hsbc - china%e2%80%99s big bang
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By Qu Hongbin, Sun Junwei and Ma Xiaoping
As the West wobbles, Beijing eyes sweeping reforms in the next 3-5 years
Interest rates to be liberalised, the bond market to double in size...
...and the RMB to become convertible within five years
Disclosures and Disclaimer This report must be read with the disclosures and analyst
certifications in the Disclosure appendix, and with the Disclaimer, which forms part of it
Macro
China
November 2012
Chinas Big BangNew leaders ready to revolutionise the financial system
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As the West wobbles, all eyes have now turned East to see what Chinas leaders will do to stimulate the
economy. While theres little doubt that policymakers will gear up both monetary and fiscal easing, likelyleading to a modest recovery in the coming quarters, focusing on short-term stimulus misses a far more
important trend a swathe of co-ordinated reforms which we believe will revolutionalise the countrys
financial system. In fact, there are clear signs that Chinas new leaders, who will take power in early
2013, will make speeding up reform top of their policy agenda in the coming years.
This chain reaction will change the trajectory of the institutions and policies that are all intertwined
banks, bonds, interest rates, the opening of the capital account and the convertibility of the RMB
triggering a wave of deregulation that could happen much faster than many people think. We think
interest rates will be liberalised, the bond market will double in size and the RMB will become
convertible within five years. These changes would not only make capital allocation more efficient,
boosting the private sector, but also provide the middle class with greater choice about where to put their
money so they can earn a higher return and therefore spend more. This should help rebalance growth
from investment to consumption and lift the potential growth rate in the coming years.
This report looks at how this process will unfold over the next three to five years. Reforming Chinas
financial system is unlikely to be a simple process. There will be bumps in the road and perhaps an
occasional diversion. But plenty of other countries have already gone down this route and we think
Beijings policymakers can learn from what was successful and avoid repeating some of the mistakes that
were made along the way.
Banks to bonds
The debt problems of local government financing vehicles reflect the pressing need for China to shift the
burden of distributing credit from banks to capital markets. The country has witnessed the largest and
fastest migration from the countryside to the cities in history, creating massive demand for investment in
railways, roads, bridges and other infrastructure projects related to urbanisation. Money is not an issue
given the country has a domestic savings rate above 50%, the highest in the world. Yet the absence of
long-term financing instruments means the projects have had to rely on bank loans for funding, resulting
in a big mismatch between the payback period of these projects and the maturities of bank loans.
To address this problem and meet future demand for funding urbanisation, Beijing is speeding up the
development of bond markets and other long-term financing instruments. Pilot programmes for municipaland high-yield bonds have been introduced and the issuance of corporate bonds is also picking up. Given
the estimated RMB20-30trn of urbanisation-driven infrastructure investment in the next 10 years and the
Summary
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12th Five-year Plans goal to lift the ratio of direct financing to 15%, we expect the expansion of
municipal and corporate bonds to double the size of the domestic bond markets in the coming five years.
However, some daunting challenges remain, such as the unification of the fragmented bond markets, the
establishment of a single set of regulations governing new issuances and the development of a stronger
institutional framework for the market. We believe that allowing sophisticated global institutions to
participate can help improve market efficiency. A wider, deeper bond market will likely give the banks
much more incentive to focus on financing small and medium-sized enterprises (SMEs) and consumers.
And a pilot reform programme in Wenzhou should also help explore new options for funding SMEs, the
life blood of Chinas economy; according to an industry body, SMEs account for 65% of GDP, 50% of
taxes and eight out of 10 jobs.
Liberalising interest rates
The latest move by the Peoples Bank of China (PBoC) to widen the floating band of both deposit and
lending rates while cutting interest rates is a positive surprise. We see this as an indication of Beijings
determination to push forward interest rate liberalisation in the coming years. Consensus on the need to
liberalise interest rates was reached many years ago, but reform was delayed by concerns that financial
institutions were not ready. Today, all the major state banks have been restructured and are more
commercially-driven and the non-state sector takes nearly 60% of total investment. The time is now ripe
to free interest rates, especially given the pressing need to deepen capital markets. The recent adjustment
to the ceiling for deposit and lending rates by the PBoC is the first step and more moves will likely followin the coming years. Meanwhile, we also expect the PBoC to gradually create a single benchmark in the
next three years, leaving all other rates freely determined by the market.
Renminbi internationalisation is taking off
Since Beijing introduced a pilot scheme to expand the role of the RMB in cross-border trade settlement
and capital flows in 2009, the momentum has been much stronger than expected. The proportion of
Chinas total trade settled in RMB has quadrupled, topping 11% in the first three quarters of 2012,
reflecting the pent-up demand for switching from issuing invoices in USD to RMB when trading with
China. In our view, this ratio is likely to reach 30% in the next three years. In volume terms, this would
make the RMB one of the top three global trade settlement currencies. This, of course, doesnt give theRMB the status of a real global and reserve currency, as this requires full convertibility. That said, seven
foreign reserve managers are starting to invest in RMB bonds and other assets, although the amount is
relatively small.
The currency is set to become fully convertible in five years
When it comes to capital account liberalisation China is likely to adopt a gradual approach. Yet Beijing is
now more confident than ever about speeding up the process, considering that: 1) Chinas trade balance is
back on an even keel (the current account-GDP ratio has fallen below 3%) and the RMB is now close to
its market equilibrium rate; 2) domestic financial reforms have already made progress and will likely gain
momentum in the coming years; and 3) the role of the RMB in cross-border trade and investment shouldcontinue to expand quickly. Further changes in the coming years are likely to include the further
expansion of the Qualified Foreign Institutional Investor (QFII) and the Qualified Domestic Institutional
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Investor (QDII) schemes, a gradual removal of limits on foreign currency purchases by both local and
foreign individuals and increased foreign access to domestic capital markets. Combined with Chinas
policy of promoting both foreign and outward direct investment, these moves will make the RMB fully
convertible within five years, in our view. Although certain restrictions on capital inflows will likely
remain, full RMB convertibility would take Chinas financial integration with global markets to a new
level and have a profound impact on both China and the world.
