China s domestic bond market

Transcription

1 GLOBAL MACRO RESEARCH SEPTEMBER 21, 2015 s domestic bond market The Next Financing Engine s domestic bond market has increased six-fold over the past decade to reach RMB40tn (USD6.3tn), making this the third largest domestic bond market in the world. We forecast it could more than triple to USD21.6tn by 2025, with bond market development being one of the key pillars of s financial reforms. We see this becoming one of the most important capital markets for both Chinese borrowers and domestic investors. It will also have rising importance for international fund managers, with potentially more than USD1tn of global fixed income funds flowing into over the coming years. Kenneth Ho kenneth.ho@gs.com Goldman Sachs (Asia) L.L.C. MK Tang mk.tang@gs.com Goldman Sachs (Asia) L.L.C Hao Tang hao.tang@gs.com Goldman Sachs (Asia) L.L.C. Maggie Wei maggie.wei@gs.com Goldman Sachs (Asia) L.L.C. Goldman Sachs does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. For Reg AC certification and other important disclosures, see the Disclosure Appendix, or go to Analysts employed by non-us affiliates are not registered/qualified as research analysts with FINRA in the U.S. The Goldman Sachs Group, Inc.

2 Table of contents Executive Summary 3 Eight key numbers on s bond market 5 Part One The current state of s USD 6 tn bond market 6 Part Two Significant potential for bond market over next 10 years 10 Part Three An opportunity for foreign investors 14 Part Four Beyond the banks: Need for a diverse investor base 18 Part Five What needs to be done to improve the market? 21 Part Six Breakdown of s domestic bond market 23 Box 1: Regulating the bond market 24 Part Seven Government related bonds the bulk of the market 27 Box 2: LGFV draft rule: A positive step towards addressing moral hazard issues 31 Part Eight Corporate sector bonds dominated by SOEs 32 Disclosure Appendix 39 Glossary: CBRC: Banking Regulatory Commission; CP: Commercial Paper; CSRC: Securities Regulatory Commission; LGFV: Local government financing vehicle; MOF: Ministry of Finance; MTN: Medium Term Note; NAFMII: National Association of Financial Market Institutional Investors; NDRC: National Development & Reform Commission; NPL: Non performing loans; PBOC: People s Bank of ; PPN: Private Placement Note SAFE: State Administration of Foreign Exchange; SCP: Short-Term Commercial Paper; TSF: Total Social Financing; WMP: Wealth management product Notes on authorship: This report has been jointly authored by our Asia Credit strategy team and our Asia economists. The views of the individual analysts, and their areas of expertise, are identified within; no other analyst is responsible. The authors would also like to thank the following economists, strategy, and sector analysts for their assistance with this publication: Steve Strongin, Francesco Garzarelli, Jan Hatzius, Charlie Himmelberg, Sandra Lawson, Katherine Maxwell, Timothy Moe and Andrew Tilton. Goldman Sachs Global Investment Research 2

3 Executive Summary s bond market to reach USD 21.6tn by 2025 s capital markets have come a long way over the past ten years. Back in 2006, the country s bond market capitalization to GDP was 27%, and we estimated then in a global paper that it could reach 60% by We have already exceeded that, with the total amount of bonds expanding six-fold to reach RMB 40tn (USD 6.3tn) at the end of August 2015, equating to 62% of GDP and making this the third largest in the world behind the US and Japan. However, s bond market as a share of GDP still lags behind that of other Asian EM countries, and is substantially smaller than many DM countries. This provides ample room for further growth, and we estimate the market could reach USD 21.6tn by A USD 1 trillion opportunity for foreign investors s domestic bond market is largely closed, with foreign holdings of domestic bonds at around USD 115bn as of June, or 1.9% of the market. This reflects the restrictions currently in place, with offshore investors required to go through one of the foreign investment programs in order to gain access. Going forward, we expect more channels to be introduced with enormous potential to draw in foreign investment. Should foreign participation catch up to roughly the level of, say, Japan and Australia, equating to around 10% to 20% of GDP, that could mean more than USD 1tn of additional global fixed income investments to be allocated to domestic bonds in the coming years. alongside broader plans towards RMB internationalization Policymakers may have concerns over the risks associated with opening of the bond market, but we see positive benefits if appropriately calibrated. Our past research 2 shows that accessing foreign capital can diversify funding sources and introduce best practices from different markets. In our view, allowing foreign investors better access to RMB denominated financial investments is an important pillar for to achieve its longer term goals of full capital account liberalization and internationalization of the RMB. The push for RMB inclusion into the IMF s SDR is an indication of policymakers desires to further integrate s financial system with the rest of the world. Opening the market to private companies remains the big challenge Over the past decade, a number of new products have been introduced and a broad range of financial instruments are now available to borrowers. But despite the innovations, government related entities still account for the bulk of the issuance, and we estimate that state-related issuers account for 94% of total bonds outstanding. The need to open up the market to the private sector, therefore, remains a key challenge. This will require encouraging a more market determined pricing of credit and reducing the reliance on implicit government support in making credit assessments steps that should pave the way towards expanding private sector participation. 1 See Francesco Garzarelli, Sandra Lawson, et al, Bonding the BRICs: The Ascent of s Debt Capital Market, November 20, See Andrew Tilton, Kenneth Ho, Sandra Lawson, Katherine Maxwell, MK Tang, et al., Harnessing global capital to drive the next phase of s growth, February 7, 2015 Goldman Sachs Global Investment Research 3

