China under pressure to reform debt market as foreign flows slow

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Concerns over deep-rooted structural problems in China’s $21 billion debt market are keeping foreign investors at bay, even as Beijing prepares to grant unprecedented access to local-currency bonds.

Global fixed-income traders sold around $35 billion worth of renminbi-denominated bonds in the first four months of this year, and many are warning capital outflows will only get worse as concerns escalate. grow on poor liquidity – the ability to buy and sell debt easily – and the country’s opaque process for resolving defaults.

The pressure on China’s bond market comes after years of steady international buying and despite the government’s efforts to boost demand for domestic corporate debt through an upgrade to Hong Kong’s Bond Connect program at the end of this month.

Asset managers say the key to improving sentiment would be for Beijing to make difficult and long-delayed market reforms, such as greater transparency on how defaults are handled.

“Access is no longer an issue,” said Jenny Zeng, co-head of Asia-Pacific fixed income at AllianceBernstein. The decision to improve foreigners’ access to onshore credit was a “good move”, she said, but it “does not change some of the longer-term structural problems” that prevent foreign investors from injecting more money in Chinese bonds.

Missed payments, in particular, have become a priority issue in the country after the high-profile default of China Evergrande, which rattled the domestic real estate sector and weighed on economic growth more broadly.

“If the default resolution process becomes more transparent and institutionalized, that can be a big factor for us to allocate more money to China,” Zeng said. “Anything that is predictable, logical – we can price it.”

Chinese debt markets were also affected by the new Covid-19 shutdowns which weighed on the renminbi exchange rate. At the same time, US Treasury yields rose as the central bank aggressively tightened monetary policy – ​​a move that wiped out China’s advantage as a more attractive country for bond investors.

“The key to the future is not so much access as investor confidence,” said Wang Qi, managing director of fund manager MegaTrust Investment in Hong Kong. Wang said recent defaults by Chinese property developers “do not give foreign investors confidence in the onshore bond market.”

The default of Evergrande, which has more than $300 billion in total liabilities, began in September last year but took months to be officially declared and was mired by a lack of disclosure on restructuring plans of the company. Foreign investors, in particular, fear that onshore bondholders will be favored over offshore creditors.

“We are not scared by the default itself,” Zeng said, adding that prioritizing onshore creditors would not be a problem if the rules were clear up front.

“The challenge here is that the resolution process is less predictable and therefore more difficult to assess the defect.”

Traders also face a lack of liquidity in China’s debt market, which is dominated by largely state-run financial institutions that typically buy and hold bonds to maturity. It also only has a limited number of market makers, which can lead to jerky trading as buyers struggle to match sellers.

“The Chinese bond market is still dominated by banks,” said Ivan Chung, associate managing director at Moody’s Investors Service. Chung said that despite some improvement in recent years, commercial banks still hold around 65-70% of Chinese corporate bonds, with insurers and investment firms accounting for another 20%.

“On a selective basis there is some liquidity,” he said, “but obviously there is room for development.”

International investors say one of the most immediate ways to help address the risks posed by such shortcomings would be to grant access to renminbi bond futures, as it would allow them to hedge their risks. as well as making leveraged bets on Chinese debt.

But recent changes by authorities have intentionally ruled out any measures opening up futures contracts and similar assets to foreign investors because it could allow them to profit from a sale, according to a Shanghai-based investment manager at a European lender.

“Regulators don’t like the idea of ​​leaving foreign investors exposed [bet against] Chinese government bonds,” the investment manager said. He added that domestic investors with huge holdings of government bonds, such as state-run lenders, were also prohibited from making leveraged bets on Chinese debt, because “the only direction of their transactions would be to sell, which would cause the market to collapse”.

This leaves policymakers with few easy options in deciding where to begin the next wave of bond market reforms. But as China grapples with an economic slowdown, it may have no choice but to make tough decisions about how to handle mounting defaults.

Chung said the rise in defaults was “of course not good for investors,” but added that recent developments would ultimately help differentiate risk levels for onshore bonds.

“Five years ago investors would panic if the bond they were holding defaulted,” he said, while they now have at least some options to try to limit losses, including negotiations. with bond issuers.

Even so, Chung did not expect capital inflows to pick up in the coming months simply because China grants easier access to its bond markets.

“The key is whether investors see attractive returns in China’s onshore market,” he said.

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