The challenges
The experiences of other countries show that the road to financial reform, especially capital account
liberalisation, tends to be a bumpy one. To stay on track and to avoid major distortions, China must get
the sequence of the reforms right, that is, to strengthen its domestic banking system, liberalise interest
rates and develop a functioning bond market before making the RMB convertible. Meanwhile, the
success of the financial reforms will also depend on Beijing pushing through changes in other areas,
including fiscal and legal reforms. As people in the investment world are well aware, the term Big
Bang refers to major reforms introduced in the UK in 1986 that transformed the countrys financial
services industry from a protected species into a global powerhouse. The increase in financial activity
completely altered the structure of the market. Now its China turn.
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China: Economic and financial reforms in the pipelineExchange rate reform Opening monopoly sectors to private investment
Why:As part of the plan to make the RMB a more international currencyChina has pledged to make the exchange rate more market-oriented. In April2012 it met this commitment by expanding the daily trading band against theUSD for the first time since 2007 to 1%, up from 0.5%.
Obstacles:Concerns that a widening of the trading band would increasespeculation about currency appreciation, triggering inflows of speculativecash, appear to be fading. Some areas of the government notably theMinistry of Commerce have opposed reforms that could lead to a strongerRMB, which undermines the competitiveness of Chinas exports.
Whats happening:With a wider trading band we can expect more two-wayvolatility, less consistent appreciation, and faster internationalisation of thecurrency. Total trade settled in RMB increased four-fold in 2011 to reachRMB2.1trn (USD330bn), about 9% of Chinas total trade last year.
Timeline:A managed-floating currency within five years.
Why:Allowing private firms to invest in the countrys railways, banking, energyand healthcare sectors will boost the economy. The potentially lucrativeservices sectors could help hard-pressed private firms shift from low-endindustries.
Obstacles:State industrial giants, which received the bulk of Beijingsmassive spending package during the 2008-09 global crisis, have longenjoyed favourable positions and they are reluctant to see more competition.
Whats happening:The State Council is making a fresh bid to open upsectors dominated by state giants.
Timeline:The NDRC, the main economic policy body, has pledged to publishdetails of its plan (called the New 36-Clauses) but how quickly reform will be
implemented remains uncertain.
Opening the capital account Bond market reform
Why:Liberalisation of Chinas capital account would give foreigners greateropportunity to invest in mainland capital markets and domestic investors theoption to invest overseas. Capital allocation would become more efficient asChinas financial institutions are forced to compete for funds with overseascounterparts. This would also increase pressure to introduce interest andexchange-rate reform, as large cross-border capital flows make control ofthese rates difficult to maintain.
Obstacles:The authorities believe that capital controls protected the Chineseeconomy from the volatile international capital flows that hit its Asianneighbours during the 1997-98 Asian financial crisis and again during the2008-09 global financial crisis.
Whats happening:The PBoC, Chinas central bank, this year released areport outlining a potential roadmap to capital account reform ending with fullconvertibility of the RMB.
Timeline:Gradual reforms over the next 3-5 years.
Why:A more developed bond market would increase the efficiency of capitalallocation. It would also help to reduce the current concentration of financialrisk in the banking system. The high-yield bond market and the private-placement SME bonds that Chinas securities regulator are promoting shouldwiden credit channels for small, private firms which struggle to get access tothe state-dominated financial system.
Obstacle:Bureaucratic turf battles have prevented the unification of China'stwo main bond markets and the establishment of a single set of regulationsgoverning new issuance.
Whats happening:Chinas bond market development is hindered by thefragmentation of the market. Different regulators oversee different types of
bonds, which also trade in different markets. However, a recentannouncement by the central bank indicated some progress towards greatercoordination among regulators.
Timeline:The private-placement SME bonds market was launched in June,but unification of the regulatory structure will take longer.
Interest-rate liberalisation Equity listings by overseas companies
Why:Phasing out government control of interest rates would enable marketforces to play a greater role in capital allocation, allowing capital to flow to themost dynamic sectors of the economy. This would also help shift the balanceof the economy towards consumption as higher bank deposit rates would givehouseholds more spending power, while higher lending rates would reduceexcess investment.
Obstacles:The big state-owned banks profit from the guaranteed spreadbetween lending and deposit rates. State industrial firms also benefit from
access to cheap capital. These groups are likely to oppose reform.Whats happening:Top central bank officials have said the time is ripe for
interest rate reform and that the government has a timeline forimplementation. Premier Wen Jiabao recently criticised monopoly profits bylarge banks. But no concrete measures have been announced.
Timeline:Within three years but reform is likely to be gradual.
Why:Shanghai's stock exchange is considering launching an internationalboard that will allow foreign companies and red-chip Chinese companies(those incorporated and listed overseas) to list and give Chinese investorsdirect access to foreign firms shares.
Obstacles:This is closely linked to capital-account and exchange-rate reform.Regulators are still working out which currency the shares would bedenominated in, and currency conversion restrictions would have to be revisedto enable foreign companies to transfer capital raised in China for use in other
countries.Whats happening:The regulator says it will launch the international board
when conditions mature but has given no timeline.
Timeline:1-2 years.
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Fiscal reform Financial and commodity derivatives
Why:A revised tax system would enable local governments to finance theirincreased social spending obligations healthcare, education, pensions, and low-cost housing without relying on land sales and financial help from the centralgovernment. A property valuation or transaction tax would also help to reduce over-investment in property. Allowing local governments to issue bonds directly wouldalso decrease the need to use heavily-indebted local government financing vehicles(LGFVs) to raise money.
Obstacles:The central government may be reluctant to cede revenue to localgovernments. Property developers and current homeowners oppose new propertytaxes, which could bring down the value of their assets.
Whats happening:Property-tax pilot schemes are under way in Shanghai andChongqing and may soon be expanded to Guangzhou and Nanjing. The cities ofShanghai and Shenzhen and the provinces of Guangdong and Zhejiang becamethe first local governments to issue local government bonds in late 2011, and the
Ministry of Finance expanded the quota for local-government bond issuance for2012 to RMB250bn (USD39.6bn).
Timeline:This year for expanded property tax trial and local government bonds;unknown for broader fiscal reform.