4 Banks are the biggest holders; further diversification needed Holders of the bond market remain highly concentrated, with commercial banks owning 62% of the overall bond market. There is clearly considerable scope for further diversification of the investor base, which carries a number of benefits. Having investors with different investment objectives will allow a wider range of issuers and a wider set of instruments to come to the market; and encouraging better access to the market will help to channel the large savings towards more productive use. We see the biggest potential impact to come from expansion and reforms in the management of pension and insurance funds. The next financing engine The buildup of savings and drive towards interest rate liberalization will create additional demand for yield products, and the existing limitations of the banking sector points towards further diversification into bond financing. We expect further financial reforms will help to drive the bond market to become the next financing engine. We believe that the bond market will become one of the most important capital markets not only for domestic investors, but also a market with rising importance for international investors. Goldman Sachs Global Investment Research 4

5 Eight key numbers on s bond market Goldman Sachs Global Investment Research 5

6 Part One The current state of s USD 6 tn bond market The Evolving Credit System in Over the past decade, has taken enormous strides to develop its bond market. The efforts have been in tandem with broader financial reforms, ranging from interest rate deregulation, to the development of the offshore RMB market, to the easing of capital controls. In a global paper written in 2006, we expected the Chinese bond market capitalization could reach over 60% of GDP by 2016, compared with 27% when the report was written (see Bonding the BRICs: The Ascent of s Debt Capital Market, November 2006). It appears that we have already surpassed that target, with the bond market having reached 62% of GDP at the end of August In nominal terms, the market has expanded six-fold in size to RMB 40tn at the end of August 2015, making this the 3rd largest bond market in the world (see Exhibit 1). Exhibit 1: s bond market has surged six-fold in size since 2006 domestic bonds outstanding (RMB tn) tn Aug-15 Source: Wind. Despite the rapid growth over the past decade, s bond market is still small as a share of GDP compared to global and regional peers. It lags behind other Asian EM countries, such as Malaysia and Thailand, and is substantially smaller compared with DM countries like Japan, US, and the UK (see Exhibit 2). Although a number of innovations have been introduced into the bond market, there is still room for substantial improvements. The pace of s credit growth has been rapid in recent years, with total social financing 3 (TSF) increasing at a CAGR of 22% from the end of 2006 to July As such, the growth in the bond market has merely kept pace with the overall increase in s credit growth. In our view, the bond market is not yet the financing engine that we think it can be. As mentioned in our report back in 2006, a key factor which hampered the development of s bond market was that the market was overwhelmingly concentrated in securities issued either by the government or by publicly-controlled policy banks, whilst the 3 Total social financing is a measure of the total amount of financing the real economy (i.e. non-financial corporates and individuals) gets from the financial system. Currently the indicator mainly includes loans denominated in local and foreign currencies, entrusted loans, trust loans, bank acceptance bills, corporate bonds, equity financing,etc. Goldman Sachs Global Investment Research 6

7 corporate sector was severely under-represented. The inability for private enterprises to obtain bond market funding has been one of the factors leading to the rapid expansion of alternative financing channels such as trusts loans. These types of financings were a negligible part of the credit system back in 2006, but they have ballooned more than fivefold since 2009 to now account for about 17% of s credit stock, although policymakers have made recent efforts to curb their growth. As noted in our Credit Conundrum piece written in July 2013, certain parts of these types of financing carry significant risks, and this is compounded by the lack of transparency in these products (see The credit conundrum: Risks, paths and implications, July 26, 2013). This is an area that we think the bond market can play a much bigger part and serve as a substitute. In addition, a significant proportion of trusts, entrusted loans and bank acceptance bills are what are called non-standard credits, or shadow banking credits by many i.e., credits that are not booked as bank loans but are effectively intermediated and funded by banks. A well-developed debt capital market will improve financial risk diversification. Exhibit 2: s bond market still small relative to GDP Domestic debt securities outstanding/nominal GDP at 1Q15 (%) Exhibit 3: Bonds remain a small proportion of credit Total social financing outstanding (RMB tn) 250% 200% 150% Corporate bond Trust loans and entrusted loans Other Rmb loans Corporate bond as % of TSF (RHS) 12% 10% 8% 100% 80 6% 50% 51% % 0% 20 2% July % Source: Haver Analytics, AsiaBondsOnline. Source: PBOC, Gao Hua Securities Research Push and pull factors to drive more bond financing The pull factor stems from the further buildup of savings, creating additional demand for yield products. s gradual drive toward interest rate liberalization will increase the proliferation of non-deposit saving vehicles. The widening spectrum of financial services to improve the social safety net will continue to promote a rapid expansion of institutional investors such as insurance and pension funds. These developments should create more demand for direct financing via the bond market. The push factor stems from the existing limitations of the banking sector. s commercial banks are facing capital and funding constraints, which restrains their capacity to create new loans. In contrast, bond financing offers many comparative advantages such as greater transparency, broader credit risk diversification and crowding in (creating a greater capacity for banks to lend to small enterprises by moving the bigger borrowers to the bond market). Partly reflecting these considerations, the authorities have been incrementally driving credit flows toward the bond market with an approach known as blocking the backdoor, while opening up the front door : on the one hand, the authorities have tightened Goldman Sachs Global Investment Research 7

