Red Capitalism (17 page)

8
Keith Bradsher, “Main Bank of China is in Need of Capital,”
New York Times
, September 5, 2008.

9
Yu Ning, “
Huida deng chang
(Huida takes the stage),”
Caijing
, July 25, 2005: 65.

10
See “
Huida zichan tuoguan fuchu shuimian Zhan Hanqiao huoren rending shizhang
(Huida Asset Management surfaces; Zhang Hanqiao likely appointed as Chairman),”
China Business News
, August 3, 2005: 1.

11
The absence of the Hainan and Guangdong figures makes one wonder about the fate of the huge amounts of “triangle debt” Zhu Rongji untangled in the early 1990s that were left over from the 1980s banking debacle.

12
Caijing
, May 12, 2008: 79.

13
www.caijing.com.cn/2009-09-23/110258742.html

14
The bond owed to Bank of China by its related AMC, Orient, was also extended as it came due in 2010; without question the similar Huarong bond held by ICBC can also be expected to see its life extended later in 2010.

15
CEO and Chairman of JPMorgan Chase & Co.

CHAPTER 4

China’s Captive Bond Market

“Compared with other financial instruments and against the backdrop of a high savings rate and high ratio of M2 to GDP, China’s corporate bond market has been developing very slowly and its role in economic growth has been rather limited. Such lack of development has also distorted the financing structure and produced considerable implicit risks, whose consequences may be grave for social and economic development.”

Zhou Xiaochuan

Speech at China Bond Market Development Summit

October 20, 2005

The demand from corporations and other issuers for cheaper capital than banks were willing or able to provide gave rise to the debt-capital markets in the developed economies. The basic assumption of issuers is that banks do not have a monopoly on understanding and valuing risk; large institutional investors, such as insurance companies and pension funds, also have the capacity to make investment judgments independently. So why rely only on banks for capital if you can get money more cheaply from other investors? Why not use markets to press the banks for cheaper funds? In China, over the past several years, a similar process appears to be happening. Its bond markets have enjoyed record issuance volumes, developed standardized underwriting procedures and allowed some foreign participation. Is it possible that in the not-distant future, investors in this market will compete with banks for corporate issuers and so take some of the credit- and market-risk burden from them, as has been one of the explicit reform objectives of the central bank?

In China, nothing is as it appears; words similar to those used internationally can have different meanings. Here, the markets were created by the same group of reformers who promoted bank reform. Beginning in 2005, with the aim of reducing excessive risk concentration in the banking system, they took over the largely moribund inter-bank market for government debt and introduced products modeled after those available to corporations internationally. On the surface, their efforts appear to have paid off. But huge issuance volumes, thousands of market participants and a growing product range do not alter the fact that China’s debt markets remain at a very primitive stage—an assessment with which no market participant in China would disagree, as Zhou Xiaochuan’s comments above attest. China’s debt markets are captive both to a controlled interest-rate framework on the one hand, and, on the other, to investors that, in the end, are predominantly banks. To understand why China’s bond markets are moribund requires digging into the technical details. But seeing how these markets are controlled is a key part of understanding how the Party manages China’s financial system: the symbols of a modern market are there, but the market itself is not.

Normally, the word “primitive” is used to indicate that the necessary market infrastructure is missing, but in China, all such infrastructure is in place. Like highways, new airport terminals or CCTV’s ultra-modern office building in Beijing, it exists because the Party believes bond markets are a necessary symbol of economic modernity. So there are ratings agencies (five), regulators (at least seven) and industry associations (at least two) with overlapping authorities and little respect for one another. There are now many of the same products that can be found in more developed markets, including government bonds, commercial paper (CP), medium-term notes (MTN), corporate bonds, bank-subordinated and straight debt, some asset-backed securities, and so on. These products are traded for cash, repo-ed
¹
out, or sold forward, and interest risk is hedged through swaps: all as might be expected.

What makes China’s bond markets “primitive,” however, is their lack of the engine that drives all major international markets. That engine is risk and the market’s ability to measure and price different levels of it. Risk, in market terms, means price; like everything else, capital has a price attached to it. In China, however, the Party has made sure that it alone, and not a market-driven yield curve, provides the definitive measure of risk-free cost of capital and this measure is based ultimately on the funding cost for bank loans, the one-year deposit rate. Consequently, in the primary (issuing) market for corporate debt, it is common practice that underwriting fees and bond prices are set with reference to bank loans, and not to true demand. Artificially low prices are then compensated for by the issuer’s agreement to an exchange of additional value outside of the market through, for example, conducting a certain amount of foreign-exchange transactions. In other words, bond-price setting is bundled with other business not in the market and the underwriter then holds the bond to maturity. Why? In the secondary (trading) market, investor demand is free to price capital, but the low issuing prices in the primary market mean that the bond underwriter will take a loss if he sells. Thus, the number of Chinese government bonds (CGB) and other bonds traded daily is in the hundreds at best. To the extent that bonds change hands, they do so at prices reflecting the premium that holders must pay to buyers to unload the security. If there is no active trading, there can be no accurate market pricing standards, only a price that might be called a “liquidity premium.”

There is an additional, historical, reason explaining the weakness of China’s bond markets. China is a country where the state—that is, the Party—owns everything and there is no tradition of private property. It might be expected, therefore, that the debt markets would have grown into the most developed market for capital. Unlike stock, debt does not touch directly on the sensitive issue of ownership. As even the most casual observer cannot help but note, however, everyone in China—from retail mom-and-pop investors to provincial governors and Communist Party leaders—is infatuated with stock markets. This has been true since the early 1980s when shares were “discovered” and is one of the main explanations for why observers believe that China is evolving along the path traced by developed economies.

So why not debt? The reason is simple: the government and SOE bosses quickly figured out that stock markets provide enterprises with “free” capital in the sense that it need not be repaid. In contrast, like a loan, bond principal must be paid back at some point and in the past, this often has proved to be “inconvenient.” Even better, a public listing provides an SOE with a “modern” corporate veneer (plus higher compensation levels for senior staff if the company is listed overseas) that issuing debt does not. Again, it’s the great attraction of symbols. Selling shares is a game-changer in these and many other ways, while issuing more debt is just business as usual. No Chinese CEO was ever lauded in the financial press for borrowing money from a bank.

China’s beautiful market infrastructure is necessary, but insufficient to raise the bond market above its primitive stage. As a result of manipulated pricing, corporate issuers are indifferent to the choice of debt instruments; bonds or loans are the same to them. More importantly, underwriters and investors are also indifferent to this market because they cannot make money. This chapter explains why this is so. Caught up in guidelines left over from the Soviet central-planning era, interest rates do not reflect true market forces, so debt valuations are distorted. But this is how the “system” likes it; the Party’s urge is to control. Party leaders believe they are better positioned than any market to value and price risk. The near-collapse of the international banking system in 2008 has only confirmed them in this belief.

What does bond market “development” mean, however, if not establishing over time a finely tuned understanding of the price of risk? Part of the notion of risk is that of change. But China’s debt-capital markets have from their inception been founded on the expectation that there will be no change, whether in the quality of issuer or in supply and demand as understood by developed markets. Zhou Xiaochuan’s remarks, therefore, are an almost-unique public indication that at least some senior officials are aware of the real systemic dangers being created by this suppression of risk. Given his expertise, his remarks on the consequences for social and economic development are not entirely surprising. If all this is true—that the market is creating risk—why does China need a bond market or, in any case, the one it has currently?