Red Capitalism: The Fragile Financial Foundation of China's Extraordinary Rise
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FIGURE 4.2 Debt issuance by issuer type, 1992–2008
Source: PBOC Financial Stability Report, various; China Bond
Note: The 2007 government bond number excludes the RMB1.55 trillion Special Treasury Bond used indirectly to capitalize China Investment Corporation.
RISK MANAGEMENT
In spite of the success of Gao’s cigarette carton and Dutch auctions, underwriting CGBs, as well as corporate and bank debt, has remained very much a political duty, just as it had been from the beginning. This can be seen from the simple fact that the market did not, and still does not, trade. What is a market without trading? The reason for the lack of liquidity is straightforward: bond prices in the primary market are set below levels that reflect actual demand. Despite its surfaces—record issuance, improved underwriting procedures and issuer disclosure, and even a grudging openness to foreign participation in some areas—it is less a market to raise new capital at competitive prices than a thinly disguised loan market.
This reality is highlighted by the fact that of the primary dealer group of 24 entities, all but two are banks.3 With the sole exception of the NDRC’s recondite enterprise bonds (qiyezhai ) that are underwritten by securities companies, banks are the dominant underwriters of all bonds including CGBs, PBOC notes and policy-bank bonds. They underwrite and hold the bonds in their investment accounts until maturity, just like loans. Due to the skewed pricing mechanism in the primary market, banks, like their cousins, the securities companies have not developed the skills to value capital at risk. They do not need to: the PBOC does it for them by fixing the official CGB trading prices in the market as well as the even-more-important one-year bank-deposit rate.
PBOC’s perfect yield curves
To fully appreciate why there is no “market” in China’s bond markets requires delving into the meaning and practice of bond “yield curves.” These curves show the relative level of interest rates payable on similar securities of different maturities (see Figure 4.3 for examples) and “cost” means what investors demand for a given level of risk. The interest rates payable by government, or sovereign, issuers are used as the basis of bond-underwriting decisions in all developed markets. This is founded on the theory that countries do not go bankrupt (which is clearly disputable) and that, therefore, they represent the risk-free standard in a given nation’s domestic bond market. In China, the MOF represents the sovereign issuer, the highest credit possible, and the Chinese credit-ratings agencies place the MOF as a unique risk category a level above the AAA (Triple-A) rating represented by, for example, PetroChina. It sounds much better to be a “Quadruple A” than the “Triple A” of, for example, the US Department of Treasury, which one Chinese agency has cheekily assigned it in the Chinese system. Figure 4.3 shows the PBOC-mandated minimum credit spreads for a variety of enterprise-bond credit ratings over the cost to the MOF. These curves show an ideal world that does not exist: why?
FIGURE 4.3 Mandated minimum spreads over MOF by tenor and credit rating
Source: China Bond, as of October 20, 2009
As in other international markets, the curves are based on the underlying MOF yield curve; for example, the minimum 10-year AAA-to-MOF spread is circled.4 The trouble in China, however, is that the MOF yield curve is disregarded in favor of the PBOC’s bank interest rates on loans. It is disregarded because it does not truly exist, as is explained below. The PBOC-mandated one-year loan and deposit rates used by banks are shown in Figure 4.4.
FIGURE 4.4 One-year PBOC RMB bank deposit vs. lending rates, 2002–2008
Source: China Bond
The regulated spread between the cost of funds on deposits and minimum bank lending rates is deliberately set to provide lenders a minimum guaranteed 300 basis point (three percent) profit.5 When a bank underwrites a bond, therefore, it will, among other things, compare its potential return with that of a loan of a similar maturity to a similar borrower. The issuing company will, of course, consider the same thing. To the extent that this comparison to loan rates influences the underwriting decision, bond pricing does not reliably reference the MOF yield curve. In actual practice, the MOF curve is frequently disregarded and corporate and financial bonds are priced lower than the curve would indicate. This is because banks are motivated by compensation from the issuer via other supplemental businesses. But they also know full well that, as mentioned, the MOF yield curve is a fiction.
Fictional curves from fictional trading
Figure 4.5 shows an actual picture of a single day’s corporate-bond trading on December 8, 2009. The yield curves presented look like something created by random machine-gun bursts against a wall. What the figure represents can be understood by examining the two highlighted AAA transactions, both for bonds with tenors of around five years. As can be seen, the trades were completed at wildly different levels—a low of less than two percent and a high of close to five percent. These are not unique transactions; the chart abounds in such examples. Why was there such a differential between two seemingly similar securities?
FIGURE 4.5 Actual enterprise-bond yield-curve data, by credit rating
Source: Wind Information, December 7, 2009; excludes MOF, CDB, and financial bonds
The absence of active market trading explains this strange data. On December 8, 2009, for example, the entire China inter-bank market for corporate bonds recorded only 1,550 trades—this in a market comprising over 9,000 members and RMB1.3 trillion (US$190 billion) in bond value. In contrast, the US Treasury market each day averages 600,000 trades comprising US$565 billion in value. If market participants do not actively trade, how can the price of a bond be determined and serve as a meaningful measure of value?