Why:China is considering launching new financial derivatives linked to theRMB exchange rate, foreign currencies, international bonds and Chinese bankinterest rates. Simulated trading of government-bond futures is under way onthe Shanghai-based China Financial Futures Exchange. Regulators have alsosaid they will gradually open up the countrys commodity exchanges to allowforeign investors to trade futures.
Obstacles:A government bond futures trading scandal in 1995 is still fresh inthe minds of many officials and traders. Such fears are supported by the factthat Chinas tightly controlled interest and exchange rates offer domesticfinancial institutions little experience in managing related risks.
Timeline:Individual products will be launched gradually.
Resource pricing, taxes Residence permit (Hukou) reform
Why:The NDRC has said it will accelerate reforms to its energy pricingsystem, which aims to make domestic fuel and gas prices closer in line withinternational rates. This would likely lead to more frequent changes in retailfuel and power prices. Senior NDRC officials said in March that Beijing will rollout tiered power pricing for residential customers by the first half of this year tocharge higher prices for heavy users.
Obstacles:Inflationary pressure could prompt authorities to hold off onintroducing reforms that would push up prices in the short term.
Timeline:Some changes are likely in the next few months.
Why: Since 2011 more than 50% of the population now lives in cities. The fullpotential of urbanisation will not be unlocked until migrants are allowed tosettle in cities permanently. The hukou system prevents people from gettingaccess to healthcare and schools for their children.
Obstacles: Chinas leaders fear that a sudden influx from the countryside intobig cities could undermine social stability and create slums.
Whats happening: The government is taking small steps to overhaul thesystem by launching pilot schemes in smaller cities.
Timeline: Unclear.
SourceReuters, Bloomberg, NDRC, HSBC.
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From banks to bonds 7
The worlds next big bondmarket 14
How to set interest rates free 22
Going global 30
The rise of the redback 37
A convertible RMB within fiveyears 44
Learning the lessons 52
Disclosure appendix 59
Disclaimer 60
Contents
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Chart 1.1 Fundraising in China {delete asterisk-Production}
0
2,000
4,000
6,000
8,000
10,000
12,000
2006 2007 2008 2009 2010 2011 2012*
(RMB bn)
0
20
40
60
80
Equity (Lhs)Bonds (Lhs)Loans (Lhs)Bonds as % of total financing (Rhs)
Source: CEIC, HSBC
Chart 1.2 Direct financing in China needs to develop
0
20
40
60
80
100
Equity Loans Bonds
(%)
China Korea
Source: CEIC, HSBC 2010-11
Chart 1.3. Loan growth and loans to GDP ratio
90
100
110
120
130
1998 2000 2002 2004 2006 2008 2010 2012f
(%)
0
5
10
15
20
25
30
35(%, yr)
Loan to GDP ratio (Lhs) Loan growth (Rhs)
Source: CEIC, HSBC
Bonding with bondsBeijing wants to significantly lift the share of
direct financing and actively promote the
development of the bond market, according to
the 12thFive-year Plan (2011-15). More
specifically, in the financial sectors 12thFive-
year Plan announced in September 2012, Beijing
wants direct financing to total at least 15% by
2015, up from 14% in 2011.
Recent policy initiatives suggest things are really
starting to move. In January the influential
National Financial Work Conference, held once
every five years, stressed the importance of
building a standardised, unified bond market (see
China: National Financial Work Conference hints
further easing and reform,8 January 2012).
Then, in April, the three bodies that oversee
different types of bonds the PBoC, the National
Development and Reform Commission (NDRC)and the China Securities Regulatory Commission
(CSRC) put together a scheme for a co-
ordinated corporate bond market, a big step
towards ending the fragmented way bonds are
regulated. We see this as a signal that Beijing is
serious about developing the bond market.
Indeed, Guo Shuqing, the head of the CSRC, told
the officialPeoples Dailynewspaper in June that
international experience shows that overreliance
on bank credit in a financial system can, under
certain circumstances, lead to systemic risk,
adding that the bond market, seriously lags
behind the demands of the real economy (source:
Bloomberg, 12 June).
Since June, corporate bond issuance has started to
accelerate in tandem with efforts to stabilise growth,
such as monetary easing and the approval of a wide
range of infrastructure projects. The average
monthly issuance of corporate bonds toppedRMB173bn by September, more than 50% higher
than the monthly average of RMB113.8bn in 2011.
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issue even more long-term construction bonds on
behalf of local governments, enabling them to repay
the loans they used to fund public work projects.
This would be easy to do as it does not require
any change in the fiscal arrangements between the
central and local governments. With the money
raised by the bonds, local government could either
finance the ongoing construction projects or repay
bank lending to avoid a default.
The central government would be able to issue
debt at a lower cost of funding than local
governments. Demand for these central
government bonds should not be an issue, given
1) the huge pool of funds sitting idle in individual
deposit saving accounts (RMB38trn); 2) demand
for this type of government debt from insurance
and mutual funds in China is rising.
More importantly, Beijing has allowed certain
prosperous local governments to issue their ownbonds to service existing debt and raise funds for
new projects. The obvious advantage of this
option is that each local governments debt will be
priced by the market according to its own specific
set of credit ratings, effectively imposing market
discipline on local governments.
We expect more progress on this front but
expanding the scheme to the whole nation would
require an amendment to Chinas budget law as
well as local governments adopting much higher
accounting standards, so it may take time. Clearer
delineation between local and central government
ownership rights of state assets is also needed.
The sale of state assets by local governments to
raise funds to repay loans could also help solve
the debt problem. Local governments still own
more than 20,000 state-owned enterprises (SOEs),
of which 70% are profitable. Local governments
also own toll roads, ports and other commerciallyvaluable assets. Selling these assets would help
them to repay their debts.
These sales are also necessary if local governments
are to shift their attention away from business
activities to public services an important objective
for government reforms in the next five years.
Public listing of local SOEs would be the best way
to do this, but the real challenge here is how to
manage the sales of these assets transparently.
A bigger bond market neededto finance urbanisation
The increasing lure of urban life also has major
implications for the bond market as more financing
is required by Chinas cities and towns. For the first
time in the countrys history, more people now live
in urban areas than in the countryside.
