Dagong Credit Monitor

Transcription

1 Dagong Credit Monitor Panda Bond Market Growing Panda that Eats Dim Sum Summary Category Market Overview Location China Date 22FEB2016 Overview Panda bonds (or RMB-denominated bonds issued in China by issuers domiciled outside the country) are on the verge of becoming commonlyaccepted international bonds similar to G3 bonds (bonds denominated in US Dollars, Japanese Yen, and Euro). We believe it is in China s best interest to expand the Panda bond market now, rather than later. Questions remain over how much the market will grow and how investors should prepare for this asset class. There is no doubt that Chinese economic growth is slowing down. Although it is not unanimous, investors confidence in both China s growth story and the RMB s value against major currencies seems to be fading. We believe that the People s Bank of China (PBOC) will not drastically devalue the RMB and will instead seek to defend its currency value by using its foreign exchange reserves (to buy RMB) and/or adjusting its policy tools to stem capital flight. The development of the Panda bond market will help boost onshore liquidity and, in effect, stem capital flight, in our view. In this report, we will discuss recent events in Panda bonds, including an issuance trend and recent regulatory developments. We will then investigate what it would take for Panda bonds to become a global fixed-income instrument in terms of five market drivers. We believe that some of the drivers could be major challenges that could both potentially stunt the Panda bonds market development and lead to a future credit crisis in China. Recent Events Issuance trend Contact Warut Promboon Chief Rating Officer (852) Warut.Promboon@dagonghk.com Panda bond issuance has risen to RMB21bn at the time of this review from RMB2bn at the end of 2014, according to Bloomberg. The size of the Panda bond market was only 0.04% of the total onshore Renminbi (aka CNY ) outstanding bonds, which totaled RMB47trn at the time of this review. The closest local currency bond market, in our view, is the Japanese local currency (JPY) bond market, including JPY bonds issued by issuers not domiciled in Japan (aka Samurai bonds ). We are mindful that the JPY bond market comprises a larger proportion of government bonds than the CNY bond

2 market does. However, there are many Chinese corporate bonds that have implicit and explicit support from the Chinese government. As a result, we believe a comparison of the total local bonds outstanding between Japan and China is reasonable. At the time of writing, Samurai bonds accounted for 2.5% of all outstanding JPY bonds. We plotted local currency outstanding bonds in Japan, the Eurozone, and China against their respective M2 money supplies (EXHIBIT 1) and found that CNY bonds have a long way to go before they reach 100% of China s M2 money supply. We also expect the share held by Panda bonds in total outstanding CNY bonds to rise towards 2.5% in the near future (from 0.04%). EXHIBIT 1: Outstanding local currency bonds vs. average M2 money supply 1,050, ,000 55% 255% 45% 850, % 35% 750, % 25% 650, % 15% 550, , , % 5% 5% -5% JPY EUR CNY Source: Bloomberg Panda bond outstanding to grow to USD268bn by 2020 The World Bank s International Finance Corporation (IFC) has predicted that the outstanding Panda bonds will exceed USD50bn by Using 2020 as a target year, we assume that the CNY bond market could grow in the same way as the JPY bond market did in Based on EXHIBIT 1 above, it took Japan about four to five years (between 2006 and 2011) to grow its domestic bond market from one-third of the size of the country s M2 money supply to the 50% mark. Assuming that outstanding CNY bonds will account for 50% of China s M2 money supply (USD21.5trn) in China by 2020 (the same as their level in 2015, which is a conservative estimate, in our view) and 2.5% of these will be Panda bonds share of the total outstanding CNY bonds, the outstanding Panda bonds could rise to USD268bn by

