Getting the Chinese Bond Market In Gear

Italy's MTS tries to kick-start effort to export European fixed-income expertise

Like much of China's financial infrastructure, the country's bond market is in a state of illiquid and opaque infancy. But the Chinese are also open-minded. Just as the country's exchanges have looked to counterparts in the West--including the New York Stock Exchange, Nasdaq Stock Market, the Chicago derivatives exchanges and Stockholm-based exchange operator OMX--for everything from informal advice to formal understandings for educational and technological cooperation, they have invited the Rome-based MTS Group in to share its expertise in building transparent, technologically sleek fixed-income marketplaces.

This month, MTS signed a letter of intent with the China Foreign Exchange Trade System (CFETS) to "cooperate toward the development of a transparent, liquid and efficient domestic fixed-income market in the People's Republic," according to a joint announcement. It would be an impressive extension of the MTS "European bond market model," which currently handles as much as EUR85 billion ($101 billion) in daily volume over its more than 15 trading platforms.

"We look forward to cooperating with CFETS and utilizing their expertise in order to further our understanding of Chinese market practices," stated MTS management board chairman Gianluca Garbi. "China is a rapidly developing economy and, as such, we also look forward to exploring the possibility of a formal venture."

If that sounds more hopeful than specific, then it probably is. The cooperative arrangement has the potential to be a far-reaching, even revolutionary addition to the nascent Chinese financial markets. But there are complications, as MTS knows all too well: It's been down this path before, through a memorandum of understanding (MOU) it signed last summer with the Shanghai Stock Exchange (SSE) that didn't yield tangible results.

"It's not really falling by the wayside," Angelo Proni, head of new markets for MTS, said of the MOU. "We did see the SSE in October of last year and we really didn't find much common ground to a way forward. But we remain open-minded."

CFETS, meanwhile, becomes MTS's second attempted point of entry into a market that is predominantly one of government bonds--the original forte of MTS, as it happens. Trading takes place through three venues--the Shenzhen Stock Exchange, SSE in Shanghai, and CFETS. The latter's trades are settled by the China Government Securities Depository Trust & Clearing Co., and the exchanges' trades are settled by the China Securities Depository & Clearing Corp.

There are also two oversight bodies: CFETS is regulated by the People's Bank of China and is limited to banks; the exchange markets are regulated by the China Securities Regulatory Commission (CSRC). Most deals are initiated by telephone and registered after the fact with the CFETS.

Not only is there no electronic trading platform, there is also no market-making mechanism for Chinese bonds, resulting in scant liquidity; Chinese citizens tend to keep their money in bank savings accounts. "It is very dangerous for a country when most of its liquid capital is in the banking system," said Liankang Fu, dean of finance at the Shanghai Institute of Foreign Trade. Experts say that liquidity and maturity in the capital market would be stimulated by the introduction of market makers or interdealer brokers, and MTS and others intend to move in that direction.

Two Years of Effort

In recent years, Chinese exchange and Ministry of Finance officials have traveled to Rome and Milan to see how MTS works. "We established contacts and relationships and decided last year that we would be interested in developing our global business in China," explained Proni. Based on MTS's experiences in other emerging markets--its most recent launch was MTS Poland, which went live in late 2004--Proni believes that a Chinese bond market could be up and running in 18 to 24 months. "What is most time-consuming is building the consensus and having everyone buy into the decision to go ahead," he said. "Once that's done, setting up operations is fairly swift."

The end product would be a fully functional market, with automated order matching and tradable quotes. The MTS, which has market-maker functionality, would get access to an existing Chinese bond market currently estimated at the equivalent of EUR450 million, with huge growth potential. "That is still fairly low as a percentage of GDP, but definitely a scale that justifies investment on our part," said Proni.

Except for convertible bonds, the CFETS dominates bond coverage in China. Being wholesale oriented, it is viewed by MTS as "more of a fit for us," said Proni, adding, "There is an awareness in the Chinese financial community that the market needs to develop and reform quickly in order to get closer to the way it is organized in more-developed countries."

However, a senior manager at the SSE, who did not want to be quoted by name, said that the exchange has a half-year head start on CFETS. "I guess we will be faster than them," he said, though he conceded that the SSE is still in a research stage, with no definite plans to move ahead with platform construction. "It's just intent that exists," he added. The Shanghai exchange did say this month that it plans to institute a market-maker mechanism for bond and stock trading as well as improvements in its technology infrastructure.

In recent months, central bank and CSRC officials have made public statements promising significant bond market reforms. At the end of 2005, for example, banks were finally allowed to invest in corporate bonds.

Institutional Advances

There is action elsewhere in the opening of Chinese financial markets. SSE officials announced plans--in addition to market making--for an increase in the daily trading band allowed for price movements, as well as expanded derivatives trading and more exchange-traded funds.

In another example of Western technology influence, information and trading giant Reuters Group, which is making a big push into China as an electronic broker, said Feb. 20 that five top banks there have signed on to the Reuters Dealing 3000 foreign exchange and money markets trading system: Bank of China, Bank of Communications, Bank of Montreal, China Construction Bank and Industrial & Commercial Bank of China. The system offers spot trading in 39 currency pairs.

Reuters Asia managing director Alex Hungate said the customer signings "show China is moving forward, toward greater currency flexibility, and major players in China are riding on the current and potential opportunities to grow their treasury FX businesses." Typical of the bankers, Zhang Wei Zhong, chief dealer at Bank of Communications in Shanghai, said, "Reuters Dealing is a great help as our trading volume in G7 currencies has increased tremendously"--in step with economic and trade growth.

According to the official Xinhua news agency, the country will allow more foreign investment in domestic markets and make it easier for Chinese insurers to invest in overseas securities. Lin Zou, the director of the capital account department at the State Administration of Foreign Exchange, said qualified foreign institutional investors (QFIIs) will get easier access to the Chinese stock markets this year, with lower minimum investment requirements and shorter lockup periods on purchased shares. The new rules reportedly will go into effect in April or May. The Chinese government has also been steadily increasing the number of QFIIs as well as the maximum limits on the domestic shares that they are allowed to purchase.

Wendy Yu contributed to this report.