At the end of last year, 51.3% of the population
were city dwellers, up from 20% 30 years ago
when China was just starting to open up its
economy. This implies that an average of 10m
people have left the countryside each year, a trendthat is likely to keep accelerating as China catches
up with developed countries. As Chart 1.6 shows, it
may take at least another two to three decades for
Chinas urbanisation rate to match that of the US.
Chart 1.5. The rise and rise of urbanisation
0
10
20
30
40
50
60
1950 1960 1970 1980 1990 2000 2010
(%)
-0.5
0.0
0.5
1.0
1.5
Urban population as % of total (Left ax is)
Percentage points change ev ery 5 y ears (Right ax is)
Source: CEIC, HSBC
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Chart 1.6. Urbanisation: Following in the footsteps of the US
Rural population as % of total
0
20
40
60
80
100
1840 1860 1880 1910 1930 1950 1970 1990 2010
(%)1950 1970 1990 2010
US China (upper scale)
Source: US Census Bureau, CEIC, HSBC
This means huge demand for infrastructure
investment. If history is a guide, for every new
urban citizen migrating from the countryside
investment of at least RMB100,000 in urban
infrastructure is needed (source: the China
Development and Research Foundation, a
government think tank). If we assume that an
average of 15-20m people a year settle in cities, a
number consistent with the last 10 years, this will
require annual investment of RMB2-3trn per year
(taking into account modest inflation) in the next
decade, or around 4.3-6.4% of GDP in 2011.
So, how will this be financed? The bond market is
the best way to meet the needs of the
infrastructure boom because:
The funds that banks have available to lend are
limited by the 75% loan to deposit ratio andother regulatory requirements. A deep, liquid
bond market would be able to accommodate
financing on a much larger scale.
Long-term bonds are a much better way to
fund multi-year infrastructure projects than
bank loans as they remove the problem of
duration mismatches in the banking system.
They would also meet demand from
institutional investors like long-term debt
instruments.
The cost of lending is lower than bank loans.
The role of banks will changeAs the bond market develops and the financial
markets become more competitive, banks should
be prepared to shift their focus away from big
projects and SOEs to retail customers and SMEs.
For some, this has already started. It can be seen
by the increase in the percentage share of the
assets of small and medium-sized banks (SMBs)
within the banking system (Chart 1.7). SMBs are
doing more and more business with SMEs, a trend
that is likely to continue in the coming years as
the reform process accelerates.
Banks have also widened their range of services,
selling different types of wealth management
products, which are short-term investments that
offer customers better returns than deposits.
Chart 1.7. Small and medium-sized banks gaining marketshare
40
45
50
55
2003 2004 2005 2006 2007 2008 2009 2010 2011
(%)
Small and medium-sized banks' asset as % of total
Source: CEIC, HSBC
The Wenzhou experiment
Beijing has launched an important programme of
pilot reforms in Wenzhou, a city in Chinas eastern
Zhejiang province where many small businesses ran
into serious credit problems (see box). This city of
8m has a strong tradition of entrepreneurship, so it is
not surprising that private business represents a
remarkable 82% of the local economy. The aim of
the reforms is to standardise and regulate thedevelopment of private financing and small-scale
financial institutions. Local residents are also
being allowed to make overseas investments.
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According to local media, Wenzhous local
government has submitted a proposal to the State
Council to implement Beijings plan. It wants to
increase the number of micro-finance companies
that lend small amounts of money.
There are around 35 today and the plan is set up
another 30 next year and a further 30 in 2013,
taking the total to about 100, enough to cover
Wenzhou and neighbouring towns. At the same
time, local branches of commercial banks wouldset up special departments for small companies,
the reform of rural co-operative financial
institutions should be finished by the end of this
year and village and township banks and their
subsidiaries should cover every county by 2013.
The PBoC is also playing a role in the Wenzhou
experiment by measuring lending activity. Its
Wenzhou branch has started to record the
percentage of lending made by local private lending
institutions on a monthly basis. It is using data from
30 rural co-operatives, 28 micro-lending companies,
30 guarantee companies, 50 pawn shops (which
include property among the assets they lend cash
against) and other financial services institutions.
The ratio was 20.4% in September, or 5ppts lower
than the peak in August 2011, suggesting that
demand for loans has slowed, as is the case in the
rest of the country.
This type of financial deregulation is taking place
in other regions too. Huge cities such as
Shenzhen, Shanghai and Tianjin have introduced
similar reforms and smaller places such as Li Shui
in Zhejiang province have received permission to
press ahead with change. More will follow,
setting the stage for major changes in Chinas
financial landscape.
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Why Wenzhou is so differentSome say it is the mountainous terrain that has kept
the place isolated; others point to the areas distinctive
dialect. What ever the case, Wenzhou has always been
a bit different from the rest of the country.
For decades it has been known as a hotbed of
entrepreneurship and grey-market lending. The
citys thousands of small businesses make, amongst
many other things, most of the shoes, eyewear and
cigarette lighters produced in China. Its known as
one of the richest cities in the country.
But Wenzhou recently became famous for another
reason its private companies were starved of credit
by banks as the PBoC tightened monetary policy through three rate increases and six RRR hikes in 1H 2011.
This led to businesses turning increasingly to unregulated shadow banking channels. When the economy
slowed and interest payments piled up, many went broke, threatening the financial stability of the region
late last year.
That was when Beijing stepped in. Premier Wen Jiabao visited Wenzhou and said the city would be thetesting ground for breaking the monopoly of the big state banks, which will help cash-starved private
enterprises get timely access to capital. The pilot project that is just getting started may one day become a
cornerstone of nationwide financial sector reforms.
Wenzhous financial model is much closer to that of the southern province of Guangdong, the economic
powerhouse that neighbours Hong Kong, than the government-led, debt-driven Chongqing model that
attracted negative headlines earlier this year (see China Inside Out: The Guangdong way is Chinas
future,30 April 2012).
Wenzhou and Guangdongs economic model is moremarket-driven than Chongqings
Chongqing
Guangdong
Zhejiang
Wenzhou
Chongqing
Guangdong
Zhejiang
Wenzhou
Source: HSBC
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Ready for take-offFrom market regulation and product innovation,
to the scale of bond issuance and the growing
investor pool, it is clear that Chinas bond market
is moving into a new era. We expect its market
capitalisation to double in the next 3-5 years,
lifting it into the worlds top three bond markets.