3 According to Bloomberg, RMB364.3bn and RMB175.6bn of offshore RMBdenominated bonds (Dim sum bonds) will mature in 2016 and 2017, of which 28.4% and 65.3%, respectively, of the maturing notional amount was from issuers incorporated outside China. Assuming that Chinese regulators will continue to allow these issuers to use Panda bond proceeds outside China, we believe that declining onshore yields and rising onshore liquidity will motivate many Dim sum issuers to issue Panda bonds to refinance their Dim sum bonds. In addition, issuers of USD bonds may consider issuing Panda bonds to diversify their investor bases and reduce currency risk (as in the case of Chinese issuers). Panda bond growth to eclipse Dim Sum bonds Panda bond development will also help expand the CNY bond market and, unintentionally, cannibalize the growth of the Dim sum bond market, in our judgment. About 95% of CNY bond investors are Chinese accounts, and a loss of foreign investors confidence in the Chinese economy will not affect demand for CNY bonds so much as that for Dim sum bonds, of which most investors are foreign accounts. Panda bonds can be issued by offshore entities of Chinese firms as well as non-chinese organizations outside China. For non-chinese issuers, we expect Panda bonds to be issued by investment- grade issuers, especially sovereigns, quasi-sovereigns, provincial governments, and high-quality financial institutions and corporates. For Chinese issuers, we believe that the Panda bond issuer list will be similar to those that issued regular CNY and/or Dim sum bonds. In other words, the Panda bonds issued by these entities will be a mixed bag of investment- and non-investment-grade credits. Regulatory developments CNY bonds, including Panda bonds, are traded in two markets: the interbank market and exchanges. The former, constituting about 95% of the total volume, is regulated by PBOC and administered by the National Association of Financial Market Institutional Investors (NAFMII). The latter are regulated by the China Securities Regulatory Commission (CSRC). In our view, revisions of Panda bond regulations will come from both PBOC and CSRC. We are of the opinion that Chinese regulators may lack sufficient experience to design the regulations of this Panda bond market. There is, therefore, more regulatory risk for Panda bonds than other traditional fixed-income products, such as Dim Sum bonds or G3 bonds. The following major regulations of Panda bonds are evolving: i. Proceed repatriation Panda bond proceeds cannot be taken outside of China. We believe that this rule may have stalled the growth of the Panda bond market in the past. IFC launched the first ever Panda bonds in Since then, only IFC, Asian 3

4 Development Bank, and Daimler had issued Panda bonds until last year when some Panda bond issuers received exemptions to repatriate proceeds outside China. We note that the proceeds of the recent Panda bonds issued by Canada s British Columbia province, however, were reinvested in RMB-denominated instruments and that the province plans to use the net return to fund its Chinese office or other trade promotions in China. We expect these exemptions to become an official rule for two reasons. First, we believe that the ability to repatriate proceeds is one of the main reasons why many issuers are now becoming interested in issuing Panda bonds. Second, we believe that the Chinese government s determination to expand the Panda bond market will encourage the central bank to relax this rule as a priority. ii. Credit ratings Credit rating exemption rationale not explained Just like CNY bonds, Panda bonds must be rated by Chinese credit rating agencies (including Dagong Global Credit Rating, Dagong HK s parent company). International investors and issuers may not be familiar with credit ratings assigned by such agencies. In addition, their lack of a business relationship with these Chinese agencies may prolong the underwriting period and perhaps deter international issuers from considering using Panda bonds altogether. Many issuers, such as Daimler and Canada s British Columbia province, have received exemptions on the Chinese credit rating requirement, and it is unclear to the potential Panda bond issuers what would be the norm. This requirement also involves difficulties in analyzing Panda bonds and the challenge within the Chinese credit rating industry, both of which will be discussed later in the report under Drivers. iii. Accounting standards Panda bond issuers must adopt Chinese Accounting Standards (CAS), which could be difficult for international issuers and/or international bond underwriters to understand. IFC is working with the Chinese government to convert the accounting rules. Daimler has been allowed to simply explain the difference in its IFRS-based and CAS-based figures without having to re-release its financial statements under CAS. 4