8 regulation to curb shadow banking, but on the other hand, they have also widened access to bond issuance, notably by allowing local governments to issue municipal bonds and some property developers to issue corporate bonds. Financial reforms, capital account liberalization and global RMB From a macro standpoint, as the bond market gradually overcomes existing frictions and becomes the next key financing engine in, we believe it will hold even greater sway over the financial conditions of the economy. 4 A well-developed bond market can also benefit the whole financial system in via more transparent risk pricing and more efficient resource allocation. Further reforms to advance domestic financial liberalization and capital account convertibility will continue, and this will push s debt capital markets to the next phase of development. Capital account liberalization has been an ongoing process for over the past years, with the drive further energized recently by the push for RMB inclusion into the IMF s Special Drawing Rights (decision scheduled for late this year). In the past few months, several notable liberalization measures have taken place: E.g., global central banks and sovereign wealth funds given improved access starting in July, foreigners can now directly purchase onshore mutual funds under a new program called Mutual Recognition of Funds. Bulk of market dominated by government-related issuers Broadly speaking, the bond market can be segregated into three categories government and municipal bonds, financial sector bonds, and corporate sector bonds. Each of these segments occupy approximately one third of the bond market (see Exhibit 4), which is a marked changed from a decade ago, when central government and financial bonds represented over 90% of the market. Exhibit 4: Corporate sector bonds, government sector bonds and financial sector bonds each represent around 1/3 rd of the bond market Breakdown of the bond market at the end of August 2015 Other 1% Corporate Sector Bond 33% Central Govt and Municipal Bond 32% Financial Bond 34% Source: Wind, Goldman Sachs Global Investment Research. 4 Long-term bond yields in already seem to have been meaningfully affecting overall financing conditions in (see Asia Economics Analyst: The long and the short of Chinese financing conditions, September 5, 2014). Goldman Sachs Global Investment Research 8

9 Although it appears that this is a well-diversified market, the bulk of the bond issuance is from government related entities. If commercial banks and corporates that have central or local governments as major shareholders are classified as government related issuers, we estimate that around 94% of the bond issues are by entities that are related to the government. This means only 6% of total issuance is coming from private enterprises. We shall discuss this further in later sections, and below is a brief summary of the various segments within the bond market: Government and municipal bonds Aggregate amount outstanding represents approximately 32% of the market as at the end of August This segment is represented by: Central government bonds (25% of total bond market) bonds issued by the central government. Municipal bonds (7%) the municipal bond market was expanded less than a year ago to assist local government in their financing needs. Financial Sector Bonds Aggregate amount outstanding represents approximately 34% of the market as at the end of August This segment is represented by: Policy bank bonds (26%) these form the majority of financial sector bonds, and include institutions such as Development Bank, Agricultural Development Bank of and the Export-Import Bank of. Commercial bank bonds (4%) the bulk of commercial bank bond issues are issued by the big four banks, and they all have the central government as the major shareholder. Other financial bonds (4%) these include insurance companies and securities houses. Corporate Sector Bonds Aggregate amount outstanding represents approximately 33% of the market as at the end of August This segment has seen the most rapid growth and is represented by: Enterprise bonds (8%) this is the most established corporate sector bond market, regulated by the National Development and Reform Commission (NDRC). Issuers are typically large state-owned enterprises. Corporate bonds (2%) this market is regulated by CSRC, the stock exchange regulator, and issuers are mostly listed companies with the bonds traded on the stock exchange. Corporate instruments regulated by NAFMII (20%) NAFMII is a regulatory body under the supervision of PBOC and the instruments include commercial paper, shortterm commercial paper, medium term notes and private placement notes. A range of different issuers utilize this market. Government supported company bonds (3%) these are issued by entities that carry strong government support, such as the Railway Bureau. Goldman Sachs Global Investment Research 9