Our confidence is based on the pace of recent
developments to deepen and broaden the market
and the growing need to fund Chinas rapidurbanisation, as millions of people continue to
move to the city from the countryside every year.
In the past there has been limited co-operation
between competing regulators but there has been
progress in a number of different areas, including:
The expansion of local government bond
issuance (the Ministry of Finance has issued
RMB250bn on behalf of local authorities this
year, up from RMB200bn in the previous
three years) and a pilot programme allowing
local governments to issue new municipal
bonds, with the option of longer maturities.
A regulatory scheme led by the PBoC toimprove co-ordination between the different
parts of the corporate bond market.
The rapid growth of credit bonds issued by
LGFVs (although Beijing is trying to make
sure this is kept under control).
The launch of private placement SME bonds
and the expected relaunch of Treasury
bond futures.
The opening up of the bond market to
overseas investors and granting quotas to
foreign central banks.
The need to play catch-up
Chinas bond market needs to catch up fast. The
worlds second-largest economy represents over
10% of world GDP, while the countrys outstanding
bonds represent 5% of the world total (3.6% if
policy bank bonds are excluded). The gap between
Chinas bond market and GDP is huge compared
with other large economies (Chart 2.1).
The worlds next big bondmarket
Chinas bond market has lagged behind the countrys spectacular
economic growthWith a wider range of products and a growing pool of investors, it
is set for rapid expansion
We expect market capitalisation to double in the next 3-5 years,
making it one of the worlds top three bond markets
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Chart 2.1 Chinas bond market needs to catch up
0
5
10
15
20
25
30
35
40
US JP FR GE CH BR UK
(As % of w orld total)
Bonds outstanding GDP
Source: ADB, World Bank, HSBC 2011 data. China bonds excl. policy bank bonds
Over the last three decades China has maintained
spectacular growth averaging 10%. Half of this is
driven by investment roads, rail, factories and
skyscrapers which runs at around 20% y-o-y in
nominal terms despite the recent slowdown.
Despite this the financial landscape remains
dominated by banks. Bond market capitalisation
accounted for 45% of GDP in 2011 (Chart 2.2),
less than half the outstanding loans to GDP ratio
(116%), down from 125% in 2010 when it was
inflated by the effects of the stimulus package.
Chart 2.2. Bond market cap dwarfed by bank lending
0
2040
60
80
100
120
140
2002 2004 2006 2008 2010 2012f
(%)
Bond market cap as % of GDP
Outstanding loans as % of GDP
Source: CEIC, HSBC estimates
Chinas bond market also lags its neighbours in
Asia. According to the Asian Development Bank,
the countrys bonds outstanding to GDP ratio
(44.8% in 2Q 2012) was 8.2ppts lower than the
average for emerging East Asia and more than
30ppts below Singapore, Malaysia and South Korea.
Chart 2.3. Chinas bond market lags Asian peers
0
50
100
150
200
VN ID PH CH EEA HK TH SG MA KR JP
(As % of GDP)
Gov ernment Corporate
Source: ADB, HSBC. EEA stands for emerging East Asia. Data as of 2Q 2012
The bond market is not only small but lacks
variety. It is dominated by treasury bonds and
other policy bonds and is light on local
government and corporate bonds. As of mid-
October 2012, 35% of total outstanding bonds
were financial bonds (mainly issued by policy
banks and state-owned banks), followed by
treasury bonds (30%), mid-term notes (11%) and
enterprise bonds (7%), see Chart 2.4. Put together,
government-backed bonds represent nearly 75%
of Chinas outstanding bonds.
Chart 2.4 Government-backed bonds dominate
0%
20%
40%
60%
80%
100%
VN JP PH ID TH CH EEA SG MA HK KR
Corporate Gov ernment
Source: ADB, HSBC. EEA stands for emerging East Asia. Data as of 2Q 2012
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Chart 2.5. A snapshot of China's bond market (outstanding)
PBoC bills
5%
CP
4%
Corporate
2%
Others
6%
Enterprise
7%
MTN
11%
Financial
35%
Treasury
30%
Source: Wind, HSBC. MTNs refers to mid-term notes; CP refers to commercial paper
Market structure
Chinas bond market has three segments: the
national interbank market, the exchange market
and the bank counters market. It has a centralised
trust and clearance system provided by China
Government Securities Depository Trust and
Clearing Company.
1)The interbank market handles over 90% of total
daily business. Established in 1997, this is also the
countrys largest over-the-counter (OTC) market.
Bond transactions are made through inquiry and
independent negotiations. As it is the most liquid
market, this allows the central bank to conduct
open market operations through central bank bills
and repos.
The interbank bond market has opened its door to
foreign banks on a trial basis, a key step towards
internationalising the RMB (see China: Onshore
RMB bond markets open up a crack,17 August
2010). Some 20 foreign institutions can now
invest in Chinas interbank bond market. These
include foreign central banks for example, the
Bank of Korea has a quota of USD3.2bn and the
Bank of Japan USD10bn.
In addition, Shanghais municipal government
aims to establish itself as global centre for RMBtrading, clearing and pricing by the end of the
12th Five- year Plan (2011-15). This means that
the expansion of the interbank market is likely to
be faster than expected.
2) The exchange market is open to various
(basically non-bank) investors on an automatic
matching trade system. Trading volume is limited
due to the lack of participation by banks. This
could change as commercial banks are to be
allowed to participate on a trial basis, according to
a joint circular by regulators.
3)Banks OTC market serves individual investors.
Treasury bonds (mainly certificate bonds and book-
entry bonds) are sold to individuals and companies.
There are four types of bonds: treasury bonds,
PBoC bills, financial bonds and credit bonds (see
Asia-Pacific Rates Guide 2012, 14 December 2011).
Treasury bonds, commonly referred to as
onshore Chinese government bonds (CGBs), are
issued by the Ministry of Finance (MoF) as the
governments main debt instrument. Maturities
typically range between 1-year and 10-year but
are increasingly available in longer-term tenors
(e.g. 15-, 20-, 30- and 50-year).