5 We understand that PBOC has, to some extent, acknowledged the validity of the IFRS. At the same time, the central bank has not offered much of an opinion on Japanese and US GAAPs 1. In our view, this could mean that US and Japanese issuers are less likely (than their European counterparts) to issue Panda bonds. In addition, the existing rule requires three-year historical financial results with a separate section on management discussion in Chinese for all Panda bond issuers. That said, translation or conversion of foreign accounting standards into CAS take time and could slow down Panda bond development. Accounting standard exemptions need to be explained In short, exemptions from the accounting standard are not clearly explained, and we believe that PBOC needs to clarify the rules so that corporate treasurers can plan their RMB financing in advance. iv. Foreign dealing We believe that foreign dealing of CNY bonds will speed up Panda bond development and stem capital flight out of China. According to Reuters, foreign investors only accounted for about 2% of outstanding CNY bonds at the end of The PBOC announced last July that sovereign wealth funds, supranational institutions, and central banks would no longer need preapproval to invest in China s interbank bond market. In our view, this will increase demand for goodquality investment-grade corporate and quasi-sovereign Panda bonds due to the limited risk appetite of these institutions. The inclusion of Renminbi in the IMF s special drawing rights (SDRs) means that central banks will increase RMB-denominated assets, including Panda bonds. China s State Administration of Foreign Exchange (SAFE) has steadily expanded its RQFII and QFII quotas, which remained at USD81.1bn (279 overseas entities) and USD444.3bn (156 overseas entities) at the end of 2015, respectively. In our view, in the absence of investors confidence in the Chinese economy and RMB value, these quotas will not make much difference to the growth of the Panda bond market. v. Issuance regulations We have recently seen Chinese property developers issuing private-placement Panda bonds and listing them in the exchanges instead of going through public offerings and listing them in the interbank market. We understand that the former merely requires approval from CSRC and pre-registration with an exchange. Private placements also do not have as many requirements, such as a maximum debt limit of 40% of net assets for issuers to be able to issue 1 Generally Accepted Accounting Principles 5

6 additional CNY bonds. In addition, these private placement Panda bonds also do not require Chinese credit ratings. Exchangetraded Panda bonds are on the rise These exchange-traded Panda bonds will be less liquid than those traded in an interbank market that is far bigger. This could mean that issuers of such exchange-traded bonds may have to pay higher coupons (than for Panda bonds listed in the interbank market). However, looser supervision and regulations could mean exchange-traded Panda bonds would be much quicker to issue and, as a result, would immediately benefit from existing onshore liquidity. Drivers In order for Panda bonds to grow, we believe that the following drivers need to be in place. However, we also see the last two drivers as major challenges. 1. Continued easing cycle in China. Stronger-than-expected economic growth in China may slow down the easing cycle and stun the growth of outstanding Panda bonds On the other hand, a more gradual-thanexpected rate hike in the US or a more aggressive-than-expected rate cut in Europe could also compete for a portion of offshore liquidity that would, otherwise, be aimed at Panda or CNY bonds. 2. Onshore liquidity, which could be a function of a capital control mechanism to retain money onshore and/or a return of investors confidence in the RMB s value against the US dollar. 3. Panda bond s attractiveness to investors (over G3 bonds). 4. Improved regulations and transparency of the Panda bond issuance procedure. 5. Improved differentiation of credit quality either by Chinese credit rating agencies or credit research. 1. Easing rate cycle Declining CNY bond yield will expand the Panda bond market China s economy is slowing down, and PBOC is injecting liquidity into the market. Interest rate cuts make it cheaper for many issuers to borrow inside China. Panda (as well as CNY) bond development will depend on whether: (1) Issuers will find it attractive to issue Panda bonds (versus bonds denominated in other currencies) and/or (2) Investors will and can have better alternatives to invest. 6

7 The former will depend on the speed of a rate hike in the US versus the speed of rate cuts in the Eurozone and China, in our judgment. The latter will depend on whether investors can still expect attractive mark-to-market gains on Panda bonds or whether they think USD or EUR bonds will offer them better returns. The declining yield environment in China will increase mark-to-market gains in RMB for Panda bonds, which makes Panda bonds attractive for investors. In addition, the declining yield environment in China will lower the funding cost and refinancing risk for Panda bond issuers. The risk here is that we could also see slower-than-expected rate cuts, stemming from better-than-expected Chinese economic growth. On the other hand, should the US Federal Reserve (the Fed) raise rates more gradually than what the market expects, USD bonds will perform unexpectedly well relative to Panda bonds, and foreign investors could decrease their bond portfolio weight dedicated to Panda bonds. In addition, should the European Central Bank (ECB) lower rates more aggressively than expected, European issuers may find it cheaper to issue EUR bonds rather than Panda bonds. In short, PBOC s slower-than-expected rate cuts, the ECB s more aggressivethan-expected rate cuts, and/or the Fed s more gradual-than-expected rate hike could all slow down Panda bond development. 2. Onshore liquidity Capital control will keep onshore liquidity for Panda bonds The slowing economic growth in China and declining investors confidence in the RMB s value against major currencies have so far hampered offshore RMB liquidity and, as a consequence, the demand for Dim sum bonds. We believe that offshore demand for Panda bonds from central banks and sovereign wealth funds, both of which are looking to diversify their bond portfolios, rather than make short-term mark-to-market gains in their home currencies, will directly boost onshore liquidity. In addition, onshore liquidity has already been rising, thanks to PBOC s monetary easing policy. Overall, we expect the majority of Panda bond demand to come from existing onshore liquidity, not offshore investments, on two rationales: First, there is onshore liquidity that cannot be easily deployed outside China. Second, Panda bonds will offer onshore investors no currency risk and more capital gain opportunities on the easing cycle in China. We have seen onshore liquidity being raised in different ways, such as reserve requirement ratio (RRR) cuts, rate cuts, and PBOC s reverse repurchase agreement activities. China s M2 money supply rose 13.6% year-over-year in December, which is above a median estimate of a Bloomberg economist 7