10 Part Two Significant potential for bond market over next 10 years Bond market to reach 97% of GDP by 2025, from 54% last year While it may take some time for the aforementioned key issues associated with the corporate bond market to be addressed, we do see the potential of the bond market to expand further in the next few years. In order to quantify the potential growth of the bond market in the next 10 years, we conducted a bottom-up analysis and estimated growth of each market segment in relation to the GDP. The estimation is separated into two parts growth issuance from the public sector, and from the private sector and based on our estimates, we expect the size of the market to reach 97% of GDP by 2025, or RMB 136tn from the current outstanding RMB 40tn, equivalent to 62% of GDP. Rising fiscal deficit and government spending plans to drive treasury bond issuance Infrastructure spending and refinancing to spur issuance of policy bank and municipal bonds Part One: Estimating public sector issuance Estimating public sector issuance focuses on the growth in treasury bonds, policy bank bonds and municipal bonds. For these bond types, we adopt the assumption that the infrastructure spending by the government will decrease gradually, in line with the gradual slowdown of nominal GDP growth. The backdrop of this assumption is that over the short to medium horizon, infrastructure investment will still be one of the main supports to economic growth, and in the long run, ongoing urbanization creates a continued need for infrastructure spending. We also expect that over time all the existing non-bond borrowings (such as bank loans and trust financings) by local governments will shift to bond financing, following the Article 43 regulation issued by the state council late last year. Treasury bond market to reach RMB 32tn by We expect Treasury bond issuance in the next few years to be driven by the cumulative fiscal deficits. Fiscal policies will likely be more active in the next few years, as the government takes up more social service responsibilities in the face of slowing growth. We expect the general government fiscal deficit to gradually increase in the next few years, and stay at around 3% in the outer years. The implied funding need will total around RMB 33tn, out of which we assume 70% will be sourced from Treasury bond issuance, similar to the share of Treasury bonds in the latest budget report in This would indicate an additional RMB 23tn net increase in the treasury bond market, and the total size of Treasury bond will amount to RMB 32tn by 2025 from RMB 9.7tn in May Policy bank and municipal bonds to reach RMB 69bn by The growth in the issuance of policy bank bonds and municipals will in part be due to the need for them to support infrastructure spending, but also to replace the non-bond financings such as trusts and other types of borrowings. We did not separate our forecasts for policy bank bonds and municipal bonds, because these two types of bonds are both designed to finance public sector expenditure, and we estimate that amount outstanding will reach RMB 69tn in 2025, from RMB 15tn at the end of May The key assumptions here: 1. 30% of the general government fiscal deficits will be met by policy bank bond and municipal bond issuance (as discussed above we expect 70% of general government fiscal deficits to be met by treasury bond issuance). 2. Besides the additional issuance related to fiscal deficits, the future total size of these two types of bonds will increase at a similar pace with infrastructure investment growth, which is then projected based on our GFCF forecasts from 2015 till 2018, and Goldman Sachs Global Investment Research 10

11 mapped to our nominal GDP growth forecasts from 2018 onwards 5. Local government used to rely on land sales to finance infrastructure investment, but with a cooling housing market and the ongoing land reforms, we believe local government will be less reliant on land sales and thus more financing will be done through other channels such as bond issuance. 3. Current non-bond borrowing by local governments can potentially be replaced with bond issuance in the next 10 years, in reflection of the latest fiscal reform move and the authorities commitment to improve local government debt management. This indicates a potential net increase of RMB 10 tn in overall bonds by While we expect more bond issuance to finance infrastructure investment in the future, we also build in some development of Public-Private Partnership (PPP) in the next ten years. PPP has recently been frequently cited as a solution for financing infrastructure projects by the policy makers recently. We believe PPP will be growing gradually in the next ten years and assumed that around 10% of infrastructure investment/around RMB 5 tn will be financed via PPP by 2025 (which is still relatively small compared with the amount financed via bond issuance). Part Two: Private sector issuance to stay high, then slow down The second part of our projection focuses on corporate bonds and financial bonds. Our forecasts in this section excludes local government financing vehicles (LGFV) 6 and policy bank bond issuance, both of which are included in the previous section s analysis, as they are considered public sector borrowings. We expect the yoy growth rate for private sector issuance to remain high for the next few years and then gradually slow down to be in line with our expected nominal growth rate for GDP in the outer years. Government to help private companies access the bond market as many underserved Corporate bonds to reach RMB 25tn by We define corporate bonds as those issued by SOEs and private enterprises, but exclude LGFV bonds as we expect them to be replaced by municipal bonds going forward. Prior to 2013, the amount of corporate bonds outstanding was increasing annually by over 30%, following the introduction of new types of instruments and a nascent market. Since 2013, the growth rate has slowed to below 20%, and for the first eight months of 2015, the yoy increase was 16.1%. Going forward, we are assuming that the growth rate in the next few years will remain at a similar level as we have seen this year (16.1%), at above the pace of nominal GDP growth. This is based on our expectation that policy support will be in place to facilitate more corporates to access the bond market, and that there remains a large section of the private sector that are still underserved. For simplicity, we estimate yoy growth in corporate bond outstanding will stay at 16.1% till 2017, and then gradually slow down till it reaches our projected nominal GDP growth by 2022 (7.23%). From , we assume the growth rate for this sector will be in line with our projected nominal GDP growth. Our projected path of growth for corporate bonds is shown in Exhibit 5. Under this path, we estimate corporate bonds to reach RMB25tn, or 18% of GDP, by Financial bonds (ex. policy bank bonds) to reach RMB 10tn by This sector comprises bonds issued by commercial banks, securities firms, and insurance firms. 5 See Global Paper No: 208: The BRICs 10 Years On: Halfway Through The Great Transformation, Dec 7, 2011 for our forecasts of nominal GDP growth in outer years 6 Until the formulation of the municipal bond market at the end of 2014, local governments in were not allowed to borrow. Given this funding constraint, local governments set up LGFVs and utilized these vehicles to borrow money and perform some of the fiscal investments on behalf of the local governments. LGFV debts do not carry a guarantee by the local governments, and rely on implicit support. Because much of these borrowings have been used for fiscal expenditure, we consider them part of public sector issuance when we formulate our projections. Please see Part Seven of this report for a fuller discussion on LGFVs. Goldman Sachs Global Investment Research 11