PBoC bills are issued by the PBoC to manage
liquidity and sterilise FX operations. Available
maturities range from 3 months to 3 years. Active
trading in PBoC bills makes it a useful benchmark
for money market rates.
Financial bonds are issued by financial
institutions and underwritten by banks and leading
securities firms. The main type of financial bonds
are policy bank bonds that are issued by three
policy banks backed by the government (China
Development Bank, Export-Import Bank of China
and Agricultural Development Bank of China) for
financing key national projects that are not
covered by the national budget.
Credit bonds in the interbank market includeenterprise bonds, commercial paper (CP),
medium-term notes (MTNs) and super and short-
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term commercial paper (SCP). CP maturities are
typically 9-months and 1-year. Maturities of
MTNs vary according to business needs and
typically range between 2 and 10 years. Enterprise
bonds maturities range from 3 to 30 years. In
addition, since the end of 2010, Shanghai Clearing
House (SCH) also launched SCP with maturities
of less than 270-days. Long-dated bonds are held
mostly by insurance companies and liquidity is
limited. Only short-tenored credit bonds have
decent liquidity.
Table 2.1 Bond products in China
Type of bond Issuing entities
Treasury bonds Ministry of FinancePolicy bank financial bonds Policy banks, i.e., China
Development Bank, AgricultureDevelopment Bank, EXIM Bank
PBoC bills PBoCLocal government bonds Ministry of Finance on behalf of
local governmentsEnterprise bonds Unlisted enterprisesCorporate bonds Listed companiesCommercial paper and mid-term
note
Non-financial firms
Convertible bonds, bonds withwarrants
Listed companies
Source: HSBC
Local government financing
Chinas local governments are deeply in debt
RMB10.7trn (23% of 2011 GDP) by the latest
conservative estimates. How did they get into this
situation when the economy has been booming for
so long? Its a long story.
In the early 1990s, Beijing launched a major fiscal
reform programme aimed at centralising tax
revenue. This resulted in the central governments
share of total fiscal revenue rising from less than
30% in the early 1990s to more than 50%, at the
expense of local governments.
The problem is that local governments still
shoulder a large part of the burden of funding
infrastructure. With insufficient revenue, most
local governments, which are not allowed to
borrow directly from banks, chose to access credit
from the banking system through what are known
as LGFVs. It is no surprise that most LGFVs have
been accumulating debt since the early 1990s, and
the pace has accelerated since the financial crisis.
Bank loans to LGFVs are made under the name of
the company responsible for the construction
project. They generally have the explicit or
implicated guarantee of local governments i.e.
local governments are responsible for their debts.
The Shanghai Securities News reported in
February that at least 65% of these loans werefully covered by cash flows.
As we mentioned in the previous chapter, to help
stimulate the economy in 2009 Beijing started
issuing RMB200bn of bonds annually on behalf
of provincial governments to support local
projects (raised to RMB250bn this year, with the
option of a longer maturity period).
While this will help local governments in the
short term, it wont fix the problem completely.However, Beijing may have found another
solution. In 4Q 2011 it started a municipal bond
trial programme, which allowed the wealthy cities
of Shanghai and Shenzhen, along with prosperous
Guangdong and Zhejiang provinces, to issue a
total of RMB22.9bn municipal bonds with 3 or 5-
year maturity.
We believe this trial programme is likely to be
rolled out in other parts of the country in the
coming quarters. All this sends a strong signal that
Beijing sees these new local government
municipal bonds as the way to solve the liquidity
problem facing LGFVs, while at the same time
providing long-term financing for public housing
and infrastructure projects. This is particularly
important at a time when the economy is slowing
and there are calls for additional easing measures.
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The surge of LGFV bondsApart from bank loans, the local governments
have found another way to get themselves into
financial difficulties LGFV bonds. Strictly
speaking, local governments are not allowed to
issue bonds but they found a way round the
regulations. LGFVs started to issue mainly credit
bonds in the late 1990s (for example, the
RMB500bn Pudong construction bond to build
the subway in Shanghai in 1999).
The volume of bonds issued by LGFVs has grown
rapidly. In 2009, urban infrastructure construction
investment companies issued bonds totalling
RMB233bn, up from RMB60bn in 2008.
Despite Beijings efforts to start cleaning up local
government debt in 2H 2010, bond issuance
bounced again in 2011 and is up 160% y-o-y in the
first half of 2012 as market confidence was restored
after the last-minute bailout of Shandong Helon.This debt-laden fibre company almost became the
first company in China to default on a corporate
bond, pushing up high-yield spreads to record
levels (seeDefault dynamics, 7 March 2012).
LGFV bonds are usually only thinly traded in
comparison with mainstream products such as
government bonds, central bank bills and debt
issued by large corporations. They also tend to
trade at high yields, given the concerns over the
risk of default.
Chart 2.6. LGFV bond issuance since 2009
0
100
200
300
400
500
2002 2004 2006 2008 2010 2012*
(RMB bn)
Source: Wind, HSBC * As of end Oct 2012
Corporate bonds need a boostThe corporate bond market is very
underdeveloped in both the primary and
secondary markets.
Broadly speaking, there are three types of
corporate bonds. They are regulated by different
authorities and trade in different markets.
Enterprise bonds: Mainly issued by unlisted
companies regulated by the NDRC, the main
economic policy body. First issued back in
the early 1980s, these bonds are mainly issued
by SOEs but private enterprises are
increasingly using them to raise funds. Most
enterprise bonds are traded on the interbank
market, with the exchange market handling
the balance. Insurance companies,
commercial banks and mutual funds are the
main investors.
Corporate bonds:Issued by listed
companies regulated by the CSRC and traded
on the exchange market. Their market cap is
much smaller than enterprise bonds (about
25% of enterprise bonds). Investors are
mutual funds, insurance companies, enterprise
annuity funds and commercial banks.
Corporate mid-term notes and commercial
paper:Regulated by the National Association
of Financial Market Institutional Investors(NAFMII), a PBoC agency, and mainly
traded in the interbank market. The approval
process is easier than for enterprise and listed
companies bonds (a credit rating is needed
but there is no requirement for a bank
guarantee). These bonds were first issued in
2008 and have proved to be very popular.
