By Maria Trombly | Securities Industry News | April 25, 2005

Now that China has embraced the World Trade Organization and is opening up to everything else that the capitalist world has to offer, it no longer presents an obstacle to the creation of pan-Asian financial mechanisms, such as a regional bond market.

In fact, according to a report by University of Pennsylvania professor Jennifer Amyx, China is now a driving force in Asian regional integration.

Signs of progress include two Asian bond funds, created by the regional central bankers group, and an Asian Bond Markets Initiative launched by the financial ministers of the Association of South East Asian Nations (Asean) member states along with China, Japan and South Korea.

As recently as 1997, China had opposed Japan's proposal to create a regional monetary fund. But that has now changed as China rapidly embraces integration with global and regional financial markets.

A regional bond market will deliver the most benefits to China, Amyx says.

The second bond fund, announced at the end of 2004 and being put together now, moved ahead surprisingly fast, says Amyx. It involves $2 billion in funds, denominated in local currencies. An earlier bond fund, put together in 2003, was denominated in U.S. dollars.

"Having China behind these initiatives is important in keeping the momentum going forward," Amyx says.

It's also an example of how involvement in these kinds of regional activities helps China, she argues. "Because of the way the money in these funds is classified, it required a rules change in Chinese law," she says. "It represented a move in the direction of liberalization of Chinese regulation."

In fact, Amyx says, peer pressure from these regional financial groups has resulted in movement on a regional level in other countries as well, and that may, perhaps, be the most important benefit of this kind of cooperation. For example, Malaysia and Thailand have both had to make it easier for foreign institutions to invest in their markets.

Patience Required

"Over the next two years, will we be seeing a big unified Asian bond market? That's probably not a realistic expectation," Amyx cautions. "We will probably see more developments at the local level, where they're cooperating on infrastructure development. We'll see a lot of local bond markets developing rapidly."

China, which lags the most and has the least open market, will probably benefit most, although it's unlikely to contribute much to the pool of regional expertise. According to Chris Hamilton, head of the risk and business group at BearingPoint, who was in Shanghai recently for a conference, China isn't exactly leading the way when it comes to regional bond trading. "The derivatives market, the hedge instruments--none of these really exist," he said. "Other Asian countries have been far down the road for many years."

In addition to the lack of derivatives, China's bond market is limited by the fact that most companies and municipalities are forbidden from issuing bonds, leaving the field occupied by just a handful of state-owned enterprises and China government bonds.

Despite these shortcomings, however, the Chinese bond market has undeniably come a very long way.

"The bond market nowadays, in volume as well as in experience, both in the primary and secondary markets, is more sophisticated than eight years ago," says Thomas Liu, professor of finance at Shanghai's Jiao Tong University. "That's why eight years ago we opposed a proposal to establish the Asian Monetary Fund. Now we are more active in participating in such a proposal. It's a different situation."

China will be a major beneficiary of such a fund, Liu says, because the country needs capital and also needs better information disclosure, more transparency, and experience in establishing a robust capital market. "Such capital cooperation can help China establish a more sophisticated, developed capital market," he said.

It will take at least five or six years, however, warns Liu. "The Asean countries plus three is a newly established mechanism," he notes.

At a recent conference in Shanghai, experts from the Asean+3 nations re-affirmed their commitment to regional cooperation. Chinese representatives suggested that large companies should be encouraged to issue bonds, including transnational infrastructure construction bonds. According to Xinhua, China's official news agency, the officials also announced that guarantee and rating institutions should be established to underwrite these bonds and to attract European and U.S. investors.

"Currently, the international rating of Asian bonds is not high, so we should have our own rating institutions," China Business News quoted a Chinese representative as saying.

Under Construction

Meanwhile, the China bond market is lacking in credit rating institutions, says Stephen Green, senior economist for China at the Shanghai office of Standard Chartered Bank. There is also a lack of a credible bankruptcy framework, Green says: "This means that investors lack the necessary protections."

According to Liu, the Chinese bond market is currently limited for the most part to government bonds.

As of the end of 2004, the Chinese government had issued over RMB690 billion worth of bonds ($83 billion). By comparison, total corporate bonds amounted to just RMB32 billion, according to government statistics.

"If there is a regional bond fund, it can help stimulate the development of the Chinese corporate bond market," Liu says. "That will be a contribution to international investors--they will more easily be able to invest in the bonds of good enterprises."

Meanwhile, there are significant internal regulatory obstacles still to overcome, adds Liu. Today, most private enterprises are not allowed to issue bonds, and neither are many of the government-owned companies.

"Most of the state-owned enterprises are not very profitable," Liu says. "If they cannot repay the principle and interest, the investors will incur a great loss and that will be an unstable factor in society." Equity issues, by comparison, don't require companies to incur repayment obligations, notes Liu.

Another source of funding for state-owned enterprises is loans from government banks. Given China's non-performing loan problem, companies have been regarding bank loans as free money as well, it seems. "The government is worried about the large number of non-performing loans," Liu says. "That is a big obstacle for the big banks going public."

So the banks are trying to crack down on bad lending in order to clean up their balance sheets ahead of public listings. In addition, the government has been trying to tighten lending in order to slow down the country's run-away economy.

When these factors are combined with the stock market's dismal performance in recent years, bonds are starting to look more and more attractive to corporations.

The Opening

Today, only a handful of state-owned enterprises are allowed to issue bonds, according to Liu. These are mostly monopoly utilities with guaranteed revenue streams, and the rates for their bonds are set by government regulation, which also serves to make them less attractive.

That's all about to change, Liu predicts.

More and more Chinese companies have listed overseas, become globally competitive, and otherwise have cleaned up their acts.

"They should be qualified to issue bonds to the public," Liu says. "That's why the government now intends to develop a bond market."

Public statements by central bank officials, as well as officials from the China Securities Regulatory Commission, indicate that the government has begun to take a serious look at bond market reforms.

Next month, for example, Shanghai will be hosting a regional conference dedicated to the bond market. Liu says he expects such reforms to happen within the next one or two years.

That's not fast enough for some. "It's very hard to understand actually why the government isn't really aggressively pushing this," says Standard Chartered Bank's Green. "I don't really understand this myself. I see all the problems, but I don't get what the big obstacle is in solving them--in streamlining the process a bit, allowing independent credit agencies, allowing some flexibility in rates, pushing forward with the bankruptcy laws. The companies are very keen and I'm sure the investors are very keen."

Muni Revolution

According to Liu, reforms are also likely to occur in the municipal bond market. Today, local and regional governments in China are not allowed to issue bonds.

Government bonds are pretty much limited to treasury bonds and short-term notes issued by the central bank, Liu says. The law forbidding local governments from issuing their own bonds dates back to 1994, during a period of excess exuberance on the part of local governments in that decade's early years.

Many of the local bonds had been used to set up special development zones and high-tech business districts. "They were worried about defaults and overheating," Liu explains.

Some municipal governments were considered to be more responsible than others and received special permission. The Shanghai city government, for example, was allowed to issue a construction bond to build up its Pudong financial area.

The law forbidding municipal bonds is also under discussion, Liu says. "Some local governments, especially those in the coastal areas, are more mature in raising funds," he says. "They have more tax power and budgetary power than ten years ago, and that's a guarantee for repaying the bonds that they issue."

Again, Liu says, this law is likely to be amended within the next two years at the latest.