years of politically motivated lending to flabby industries now on the wane amid a slowing economy.
The International Monetary Fund is worried about China’s debt level, arguing it could spark a larger crisis if the country’s authorities fail to deal with the issue.
And while the official bank non-performing loan ratio was only 1.75% as of March 31, most onlookers feel this figure heavily understates the real level of bad debts sitting with the country’s lenders.
It’s not just companies and banks feeling the pinch. China’s problems are hurting its middle class too. J Capital Research offered a damning indictment this week, noting that while most attention focuses on how banks will cope with corporate defaults, “for at least two years now, average people in China have been losing their entire savings through online investment schemes, pre-paid property developments that were never delivered, government-sponsored OTC exchanges, informal commodities exchanges, illiquid property markets, and ‘share’ investments in companies – often their own employers – that promised to pay monthly ‘dividends'.”
This was exacerbated by a regulatory system that failed to oversee much of this activity. Until recently many private funds were barely regulated, and as a result many were effectively ponzi schemes, as reported in the June issue of AsianInvestor. The government is beginning to take action, but for many it has been too little, too late.
The upshot is that China’s lax regulation has burned many of the people that should act as natural investors into local fund houses, while propping up companies that should never have enjoyed capital. And of course, families that have squandered money are in a worse position to repay any debts they have – including mortgages.
The danger is that this puts pressure on the property market, which sits at the very centre of China’s economy and is beginning to look overheated in tier-one cities.
The combination of troubled companies, insufficient regulatory oversight, local bank lending largesse and out-of-pocket investors has led to a market lacking in confidence, and a lot of risk. And yet China’s local rating agencies continue to rate the vast majority of local bond issuers between AAA and AA-, blithely ignoring the reality surrounding the country’s borrowers.
Increasingly the country looks like it has two choices. It can undergo a painful restructuring that includes letting defaults take place, hurting bank balance sheets and consumer pockets alike, but also creating a culture of appropriate risk-taking. Or it can continue bailing companies out, in the process propping up zombie companies while destroying its longer-term growth prospects, a la Japan.
Either way, China offers sizeable credit risk implications.
To be sure, there are ways for international investors to minimise their exposure to such risks.
They would be likely to stick with the most solid of names; big local banks and large state-owned enterprises, or the most highly regarded of the municipal borrowers that can issue debt, such as Beijing, Shanghai or Guangzhou. It’s unlikely in the extreme that such borrowers would default on their debts.
But that doesn’t mean they won’t be affected. Alicia Garcia Herrero, chief economist for Asia Pacific at Natixis, believes the government will likely embark on a drip-feed strategy to deal with the rising level of bad debts the banks are undoubtedly sitting on. She argues that there will be a combination of debt-for-equity swaps, securitisations and selling assets to the country’s fund managers (bad debt agencies by another name) to help handle these sour debts.
The upshot is that even the most robust of local banks will be forced to spin out bad assets or provision more capital against them. While these balance-sheet restructurings and write-downs are not likely to cause lender collapses, at least among the big players, they could force local investors to finally raise questions about risk versus reward in the bond market.
Perhaps more worrying would be a situation where the bonds of such banks are not re-appraised. That would leave international investors with an unpalatable situation in which institutions with obvious balance-sheet problems are still viewed – and priced – as ultra-safe investments.
Ultimately, all of the seeming confidence in the local bond market is perilously balanced on moral hazard – the belief that Beijing will underwrite all the debts these banks have accumulated. Until now that has been a good bet. The government’s fear of unrest and disharmony has led it to largely bail out those who have invested in the debts of companies going bankrupt.
But China’s debt problems are vast. At this point it’s a question of when, not if, the government decides to start allowing some bad borrowers to go to the wall. And at that point banks will start having to write down assets in earnest, while some local investors will end up out of pocket.
If the local market hasn’t developed a more enlightened attitude towards risk by that point, it could see some very marked shocks, and likely sudden periods of complete illiquidity.
China’s bond market offers a potential feast of yields, which is likely to prove irresistible to return-starved international investors. In some ways, this could prove a good thing, with more international investor activity hopefully bringing a level of maturity to a relatively nascent market.
But as they dine on local interbank bonds, foreign investors had best be careful – some of those tasty delicacies could yet turn very sour.