Outstanding mid-term notes stood at
RMB2.7trn as of October 2012, more than the
combined amount of enterprises andcorporate bonds.Commercial banks and
mutual funds are the main investors.
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We believe corporate bonds should play a larger
role in direct financing. They provide long-term
capital at a lower cost than bank loans and unlike
equities bonds dont dilute the shareholders
interests. And, more importantly, they will help
broaden the financing channels for SMEs. Today,
corporate (and enterprise) bonds account for only
9% of outstanding bonds, excluding mid-term
notes and commercial paper. The market is still
dominated by SOEs and large companies.
However, two recent policy initiatives suggest the
pace of development is speeding up.
For the first time Beijing set up a
consolidation scheme (led by the PBoC
working with the CSRC and NDRC) in April.
Few details are available but this move is
expected to eventually lead to the
consolidation of Chinas bond market, which
should boost liquidity and issuance.
The Shenzhen Stock Exchange launched
private placement SME bonds from June
2012. This should help to ease financing
difficulties for SMEs.
Asset securitisation stillminimal
China launched the first asset backed security (ABS)
in 2005. Development has been very slow due to: 1)
a lack of co-ordination among policymakers; 2) thefragmented nature of the interbank and exchange
markets; and 3) the ABS market was suspended
during the global financial crisis.
ABS issuance resumed in 2012 when three
financial regulators the PBoC, the China
Banking Regulatory Committee and the Ministry
of Finance issued a joint notice to promote ABS.
Banks are allowed to issue up to a combined
RMB50bn in these types of securities. China
Development Bank (CDB) made the first ABS
issuance of RMB10.2bn, marking the resumption
of this process. However, outstanding ABS
represented just 0.1% of total outstanding bonds
as of end October 2012.
Chart 2.7 Outstanding asset-backed securities still minimal
0
10
20
30
40
50
60
2005 2006 2007 2008 2009 2010 2011 2012*
(RMB bn)
Source: Wind, HSBC * As of end Oct 2012
Plenty of demand
Demand for bonds is not a problem. Insurance,
pension and mutual funds as well as the large pool
of household savings are all looking for long-term
investment instruments. Chinas households andcompanies have generally high savings rates,
which require effective investment channels. The
bond market provides long-term investment
instruments with fixed returns, a sharp contrast to
the more volatile and riskier equity market.
Further development of the bond market will
provide the middle class with greater choices
about where to put their money so they can earn a
higher return and therefore spend more.
Moreover, the number of institutional investors is
on the rise. By the end of September 2012, there
were 411,711 institutional investor accounts on
the Shanghai A-share market compared with
around 200,000 in early 2005. Fund management
companies, securities companies, insurance
companies and social security funds are all
important investors.
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Second, the market is increasingly open to foreign
investors. By the end of September 2012, 188
institutions had received QFII licences with an
investment quota of USD30.8bn. China is now
planning to lower the entry barrier for foreign
institutional investors as part of reforms to add depth
to the countrys capital markets. The government
will cut the minimum requirement on assets under
management to USD500m from USD5bn for
companies seeking a QFII licence, the CSRC
announced on 19 June 2012 (source: Bloomberg).
The regulator also said it will allow the QFII
funds to invest in the countrys interbank bond
market. Under the new rules foreign investors will
be required to have at least two years of
operational experience, compared with the current
minimum of five years. The CSRC hopes that
introducing more long-term funds from abroad
will help improve market confidence and promote
stable growth in Chinas capital markets.
Chart 2.8. QFII investors expanding
0
20
40
6080
100120
140160
04 05 06 07 08 09 10 11 12
0
10
20
30
40(USDbn)
No. of institutions approved (Lhs)
Approved inv estment accumulated (Rhs)
Source: CEIC, HSBC
But a stronger institutionalframework is needed
An efficient, well-supervised bond market would
reduce transition costs and lower risks in the
financial system. We believe corporate
governance, the legal framework and regulatory
supervision all need to be improved. We think the
following are needed to build the right
institutional framework:
Information disclosure: Better transparency
is needed to accelerate the development of the
local government bond market. The balance
sheets of many local governments lack clarity
and need higher accounting standards. The
current accounting law only applies to
companies it should also be applied to local
governments. This will help price the risk of
local government bonds.
A credit evaluation system: A proper creditratings system is vital, especially in a market
which has a short history (the four major
domestic rating agencies are inexperienced)
and lacks statistics on default ratios.
Consolidationof the fragmented bond
markets, but this will take time. The current
segmentation splits liquidity and prevents the
formation of a complete yield curve.
Improving yield curves: A properly-functioning yield curve provides the benchmark
for pricing risk. Chinas yield curves need
further improvement through: 1) the
strengthening of market makers; 2) more
diversified products and maturity; 3) deeper
liquidity; and 4) interest rate liberalisation.
Bringing in global playerswould help
There are many ways Beijing can strengthen theinstitutional framework of Chinas bond market
enhance regulation, increase co-operation with
overseas exchanges and regulatory authorities and
nurture domestic investors and rating agencies.
But for us the best option would be to attract top
global institutional investors who are more
capable of identifying, pricing and managing risks.
Their active participation would encourage
companies to improve the quality of disclosure
and help domestic rating agencies raise their
standards to international levels.
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This can be achieved by expanding the current
QFII and RQFII schemes and further opening
bond markets to foreign central banks and
international organisations. There are signs that
this is already starting to happen.
On top of the increase in the QFII quota from
USD30bn to USD80bn, as mentioned earlier the
CSRC is considering further relaxing QFIIs
investment rules. This includes allowing QFIIs to
invest in the interbank bond market and changingthe rule that no less than 50% of QFII
investment must be in equities. Meanwhile, the
fact that Bank of Japan and Bank of Korea have
recently received approval to invest in the
interbank market is another positive sign (see the
chapter: A convertible RMB within five years).
Increased participation by sophisticated global
investors will accelerate the pace of building a
more transparent and liquid bond market one
that matches Chinas rapid economic growth.
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Ready for action
Zhou Xiaochuan, governor of the central bank, the
PBoC, made his point very clearly. Writing in the
March issue of China Finance magazine, he
stated that conditions were basically ripe for
liberalising domestic interest-rate policies. His is a
powerful voice he has held that important job
since 2002.