The true character of China’s bond market becomes even clearer when the focus is put on only MOF and CDB bond trades, as shown in Figure 4.6. On December 7, 2009, the number of trades totaled 52 for MOF bonds and 108 for CDB. These numbers could, in all likelihood, be halved since market-makers create volume (as they are required to do) by, among other actions, selling a bond to a counterparty in the morning and buying it back in the afternoon. With trading volume so light, whatever yield curves that can be drawn are almost arbitrary. How then can the MOF curve be considered a meaningful pricing benchmark for corporate-debt underwriters or, indeed, corporate treasurers?
FIGURE 4.6 MOF and China Development Bank bond trades
Source: Wind Information, December 8, 2009
Fixing a yield curve
The data raise a question regarding the basic quality of the MOF curve represented in Figure 4.3. China uses what are called in the financial industry “daily price fixings” for its debt securities. This means that there is an “official price” set for traded products such as foreign exchange or securities. Usually, this is done by the central bank or market regulator in consultation with a number of market participants and is necessary because the given product did not trade or traded too few times for the market to establish a price.
Official price setting is not an uncommon practice: there are fixings even for such actively traded products as the Japanese yen, as well as such partially convertible currencies as the Indian rupee and, of course, the Chinese renminbi. In China, since October 2007, this official “fixing” for bonds has been done by the China Government Securities Depository Trust and Clearing Corporation, a nominally “independent” entity owned by the PBOC and the depository for all bonds traded in the inter-bank market. Bloomberg carries the China Bond daily fixing table for CGBs and CDB bonds, as illustrated in Table 4.2. The actual traded price information for each bond traded on that day is also shown.
TABLE 4.2 China Bond price-fixing data, January 4, 2010
Source: Bloomberg, China Bond, and Wind Information. All fixed-rate bonds
The trading data show that on January 4, 2010, there were a total of 32 CGB trades with a combined value RMB5.57 billion and 55 CDB trades with a combined value of RMB29.53 billion. The actual trades used in the daily fixing table were extracted from th
is voluminous activity and illustrate precisely why Chinese sovereign yield curves are more fiction than fact. For the one-year to five-year section of the CGB yield curve, not one of these bonds traded, not even once! This official yield curve, built out of nothing but assumptions, did dovetail nicely, however, with the six-, seven- and 10-year bonds, which traded a grand total of five times that day.
Data for the MOF and CDB bonds shown in Table 4.2 have been charted in Figure 4.7. Together, they describe a smooth, upward-sloping yield curve. Against this background, what reliance should market participants put on CGB yield curves or, in the case of the CDB bonds, to a notional spread over treasuries? It is not surprising, therefore, that the absence of trading for what should be the most liquid products characterizes the market as a whole as well.
FIGURE 4.7 MOF and CDB “fixed” yield curves, January 4, 2010
Source: Wind Information, January 4, 2010
Also on January 4, the entire inter-bank market saw only 615 trades (see Table 4.3), among which CGBs incredibly traded the least of all and represented only 3.3 percent of the total value traded. In contrast to the US$25 billion in bond value traded that day in China, the average daily trading volume in the US debt markets is US$565 billion, a figure itself far in excess of the average total daily global equity trading of US$420 billion.6 These US trades result on average in over US$1 trillion in bond value moving between accounts each day on the US Federal Reserve Bank’s electronic settlement system.
TABLE 4.3 Inter-bank bond trading summary, January 4, 2010
Source: Wind Information
If the price points, “fixed” or not, on Figures 4.5 and 4.6 measure anything, it is the liquidity premium paid by investors to sell their bonds into a saturated market. This accounts for the widely scattered price points around faint yield curves. The story is summed up in Figure 4.8, which illustrates the fundamental illiquidity of CGBs, corporate and financial bonds. In all of 2008, for example, MOF bond turnover was only RMB3.5 trillion or about 10 percent of all outstanding CGBs. The most liquid securities are the shortest in tenor—MTNs, CP and PBOC notes—but even these turned over less than one time during the entire year.
FIGURE 4.8 Inter-bank market trading volume and turnover, FY2008
Source: PBOC
In sum, the absence of active market trading limits the price-discovery function of China’s bond markets. In turn, unreliable prices mean that the market participants cannot value risk accurately. A simple question such as how much a AA issuer would have to pay investors to buy its 10-year bonds cannot be answered with any certainty. On the other hand, China’s market investors don’t really care. Why should they when the majority of bonds offer “riskless” yields well over the one-year bank-deposit rate of 2.25 percent but, at the same time, well under demand in the secondary market? As long as inflation remains under control, why shouldn’t banks be happy to hold the bulk of these securities to maturity, just as they do their loan portfolios?