12 Historically, the growth in commercial bank bond issuance have followed that of TSF growth, with notable increase in issuance volume in 2008 and 2009, a slowdown in 2010 and also slower growth in 2013 and But in recent years, we have seen a much faster pace of growth in bond issuance by securities firms. In 2006, securities firms accounted for 2% of non-policy bank financial bond outstanding, and they now represent 32% (up from 20% at the end of 2014). In fact, we have seen a 52%yoy increase in the amount of financial bonds (ex. policy bank bonds) outstanding as of August this year, the bulk of the growth having been driven by securities firm issuance. We view this sharp increase in securities firm issuance over the past year as being driven by the strong performance in the domestic equity market (before the sharp correction in 2H). Going forward, we are assuming that the increase in financial bond issuance will be more gradual, and follow a path similar to that of TSF growth. As such, our assumptions from 2016 onwards are similar to the assumptions we are using to project the growth in the corporate bond market, namely that it will increase at 16.1% yoy (above the pace of TSF growth) till 2017, then gradually slow down until the pace of growth reaches our projected nominal GDP growth by 2022 (see Exhibit 6). Under these assumptions, we expect the sector to grow to RMB10tn, or around 7% of GDP, by Exhibit 5: Pace of growth to slow for non-lgfv corporates notional outstanding yoy growth of outstanding non-lgfv corporates Exhibit 6: Our projected path of growth for non-policy bank financials notional outstanding yoy growth of outstanding non-policy-bank financials 90% 80% 70% 60% 50% 40% 60% 50% 40% 30% Forecast 30% Forecast 20% 20% 10% 16% 7% 10% 7% 0% % Source: Wind, Goldman Sachs Global Investment Research. Source: Wind, Goldman Sachs Global Investment Research. Results are similar when adopting a top down approach With our bottom up approach, we estimate that the size of the bond market could reach RMB 136tn by 2025, or 97% of GDP from 62% now. As a crosscheck, we conducted a second estimation using a top down approach, using a methodology that was used in our previous work back in 2006 to estimate the growth of the market. Under this approach, we derived the expected overall bond market size relative to GDP using three factors: the income level (represented by GDP per capita growth), demographics (represented by the dependency ratio), and the degree of financial liberalization (represented by financial Goldman Sachs Global Investment Research 12

13 liberalization index developed by Kaminsky and Schmukler 7. Our analysis relies on a panel of data for all G7 countries from the early 1970s to the mid-1990s, looking at the evolution of those markets and the factors that drove their development. The bond markets of Europe and Japan increased, on average, by the equivalent of 70% of GDP between 1970 and 1995, and we estimate that just over two-thirds of this growth can be attributed to the expansion in income per capital. Adopting this model and using our assumptions for s per capital income growth over the next decade, we arrive at a top down estimation of the bond market size will be 99% of GDP by 2025, in line with our bottom up estimate of 97% (Exhibit 7). Exhibit 7: Top down approach review Top-down projection approach review Factor Coefficient Projected chg in the Implied % of next 10 years GDP change A 10% increase in per-capita GDP A full financial liberalisation A 1 point increase in the dependency ratio R-Square Durbin-Watson Implied bond market size to GDP(%) by 2025 vs bottom-up approach projection Source: Goldman Sachs Global Investment Research Exhibit 8: Projected bond market size (relative to GDP) Bond market size as percentage of GDP (%) Treasury bonds Municipal, policy bank and LGFV related corporate bonds Other corporate and commercial bank bonds Source: Goldman Sachs Global Investment Research 7 The index is based on various criteria including degree of restriction in the banking sector, stock market and capital account. Goldman Sachs Global Investment Research 13