8 survey of 13.3%. In an attempt to boost the money supply (and CNY liquidity), PBOC lowered its RRR for major Chinese banks four times in 2015 to the current 17.5%. China s RRR was 20% from May 2012 to February Falling inflation in China has enabled PBOC to cut rates in order to boost the Chinese economy. A 40-bp one-year benchmark lending rate cut in November 2014 was the first of its kind since July The PBOC cut the benchmark lending rate five times in 2015 to the current 4.35%. The central bank also cut a one-year benchmark deposit rate five times in 2015 to the current 1.5%. We believe that the market will see more RRR and rate cuts in PBOC s attempts to boost spending and investments onshore. We note that the spread between one-year lending and one-year deposit rates has been 285 bps since November 2014 (down from 300 bps). We would not be surprised to see this spread tightening even further. The rate and RRR cuts will increase the money supply and demand for CNY (and Panda) bonds or interbank assets, all of which will lower onshore yields, in our view. >2% cheaper for the Chinese government to borrow in RMB for one year inside China Onshore liquidity is the main reason the RMB borrowing rate is cheaper onshore than offshore, in our view. Chinese government bonds yield bps less onshore than offshore (i.e. Dim sum bonds) in maturities from one year to 30 years (EXHIBIT 2). EXHIBIT 2: CNY vs. CNH (offshore RMB) yields of Chinese government bonds Source: Bloomberg 8

9 3. Attractiveness to investors The following characteristics of Panda bonds are what, we believe, add more benefits for bond investors (besides returns). Familiarity Many Panda bonds will be issued by international issuers, with which international and local investors are familiarized. This enables investors to take advantage of the easing cycle without relying on extra credit work on unknown issuers. In our view, this familiarity with issuers will eventually lead to the following: 1. Panda bonds could become more liquid than the CNY bonds issued by many Chinese issuers. 2. Knowledge of issuers will allow investors to better differentiate credit quality. This will translate into spread differentials between strong and weak credits, in our opinion. Panda bonds will eventually attract more international investors. The development of the RMB bond market depends on knowledgeable and well-informed investors who can price bonds efficiently, in our view. An increase in international investors will also make available more research and opinions, which will eventually contribute to even more familiarity with Panda bond issuers. Better disclosures In our view, Panda bond development will introduce more international issuers to China. These issuers will bring with them a more transparent practice, which will eventually motivate Chinese issuers to follow suit. More savvy investors will also help encourage CNY bond issuers to meet international disclosure standards. We believe that improving disclosures in China is crucial for the country s transition to a more international financial hub. The other side of the coin, in our opinion, is that a lack of transparency could also stall the development of the Panda bond market. Portfolio diversification Since most investors will be onshore, an investment in Panda bonds issued by non-chinese issuers will offer diversification away from China. For international investors, Panda bonds will offer currency diversification. 9

