China late last month ended a 13-year ban against banks’ trading bonds on equity exchanges. It is the latest initiative to develop the domestic debt market and potentially reduce reliance on bank loans to sustain economic expansion – but don’t expect capital to flood the market just yet.
But weak market fundamentals and limitation commercial lenders face in trading exchange-listed debts will likely make it difficult for bank capital to flood the market quickly on the initial stage.
Under the regulatory arrangement, all 16 Chinese listed lenders will be permitted to trade spot debt on the Shanghai and Shenzhen stock exchanges. The project will likely be expanded pending on the results of trial operations.
In early 1990s, Chinese lenders were quite active bond traders on the domestic exchanges. However, a large chunk of bank capital was founded then to have sneaked into the stock market illegally via bond repurchases, fanning regulatory concerns about financial stability.
With the creation of the interbank bond market in 1997 – which plays host to institutional investors including lenders, insurers and brokerages under the supervision of the People’s Bank of China (PBoC) – the banks were excluded from bond trading and debt repurchases on the stock exchanges.
While this has worked out well in terms of regulation, it has greatly reduced the liquidity available for the exchange debt market. As a result, companies have been drawn to the interbank bourse. In the first three quarters, a total of US$1.18 trillion in debt was sold on the interbank market, far outpacing the US$2.97 billion worth of bonds issued on the two stock exchanges.
The authorities know that they must open up new financing channels to meet the demands of companies that seeking to expand on the back of China’s economic growth. The fact that bank lending remains the dominant source of funding – outstanding bank loans were more than twice the size of debt securities at the end of last year – doesn’t bode well for long-term development of the financial sector or the corporations that depend on it.
Obviously, re-opening the market to listed banks is in line with China’s promotion of a direct financing segment. Having more investors on the exchange debt market will encourage more companies to issue bonds there. As a growing number of banks move in, industry conglomerates may also shift sales of part of their medium-term bills to the stock exchanges from the interbank market for diversification.
An added incentive is the greater yields available on the exchange debt market – bonds tend to be priced higher than on the interbank market due to the smaller number and range of products available.
There are, however, some restrictions to banks participation in the exchange debt market. Under the current arrangement, they are only allowed to trade spot bonds on the stock exchanges and can’t conduct bond repurchases, which largely reduces the market’s appeal to some institutional investors. Lenders are also limited to trading under the stock exchanges’ automatic matching system, which includes retail investors and big institutions. The other system – the fixed-income platform, which features market makers and block deals – is excluded from the trial program.
But the top priority is to work out follow-up actions to integrate the exchange-based and interbank debt markets. This is no easy feat given that they are overseen by separate regulators – the PBoC is responsible for the interbank market while the China Securities Regulatory Commission runs the stock exchanges.
While integration will be gradual, all parties must agree that the ultimate goal is for any investor to trade any types of bonds without restrictions in either market. This is the only way to ensure efficient capital allocation.
Once banks return to the exchange-based debt market, China’s corporate bond market should progress more rapidly. The exchange bond market is expected to be eventually dominated by institutional investors while retail investors largely participate through mutual funds and wealth management products offered by brokers and banks.
A twist in the tale is that Chinese regulators are considering plans to allow domestic fund houses and brokers to raise renminbi-denominated capital in Hong Kong to invest in mainland stocks and bonds. Some large Chinese banks have also expressed an interest in participating in this mini-QFII scheme (so called because it mirrors the Qualified Foreign Institutional Investor program whereby overseas financial institutions are allowed to buy mainland capital markets products).
If the program is further deregulated to lenders, it could open up new funding channels for the mainland stock exchanges and thereby accelerate the development of the exchange-based debt market.
All of this will of course take time. Banks need to gauge the risks and map out investment plans for the new market while regulators must draft unified issuance rules and supervision standards for both the exchange and interbank markets.