14 Part Three An opportunity for foreign investors s bond market still largely closed, but starting to open up Although the domestic bond market is one of the largest in the world, foreign participation is minimal. Foreign holdings of domestic bonds were around RMB 764bn at the end of June 2015, or around 1.9% of the market. The reason for the low foreign penetration is because offshore investors are required to go through one of the quota- and case-by-case approval- based foreign investment programs in order to gain access. We have seen the size of the quota increase rapidly in recent years, but this is from a very low base. While headlines on financial market liberalization in the past year have largely focused on the equity market, we think that there is significant room for offshore access to the bond market to increase substantially. There are three main programs in existence allowing foreign access to domestic bonds, namely QFII, RQFII and the PBOC bond program pilot. 1. The Qualified Foreign Institutional Investor (QFII) program. The QFII program was launched in 2002 to allow qualified foreign investors to invest in the domestic securities market. The program is regulated by CSRC, SAFE and PBOC, with SAFE setting the investment quota for the qualified institutional investors and CSRC regulating the onshore securities investments by these investors. Together with SAFE, PBOC monitors and regulates the remittance and repatriation of funds across the border. The authorities have been relaxing the QFII investment restrictions since March In particular, QFIIs can now apply to the PBOC for access to the interbank bond market (while previously, they could only invest in the exchange traded bond market, which is much smaller and less liquid). That said, although the QFII quota approved by SAFE have been expanding fast by over 40% yoy, the scale is still fairly small at about USD 77bn as of August 15, and only about 10% of QFII s $49bn net investment was in bonds as of end-2014, with the remainder mostly in equities. The low share in bonds owes much to the strict approval process for access to the bond market. 2. The Renminbi Qualified Foreign Institutional Investor (RQFII) program. The RQFII program was launched in December 2011 to allow Chinese financial firms to establish RMB denominated funds in Hong Kong, through which overseas investors can use offshore RMB to invest in the onshore securities markets. Like the QFII program, the RQFII program is jointly regulated by CSRC, SAFE and PBoC. The rules for the program have been relaxed, and newly approved RQFII quotas are no longer subject to rigid asset allocation rules. Like the QFII program, the scale of the RQFII quota is still relatively small at USD 64bn at the end of August 2015, despite rapid growth, and net investment is even smaller still, at about US$28bn at end There is no disclosure on the type of assets investment through the RQFII program, though we believe that portion invested in bonds is higher than the 10% for the QFII program. 3. PBOC bond program. This program was launched in 2010 and is separate from QFII/RQFII. It was originally based on a case-by-case approval by the PBOC, and investors included foreign central banks, sovereign wealth funds, insurance companies, international organizations and offshore RMB clearing and participating banks. In late May, the PBOC significantly loosened investment restrictions for offshore RMB clearing and participating banks under this program, allowing them to use their bond holdings to conduct repo financing and take the proceeds back offshore. Following up on that, in mid-july, the PBOC further eased bond investment by allowing foreign central banks, sovereign wealth funds and international financial institutions to participate in onshore interbank bond market through a registration-system. These investors tend to have particularly long-term investment mandate. Goldman Sachs Global Investment Research 14

15 Exhibit 9: QFII and RQFII approved quota has been growing, but still relatively small QFII approved quota (USD bn) RQFII approved quota (USD bn equiv.) QFII+RQFII approved quota as % of A share market cap (RHS) 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0 0.0% Jun-03 Jun-05 Jun-07 Jun-09 Jun-11 Jun-13 Jun-15 Source: CEIC, Goldman Sachs Global Investment Research. Through the various existing programs, the total number of foreign institutional investors allowed to invest in the interbank bond market has grown to about 252 as of Aug 2015 (Exhibit 10), and their total investment was about RMB 764bn as of June. (Exhibit 11). While the scale has been on a fast upward trend, so far it represents only about 1.9% of the onshore bond market capitalization; and even including offshore RMB bonds, foreign holdings still account for only about 3% of total RMB bonds outstanding. Exhibit 10: Foreign access to the bond market has grown Number of foreign institutional investors allowed access to the bond market Exhibit 11: Foreigners investment in the bond market has risen fast, although still of limited scale Data in USD bn Onshore RMB bonds held by overseas entities Offshore RMB debt securities outstanding Aug Mar-10 Mar-11 Mar-12 Mar-13 Mar-14 Mar-15 Source: PBOC (financial market operation report), Shanghai Clearing House. Source: BIS. Goldman Sachs Global Investment Research 15

16 Enormous potential to draw in foreign investment With the bond market already the third largest in the world and with considerable scope to expand further, it has the potential to become a sizeable opportunity for global bond investors. In our view, the Chinese authorities have a strong intention to push ahead with the liberalization of the bond market as a way to foster its development, both in terms of size and sophistication indeed a key policy objective that is closely intertwined with the ongoing efforts to advance RMB internationalization. We expect more channels will be introduced to allow wider foreigners access. The Chinese authorities have announced that starting July 1, foreigners can directly purchase onshore mutual funds under a new program called Mutual Recognition of Funds. According to the authorities, there are currently a total of 850 onshore mutual funds with RMB 2tn in AUM that are eligible for the program, with close to half of those equipped with a bond investment mandate (i.e., either dedicated bond funds or mixed funds with stock and bond investment). While the initial quota is set at RMB 300bn for total foreigners purchase of onshore mutual funds, it will likely ramp up over time. Likewise, we expect a continued increase in the scale of the existing QFII/RQFII and PBOC bond program. We also believe more loosening of the investment restrictions on those programs will be likely (e.g., relax approval for RQFII/QFII investors to access the interbank bond market, loosen lock-up and repatriation regulations, allow wider use of derivatives), thereby making investment in the onshore bond market even more attractive to global investors. How much can foreign holdings grow? To make a rough gauge on the size of potential scope for foreign participation in s bond market, we took a look at current foreign participation in a few other more opened markets. Even if we only look at possible foreign official holdings, RMB also has a lot of room to develop: According to IMF COFER data, foreign official holdings of RMB amounted to around 1% of GDP, while in countries like Canada and Australia, foreign official investors holding is around 6-8% of GDP (see Exhibit 12) If foreign official holdings of RMB catches up with the current size for AUD or CAD, that would imply around 600 bn USD confirmed inflows into RMB. More broadly, compared with the size of international debt securities denominated in other major currencies, the scope for RMB/ bonds to rise in relevance in the world marketplace is clearly considerable: Should RMB/ bonds catch up to roughly the level of, say, JPY and AUD bonds in terms of foreign penetration (i.e., foreigner holdings reaching about 10%-20% of GDP), that could mean an additional over $1tn in global fixed income investment to be allocated to RMB/ bonds. This amount would be significantly higher still should RMB/ bonds reach the sort of foreign penetration seen for EUR and USD bonds (about 60-70% of GDP). Goldman Sachs Global Investment Research 16

