China's central bank has surprised market watchers with a rapid-fire series of moves to liberalize the country's domestic bond market.
A market link to allow trading by Hong Kong retail and institutional investors opened on July 1, just three and a half months after the idea was embraced by Premier Li Keqiang. The launch was quickly followed by news that the domestic corporate bond market will be opened to foreign ratings agencies.
In other moves, U.S. investment bank JPMorgan Chase was granted a domestic bond-underwriting license and rival Citigroup was approved as a domestic bank settlement agency. The China interbank bond market program, launched last year, was loosened to allow more flexible foreign exchange hedging options.
While total foreign holdings of local debt issues reached 804 billion yuan ($119 billion) as of the end of June, up 6% from the end of 2016, this still represents just 1.7% of outstanding domestic bonds.
Data from the Shanghai Clearing House indicates that investors have been slow to use the new Hong Kong Bond Connect link. In its first month of operation, investors put 1.5 billion yuan into new short-term corporate debt and around 2 billion yuan into bonds traded on the secondary market.
Market participants say Chinese fund managers operating through their Hong Kong subsidiaries account for the bulk of this activity. No doubt Hong Kong Exchanges & Clearing is pleased to see the volumes, but allowing Chinese money to flow back into the domestic bond market is hardly the point of Bond Connect.
Bond Connect was never going to herald a rush of foreign investors into the market. Many institutions had already been exploring or using the direct access interbank route.
But more importantly, foreign investors are too wary of China to rush in, even if Citigroup and others have started adding Chinese local bonds to their global indexes. Investors have been burned often enough to know that caution remains the best watchword.
The most significant recent development was the announced introduction of foreign ratings agencies. Access to China's market has long been on their wish list. Until now, foreign agencies have needed to partner with local ratings entities. Even then, they have been restricted to rating offshore Chinese offerings.
The perpetual concern about current onshore ratings is that they are either political in nature or that they reflect the fees paid to local agencies. Most bonds in China enjoy "A" ratings or higher. Few investors have concerned themselves with domestic ratings because most think the government will bail out troubled issuers.
This has begun to change as a result of the growth of nonperforming loans, weakened corporate financial positions and official statements that investors should not rely on government bailouts. As a result, fears of default are growing as stresses in the economy increase.
No tidal wave of default has materialized yet. This has been due in part to better-than-expected economic performance in recent months. More important has been the incredible ingenuity and creativity of banks and issuers in finding ways to funnel money to where it is needed in spite of government rules intended to limit credit growth.
A NEW SCORECARD Should foreign ratings agencies follow local agencies and factor in implied support from local and state governments? Or should they stick to their traditional approach and focus primarily on corporate fundamentals? If they churn out ratings well below those published by their Chinese peers, will they be allowed to continue in such an independent fashion?
The problem the agencies face is that the political winds have changed significantly over the past decade. Despite their growth, Chinese markets have never been under such close political attention as now. That is especially true this year, as China approaches the expected announcement in the fall of a second five-year term for President Xi Jinping as head of the Chinese Communist Party.
Widespread downgrading of the corporate sector by a large foreign ratings agency would, without doubt, incur the wrath of the political leadership and the Chinese media and be seen as destabilizing the debt market. But the flip side is that if foreign ratings agencies temper their assessments for political reasons and fall in line with their Chinese counterparts, what value do they bring to investors?
Even the performance of the relatively safe government bond market can no longer be easily predicted. Yields on 10-year government
bonds in May traded lower than those of one-year bonds, contrary to customary expectations. Liquidity can be hard to find as many banks, insurers and funds hold bonds to maturity.
Greater access for foreign capital to China's debt market is more than welcome. It has been years in the making and is long overdue. But no one should expect a great turnaround in Chinese markets or changes in their specific characteristics.
Foreign participation comes too late and at too sensitive a time for markets to make great strides quickly. The problems that foreign ratings agencies have faced in accessing the market have been replaced by a pressing need to understand what they have got themselves into.
Fraser Howie is co-author of "Red Capitalism: The Fragile Financial Foundations of China's Extraordinary Rise." He has worked in China's capital markets since 1992.