Cash vs. repo markets
China’s repo markets illustrate just what liquidity means in a bond market. Figure 4.9 shows the seven-day repo interest rate for 2008. Contrast the active trading in interest rates here with the anemic yield curves traced by the CGBs and CDB bonds shown in Figure 4.6. Clearly the cost of capital is being driven by supply and demand. What accounts for such trading? The wildly speculative bidding on shares offered in Shanghai IPOs forces investors to put together the largest amount of funding possible to secure an allotment in the share lottery. In IPO subscription lotteries, massive amounts of capital—often equivalent to tens of billions of dollars—are frozen to secure allocations of shares. A large portion of these funds is raised by repo transactions. This market, however, is much more akin to the pure short-term inter-bank loan market than to the long-term capital-allocation function of bond markets. The point, however, is that demand drives the price of capital here, but not in the bond market.
FIGURE 4.9 Seven-day repo volumes, interest rates vs. capital frozen in IPO lotteries
Source: Wind Information
Note: “Offline Frozen” indicates amount of capital used in bids for shares in the institutional “offline” IPO lottery.
As is obvious to even infrequent observers of China’s economy, speculation is a fact of life. This largely stems from the artificially fixed returns on bank deposits, loans and bonds, the only available investment alternatives outside of real estate, shares and luxury goods. Set at levels unreflective of the true demand for capital, the managed rates for these products create a stillborn fixed-income market and force investors to speculate. Capital gains, which are untaxed, are the main play for investors in China, whether retail or institutional, and none can be found in the debt-capital markets.
The “327” Bond Futures Scandal
If any one incident highlights why the government seeks to strictly control markets, it must be the bond futures scandal of 1995. This story is already ancient history, but it explains why there is still no financial-future product of any kind in China’s capital markets.7 At its simplest, the scandal was a struggle between a major local broker backed by the Shanghai government, and the MOF; in other words, between local and central government interests. Wanguo Securities, owned by the Shanghai government, received inside information that the MOF planned to issue 50 percent more bonds in 1995 than it had the previous year. Expecting this larger volume to offset any gains from declining inflation, Wanguo’s traders, in contrast to the overall market view, expected bond prices to remain low. Over the early part of 1995, they accumulated a huge (and illegal) short position in bond futures contracts, in particular, the March 27 contract (which gave the scandal its name). News of this leaked out (nothing in China remains secret for long) and other market participants began to accumulate long positions, expecting prices to be higher in the future. This trend increased when other brokers learned that the MOF had determined to significantly reduce its issuance plans. Somehow, Wanguo remained ignorant of this and continued to build its short position in an effort to corner the market.
Acting through its wholly-owned China Economic Development Trust and Investment (China Development Trust; Zhongjingkai), the MOF took a corresponding long position. As the head of the China Development Trust was Zhu Fulin, the former Director of the Treasury Bonds Department of the MOF, this was never going to be a fair fight. When the MOF at last announced its much-reduced issuance plans and bond prices remained high, Wanguo frantically sought to square its position during the last eight minutes of market trading. Market volumes soared to unprecedented levels. By the end of the day, Wanguo’s actions had driven prices down but at the cost of a market collapse and the technical bankruptcy of many other brokerages. That evening, the Shanghai exchange, facing the reality that the futures market had collapsed, canceled all trades that had taken place in the last 10 minutes of trading and closed the market for three days so that contracts could be unwound and renegotiated. This meant that Wanguo itself faced being bankrupted.
An investigation ensued and Wanguo’s chairman, a respected founder of the Shanghai exchange, was arrested and later sentenced to 17 years in prison. The fallout continued when Wanguo itself was merged with Shenyin Securities, then Shanghai’s second-largest firm, to become today’s giant Shenyin Wanguo. The very reformist chairman of the CSRC, Liu Hongru, took responsibility, although he had no direct control over the exchange at this time, and the financial-futures product was eliminated and remains so. Soon thereafter, Beijing took over control of both securities exchanges. Shanghai was most definitely the loser in this battle.
In this zero-sum game, someone had to be the winner and, of course, it was the MOF. China Development Trust was rated the top broker on the Shanghai exchange for 1995 “due to its massive trades in treasury bond futures . . . accounting for 6.8 percent of total annual exchange turnover.”8 Politically astute, China Development Trust seems not to have booked for itself what must have been massive profits. Rather, it allowed its “clients,�
� who no doubt included the MOF, to do so. In the following years, this powerful company became a major institutional market manipulator, whose actions could be seen in some of the most outrageous cases of stock ramping and corporate collapse. However, given its MOF background, Zhongjingkai escaped censure and closure until Zhou Xiaochuan finally closed it in 2001. It was not the only such institutional player with a central government background.