17 Exhibit 12: Official FX holdings of CNY at comparatively low levels Official FX Holdings as % of GDP as of end 2014 Exhibit 13: Massive scope for global bond investment to be reallocated to /RMB bonds going forward International debt securities as % of GDP as of end USD EUR GBP AUD CAD JPY SWF CNY GBP EUR USD NZD AUD CAD JPY CNY Source: IMF COEFR, Haver Analytics Source: BIS, IMF, CEIC, Goldman Sachs Global Investment Research Goldman Sachs Global Investment Research 17

18 Part Four Beyond the banks: Need for a diverse investor base We see pension funds as probably the single largest potential boost to bond demand Bonds held mostly by banks, pension funds likely to boost buying Despite the rapid growth in the size of the bond market, the holders of the bond market remain highly concentrated. According to data provided by bond.com.cn (data which we estimate represents around 80% of the bond market), commercial banks held 65% of the overall bond market in These proportions have remained broadly unchanged, with commercial banks owning 62% of the overall bond market in July In terms of government bonds, the percentage is even higher, with domestic banks holding around 75% of outstanding issuance at the end of 2012, compared with a G-20 average of less than 20% (see Exhibit 14). Creating a broader set of investors with different investment objectives though will allow a wider range of issuers and a wider set of instruments to come to the market. We see pension funds as probably the single largest potential boost to bond demand. First, there remains a large scope for the assets of state-provided basic pension ( pillar 1 ) to increase, given the financing short-falls under the current pay-as-you-go system and the ageing demographics. Second, a more systematic and professional approach to managing the basic pension assets, could lead to a significant increase in corporate bond investment. Third, the enterprise annuity segment of the pension system is a promising growth area it is indeed a policy priority, as the government has recently introduced tax deferral (early this year) and relaxed the investment restrictions regarding enterprise annuity assets (in March last year) in order to encourage a greater participation in the voluntary pension scheme. Exhibit 14: Commercial banks hold a much larger share of government bonds in Share of government bonds held by banks % Source: Asia Bond Online Goldman Sachs Global Investment Research 18

19 Exhibit 15: Bond holding still concentrated in commercial banks Bond holding breakdown by holder type (Data in RMB bn) July Whole market Corporate sector Whole market Corporate Sector Holder Type % % % % Commercial Banks 62% 29% 65% 35% Funds Institutions 13% 32% 3% 12% Insurance Insitutions 7% 9% 10% 30% Special Members 6% 1% 6% 0% Exchanges 5% 20% 6% 7% Credit Cooperative Banks 2% 4% 4% 5% Others 2% 1% 0% 1% Securities Companies 1% 4% 0% 2% Non-bank Financial Institutions 0% 0% 5% 6% Non-financial Institutions 0% 0% 0% 1% Individuals 0% 0% 0% 0% Total 100% 100% 100% 100% Source: bond.com.cn. We see considerable scope for other segments to increase the demand for bond holdings. As shown in Exhibit 16, non-bank financial assets reached RMB 48tn at the end of 2014, more than double the level at the end of We see demand for bond holdings coming mainly from the following five broad sets of institutional investors: Pension funds, carrying roughly RMB 3.6tn in assets. Most of them are still managed at local government level in an unsystematic manner, and have been restricted to invest only in bank deposits and government bonds, until recent relaxations 8. There is a part of the pension funds called enterprise annuity, which is essentially voluntary company-provided pension plans (or the so-called pillar 2 pension) and is managed by professional asset managers subject to relatively loose investment restrictions. But this part of the system is still relatively small, at only about RMB 600bn. Insurance funds, carrying around RMB 11.2tn in assets. About RMB 1.1tn of this is social insurance provided by the state (e.g., unemployment insurance). Currently, according to CIRC, about as much as about 30% is in low-yielding bank deposits. Collective trust funds, carrying around RMB 5.6tn in assets. Their investors are mostly high net worth individuals with higher risk tolerance and looking for higher returns. According to Trust Association, about RMB 1.3tn in trust assets are dedicated to bond investment. Mutual funds, carrying about RMB 6.7tn in assets. They cater mostly to mass retail investors. About 60% of their assets are invested in bonds, according to Bond data. Wealth management products (banks-managed), carrying about RMB 15tn in assets. They are popular alternative non-bank deposit savings vehicles for households. Approximately 44% of their assets are invested in bonds and money market instruments as of end 2014, according to CBRC data. Beyond domestic non-bank investors, allowing greater participation by foreigners in the bond market would certainly be another key element in diversifying and expanding the investor base. 8 In August, the State Council approved basic pension funds to invest up to 30% of their assets in listed equities, equity mutual funds, mixed funds etc. Goldman Sachs Global Investment Research 19

20 Exhibit 16: The non-bank institutional investor base has been expanding in size Non-bank financial asset size (RMB tn) WMP 60 Mutual funds Fund trust 50 Insurance Pension Banks' holding in total non-mof bond (%, RHS) Banks' share in non- MOF bonds (%) Source: CEIC, CIRC, NSSF Goldman Sachs Global Investment Research 20