10 4. Regulatory risk Unclear regulations Panda bonds fall under the Chinese regulatory regime. Unlike English, HK, and US laws, which govern most international bonds, many Chinese regulations (i.e. bankruptcy law) are untested and/or relatively unknown to foreign issuers and investors. Investors will need to be able to price the bonds, based on not only the ability to service debt, but also the willingness to pay debt. The latter requires knowledge of Chinese law and regulations governing CNY and Panda bonds. Chinese regulators could also lack the experience to design proper regulations for the Panda bond market. PBOC is known to be reactive, rather than proactive, when it comes to regulating new products or markets. As mentioned in the Recent Events section, Chinese regulators need to clarify the official rules in a timely manner in order for the Panda bond market to grow. The PBOC has been gathering opinions and was, in fact, widely expected by the market to release revised Panda bond guidelines by the end of While we believe that PBOC will be careful about the new rules and will accordingly take its time in announcing them, we expect the new rules to favor Panda bond market development. 5. Credit quality differentiation Last but not least, we believe that investors ability to differentiate credit quality among Panda bonds is a crucial milestone. In general, investors carry out credit due diligence through credit ratings and credit research. The former relies on Chinese and international rating agencies, while the latter relies on in-house credit teams, asset managers, and/or sell-side research houses. The PBOC requires that all Panda bonds must be rated by Chinese credit rating agencies, although the central bank has approved some exemptions. For Panda bonds issued by less-well-known issuers, a rating from Chinese credit rating agencies is crucial for an efficient allocation of capital. Nevertheless, the general opinion in the market is that Chinese credit ratings may not provide sufficient differentiation of credit quality. About 99% of outstanding CNY bonds, excluding commercial papers were, at the time of writing, rated AA- or above (by Chinese credit rating agencies), while most CNY bond ratings are AAA. In our opinion, a AAA local rating accounts for an issuer s systemic importance to the Chinese economy, which may lead to state and local government support and only compares rated entities or issues against national peers. Chinese regulators and an onshore market convention have regarded any CNY bonds rated below AA- (by the Chinese credit rating agencies) as high risk. For example, investors who want to trade CNY bonds that are rated below AA- on the Shanghai Stock Exchange would need to have financial 10

11 assets of at least RMB5mn and sign a statement that they understand the higher risk. Abundance of AAA ratings clouds credit quality differentiation That said, the abundance of AAA ratings for CNY bonds, including a few AAA ratings for the existing Panda bonds, makes it difficult for investors to price Panda bonds without doing their own credit homework. Specifically, all of the Panda bonds rated AAA by Chinese credit rating agencies would have very different ratings if the ratings were to be converted into an international scale. From another point of view, without a proper rating scale and conversion, market chaos could ensure rising credit losses and/or insufficient capital cushions for onshore investors as they cannot properly assess the credit risk of Panda bonds. In other words, the lack of a proper credit rating system will lead to inefficient allocation of capital whereby poor quality issuers may not necessarily get to borrow at a funding cost that reflects their credit risk. In our view, Panda bond ratings should take into consideration the ability of an issuer to service its debt in RMB and China s evolving regulatory environment. We also believe that such Panda bond rating should be accompanied by a Panda bond issuer rating, which should be on an international scale. We admit that it is a challenge for Chinese credit rating agencies to adjust their rating scales, but bond investors need the ability to convert a Panda bond rating into an international scale in order to compare among international peers. In addition, the rating quality of each Chinese credit rating agency varies and is not standardized or even as strictly regulated as in HK, Singapore, the US, or the Eurozone. A practice of issuing a AAA rating in China to win a rating business could also send the wrong message to subsequent Panda bond issues and to global investors. We found this problem to stem from a lack of rating agency supervision in China. In other words, this is also a regulatory risk for Panda bonds. We believe the Chinese authorities need to better regulate the domestic rating agency industry now, rather than later. We note that well-known international issuers (i.e. HSBC and Daimler) of Panda bonds may already have existing international ratings and the Panda bond ratings will become less relevant for investors when making credit quality differentiations. 11

12 Besides credit ratings, we note that not many brokers or asset managers have dedicated research to CNY and/or Panda bonds. Credit due diligence on unknown Panda bond issuers is, therefore, more difficult than on international peers. However, we expect the availability of research and ratings on CNY and Panda bonds to grow in tandem with the rising demand and supply of Panda bonds. So far, Panda bond prospectuses and other documents are in Chinese, and this could deter foreign investors who do not have Chinese language resources. On the other hand, the language difficulty also presents a good opportunity for Chinese research houses to grab a greater readership, in our opinion. 12

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