China's volatile stock market has regularly captured the headlines over the last year. But, China's other major market, the bond market, is quietly undergoing meaningful changes. China's onshore bond market is evolving rapidly, and opening up to global investors.
Mainland China has the world's third largest local bond market at roughly 4.2 trillion USD as of June 2014 according to the BIS, after the US (roughly 36 trillion USD) and Japan (almost 13 trillion). China's local bond market is roughly double the size of Brazil's, the second largest EM market. In relative size terms, the bond market is roughly 50% of GDP (see chart on the right), compared with the most current stock market capitalization of 75% of GDP.
The pace of China's bond market growth has picked up in recent years. Total outstanding local currency bonds are up 12% from last year, and trading volume in the corporate bond market rose 15% in Q2 this year compared to last. As of July 2015, total oustanding non-financial bonds grew almost 19% from July of last year.
Onshore corporate bond issuance has accelerated over the years from near nonexistence a decade ago (see chart on the right). Firms have been incentivized to diversify funding sources and migrate to the lower funding costs of the bond market over bank loans. Beijing has also been incentivized to grow the corporate bond market in an attempt to diversify risk away from commercial banks and onto the books of a much broader base of financiers. It is important to note however that as of the end of 2014, state owned firms accounted for 90% of outstanding corporate bonds, and 70% of corporate issuers, according to Fitch. The onshore corporate bond market is still more quasi-sovereign market than a pure corporate one. And, banks still own the lion's share of the bond market. As the bond market matures, defaults take place, and foreign investors have greater participation, look to the issuer base to diversify away from state affiliated firms and the investor base to diversify away from banks.
Ownership in the bond market
Banks are the primary owners of bonds in China's market, with individual investors, more interested in stocks and property, holding only a small share of the total. Households allocate nearly all investable capital to bank deposits, property, and more recently stock holdings to a lesser extent.
According to the Asian Dev Bank, commercial banks own 74% of the government bond market (including central gov, local gov, central bank, and policy bank bonds). The next closest are investment funds with 6% of the total, and insurance firms with about 5%. Banks account for roughly 70% of all bond trading volume.
Foreign participation
Unless you are a central bank or sovereign wealth fund, accessing China's onshore bond market is difficult now, but opening up more and more each month. Foreign investors can participate in the Chinese bond market via two programs used by Beijing to open the capital account in a slow, controlled manner. The first, launched in 2003, is the Qualified Foreign Institutional Investor (QFII) program. This program allows licensed foreign investors to buy and sell both local bonds and stocks. As of June 2015 the total quota for the QFII program was $75 billion USD, roughly 0.80% of the market, for 285 approved foreign investors. The quota has expanded quickly in recent years as China works to open the current account as part of broader financial reforms.
The second program is the RMB Qualified Foreign Institutional Investors (RQFII) program. Started in 2011, the RQFII allows investors to access the China bond and stock market via yuan denominated accounts held overseas. As of recently, 11 countries participate in the program. As of June 2015, the maximum quota for the RQFII program was 383 billion RMB.
See my inforgaphic for more details on foreign investment programs:
Five years ago Beijing also started allowing central banks and overseas lenders that conduct trade settlement in yuan access to the local bond market. According to Standard Charterd Bank, over 50 central banks hold some yuan denominated bonds, although many of these are offshore yuan denominated securities - "dim sum" bonds.
These programs continue to open the country up to foreign participation, which will ultimately lead to Beijing's reform goal of a fully convertible currency sometime in the future. As of March 2015, offshore institutions held roughly $93 billion worth of local currency bonds, up 44% from the prior year. That number is roughly 1.60% of China's total bond market.
Most foreign investors access China's market via offshore bonds, most of which are denominated in US dollars. The offshore market is dominated by large state-owned issuers, with higher yielding property developer issuance growing rapidly. Offshore bonds come with a higher yield, roughly .50% to 0.80% for medium-term state owned enterprises. Offshore bonds also have a the added advantage of minimal direct currency exposure. Currency hedging the onshore bonds as of the writing of this article will cost around 5 - 6%, fairly expensive. According to Morningstar, the offshore bond market is $349 billion, with risky property developers about 12% of the total. Beijing recently reduced barriers to offshore debt issuance, and rapid growth will continue. China will continue to quickly grow as a large constituent in a number of bond indices, like the JP Morgan EMBI.
The bond market and China's reserve currency prospects
The comparable sizes of the world's top three bond markets have an impact on the pace at which China's yuan can replace the USD as the world's most dominant reserve currency. It will be some time before the yuan can replace the dollar's dominance as the world's number one reserve currency. As you can see from the market size comparisons at the top, China's treasury bond market is not yet deep enough to accommodate the lion's share of the $11 trillion global reserves held by central banks around the world. The market will need to grow significantly to accommodate Beijing's reserve currency aspirations.
China's acceptance as a reserve currency by central bankers could eventually result in trillions of inflows into its markets, and in turn keep interest rates relatively low for some time. According to Deutsche Bank, three trillion yuan could flow into China's bond market over the next 3 - 5 years as China opens the market and central banks buy China's bonds for reserve purposes.
Types of bonds in China's bond market:
- Central government bonds are issued by the Ministry of Finance, and constitute one of the largest pieces of the bond market. Bonds issued by local governments are only a small, but rapidly growing, portion of government bond issuance. In 1994 local governments were restricted from issuing their own debt. But in recent years, in order to roll-back the opaque and difficult to control local government debts, Beijing is trying to grow the local government bond market. This year local governments will be allowed to convert 3.2 trillion RMB of opaque debt for transparent municipal bonds. Central government bonds account for roughly 27% of China's bond market. Local government bonds only account for about 3% of the market.
- Non-financial corporate bonds issued by state affiliated and private firms come in various tenors, from commercial paper to longer-term notes. The most common and liquid are medium-term-notes with tenors of three to five years. Longer tenors are traded less frequent and are harder to exit. The largest category of non-financial corporate bonds are "enterprise" bonds, issued by large state affiliated and state owned firms. Corporate notes, enterprise bonds, and commercial paper account for around a quarter of all bonds. A list of the top corporate bond issuers is on the left.
- Central bank notes and short-term instruments are issued by the PBOC for the implementation of monetary policy.
- Financial bonds are issued by policy banks and commercial banks. Policy banks are China's largest bond issuers. These banks include China Development Bank (CDB), China EximBank, and Agricultural Development Bank. Their primary purpose is to lend money based upon furthering political and economic policy agendas. Bonds issued are backed by the central government and the PBOC. The largest policy lender, CDB, is primarily responsible for funding infrastructure projects, such as the Three Gorges dam and the Shanghai Pudong airport. Policy banks account for roughly 27% of the bond market.
Going forward
Beijing will continue to rapidly grow the bond market as it tries to diversify financial markets away from bank loans and create a less opaque debt load. Getting foreign money into the bond market is also a key goal. While approvals for more outgoing investment have been stagnate for the last 4 months, inflow approvals have been on the rise. The continued opening of onshore markets to foreigners will have the combined effect of growing the bond market, opening the capital account per reform plans, expediting Beijing's goal of making the RMB a major reserve currency, and offsetting capital outflows. The last item is the more pressing issue recently given the surge in outflows from sinking investor confidence and a PBOC effectively printing money while the Fed is planning to move in the opposite direction.