21 Part Five What needs to be done to improve the market? Despite the rapid growth over the past decade, there is still ample scope for further development. This includes areas such as improving market access for private enterprises, developing a broader investor base, and improving the trading liquidity of the market. Below are areas of improvement we have identified: Reduce moral hazard issues in our view, one of the reasons why the market is so heavily concentrated by state-related entities is the implicit support that these bond carry. The expectation that state-related entities will be supported by the government has led to SOEs and LGFVs being able to tap the bond market, despite some of those issuers having very weak financial performance and crowding out private enterprises. In our view, tackling the problems of moral hazard requires reforming of the SOE sectors, and we are seeing tentative steps in that direction. In July 2014, the Stateowned Assets Supervision and Administration Commission announced that six SOEs have been selected for a pilot program to deepen mixed ownership reform, and further reforms are expected. We also saw the first SOE defaulting on its bond obligation, when wholly state-owned Baoding Tianwei Group Company missed an interest payment in April this year on its RMB 1.5bn medium term note. We see this default as an important step towards more reforms, and how this default will be handled could provide us with more clues as to how over-levered SOE will resolve and restructure their indebtedness. Promote price-based monetary policy market pricing has been assuming an increasing role in allocating credit in s financial system. This has been led by the shift in the PBOC s policy framework, which has gradually been relying less heavily on direct controls over the bank loan market (such as through loan quota and bank interest rates) and more on price-based mechanism centering around short-term interbank interest rate management. Nevertheless, the process is by no means complete. While bank loan rates have been fully liberalized, bank deposit rates are still not fully market-driven, which mutes the role of price signals and contributes to segmentation in the credit system. Moreover, despite recent progress, there is still scope to further enrich the PBOC toolbox to secure more effective control over shortterm rates, as well as to strengthen communication and bolster guidance to market participants regarding monetary policy intention. For instance, the sizable interbank rate shocks in late 2013 caused volatile responses in the bond market such episodes could dent bond investors confidence, especially as interest rate hedging instruments are still not very liquid. A greater stability and predictability of the monetary environment would help promote growth of the bond market. Improve co-ordination between regulators and better investor protection the establishment of NAFMII and the introduction of new types of products such as MTN and PPN have been instrumental in driving the corporate bond market significantly in recent years, and further development will be needed. For example, more uniform rules and approval processes between the three different regulatory would make it easier for companies to tap the different markets. And if the market is to become more market determined and less reliant on implicit government support, then the regulators will need to work on improving investor protection, such as tighter covenant packages. Clarify bankruptcy procedures a new Enterprise Bankruptcy Law was introduced in 2007 and was expected to be an important step in paving the way for creditors to pursue claims via a bankruptcy process. In particular, the law streamlined the bankruptcy process and unified procedures for SOEs and private enterprises. However, the implementation of the law has been a challenge. In most cases of defaults that we have come across, the workout was conducted via out-of-court settlements. As we Goldman Sachs Global Investment Research 21

22 noted in a study we did on offshore defaults by Chinese companies 9, local government decisions often have a large impact on the resolution process. It is therefore possible that creditors prefer to handle stressed situations by working with the local governments, rather than via the bankruptcy process. In our view, it is difficult for market pricing of credit risk to develop without further clarity on the default resolution processes. However, since March 2014, we have seen four cases of defaults in the corporate bond market (see Exhibit 17), and these could provide clues on the resolution processes. Exhibit 17: List of domestic bond default cases Date Issuer SOE/Private Principal/interest default Bond type Principal amount March 7, 2014 Shanghai Chaori Solar Private Interest Corporate bond RMB 1bn April 7, 2015 Cloud Live Technology Group Private Principal Corporate bond RMB 480mn April 21, 2015 Baoding Tianwei Group Company SOE Interest Medium term note RMB 1.5bn May 28, 2015 Zhuhai Zhongfu Private Principal Corporate bond RMB 590mn Source: Goldman Sachs Global Investment Research. Improve the credit rating process corporate bond issuers require each bond issue to be rated by a domestic credit rating agency. However, domestic credit ratings adopt a more top-down approach than international credit rating agencies, meaning that heavy emphasis is placed upon support by the parent entities or on the scale of the companies. This can be seen in the LGFV bond ratings. As we noted in the credit conundrum piece we published in July 2013, LGFV bond issuers have very weak financials, and therefore should carry low credit ratings. However, they are able to achieve domestic ratings of AA- or above, as government support is incorporated, even though LGFV bonds do not carry any explicit support from the local governments. This contrasts with international rating agencies, which adopt a more bottom-up approach by looking more at the standalone credit strength of the issuer. Whilst we believe that many of the staterelated entities do benefit from high levels of implicit support, allowing more differentiation in credit ratings will help in better achieving a market determined pricing mechanism. Exhibit 18: Rating agencies ranked by est. market share as of August 2015 Other, 1% Shanghai Brilliance, 9% Chengxin Co., 38% Dagong Global Co., 20% Lianhe Co. 25% Pengyuan Co., 7% Source: Wind, Goldman Sachs Global Investment Research. 9 see Recovery on High Yield: May be greater than you think, Asia Credit Line, November 10, 2011 Goldman Sachs Global Investment Research 22