Interest rate liberalisation lies at the heart of
Chinas financial reforms and much needs
changing. Under the current system the PBoC setsa ceiling for bank deposit rates and a floor for
lending rates, creating a high spread that generates
fat bank profits. It also means that the returns
savers earn on their deposits are below the level of
inflation, so they are effectively losing money. As
The Economistmagazine put it recently: A
banks depositors, in effect, pay the bank to
borrow their money from them.
This, in turn, works against the governments
policy to make consumption a bigger driver ofeconomic growth. Consumption in China was
51.6% of gross domestic product in 2011,
compared with about 70% in the US.
Chart 3.1 Real interest rates in China
-5
-4
-3
-2
-10
1
23
4
5
00 01 02 03 04 05 06 07 08 09 10 11 12
%
Real interest rate Long-term av erage
Source: CEIC, HSBC
Reformers like Mr Zhou believe that liberalising
interest rates is vital for other reasons too it
would help to develop the bond market and make
it easier to lift capital controls and internationalise
the RMB. Importantly, interest-rate liberalisation
is now official government policy as it is part of
Chinas 12th Five-year Plan, which runs from
2011 to 2015. Mr Zhou believes it should be
possible to make considerable progress during this
period for a number of reasons, including:
How to set interest ratesfree
The governor of Chinas central bank says the time is ripe for
liberalising interest rate policies
The powerful state-owned banks stand to lose the most from
reform, but there is little they can do to buck the trend
In our view, liberalising interest rates will be a step-by-step
process that could be completed within three years
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The process of financial restructuring and
listing the major domestic commercial banks
is largely complete. The banks should be able
to stand on their own feet.
The ability of financial institutions to price
interest rates and manage risk has improved
significantly.
The central bank has become more proficient
at adjusting market interest rates through open
market operations (buying and selling
government securities to expand or contract
the amount of money in the banking system).
The Shanghai Interbank Offered Rate
(SHIBOR) is now an established benchmark
for pricing financial products.
A deposit insurance system and a survival of
the fittest mechanism to weed out weak
financial institutions are being established.
However, the problem is that reform in China is all
about timing and the order in which changes should
be made. Beijing likes to test the water by rolling
out pilot schemes in certain cities or provinces. But
this is not practical for interest rates and thats why
they were not part of the Wenzhou reforms. With
the global economy still weak and China facing the
risk of an economic slowdown at home, liberalising
interest rates cannot be rushed. We think it will be a
step-by-step process that can be completed withinthree years.
Our confidence is based on a number of factors.
Firstly, Mr Zhou is not a lone voice. In October, it
was announced that three bodies that regulate
banks, equities and insurance would all be led by
former PBoC vice-governors; Shang Fulin at the
China Banking Regulatory Commission (CBRC),
Guo Shuqing at the CSRC and Xiang Junbo at the
China Insurance Regulatory Commission (CIRC).
They are proven reform-minded problem solvers and
protgs of former premier and economic reformer
Zhu Rongji, who did much to change China in the
late 1980s and early 1990s. For more details see
China Investment Atlas, Issue 37, The markets
driving forces in 2012, 18 November 2011.
Then, in January, the powerful National Financial
Working Conference (NFWC), that meets every
five years, came out strongly in favour of a string
of broad based financial reforms.
More evidence of change came in February with
the release of the China 2030report by the World
Bank and the Development Research Center, a
think tank with links to the State Council, the
countrys top executive body. This presented a
sweeping reform agenda, including interest-rate
liberalisation and limits on the power of SOEs.
Then came Mr Zhous comments in March. In
addition, Premier Wen Jiabao has also stated
Chinas road to reform cannot be changed and
separately called for the power of the state banksto be reined in.
So what happens next? In the next three years or
so we think the pace of deregulation will be
guided by a series of small changes that make
both lenders and borrowers more responsive to the
cost of funding.
An assessment by the PBoC suggests that all
commercial banks and rural credit units already
have interest rates pricing systems based on costof funding and risks in place, ready to be rolled
out. Chinas financial institutions appear to be
ready for the complete liberalisation of
benchmark lending and deposit rates.
Indeed, Chinas Banking Association is working
on setting up a mechanism to decide benchmark
deposit and lending rates. We think the sector is
preparing for the final push towards interest rate
liberalisation. It is likely to start with rates for
long maturity, large deposits before moving to
short- term small deposits.
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As theAsian Wall Street Journalreported on
20 March 2012, the PBoCs Mr Zhou and others
are also calling for the creation of a government
deposit insurance system, similar to the US and
other developed countries. This would put Chinas
banking system on a more solid footing and
ensure that depositors money would be safe even
if some banks shut down because of the
increased competition.
The next stepsMr Zhou has laid out a widely reported two-stage
roadmap for liberalising interest rates by 2015.
First, four preconditions must be met, followed by
a six-step reform process. The preconditions are:
1) China has a competitive financial market with
diversified financial institutions that can price
market risks at different levels depending on their
funding costs and financial strength. Current
status:Some of the stronger commercial banksalready have pricing power.
2) Commercial banks, which operate in a tougher
environment than policy banks, are to be given
more price setting power. Current status:
Competition has strengthened since the banks
were restructured and floated.
3) Chinas banks still see market share as the most
important factor when it comes to competition.
This mindset needs to change. Current status:Commercial banks are becoming increasingly
focused on promoting financial services.
4) Commercial banks need to reduce their reliance
on interest rate income. Prices of other financial
services also need to be deregulated. Current
status:The contribution of interest rate income at
the big four banks has declined significantly in the
past few years.
Where are we nowChina, like many developing countries, has kept
interest rates artificially low to increase industrial
output growth and reduce financing costs for large
state-run companies. The net interest rate margins
for Chinas banks were negative during the
majority of the first two decades of economic
development (1978-1996).
The downside is that this financial repression,
as it is known, has slowed the development of
financial services and reduced the efficiency of
allocating funds to businesses. In simple terms,
credit does not always get to where it is needed
most. For example, it is easy for big SOEs to get
credit while many SMEs are starved of funds.
The aim is to establish a market-oriented structure,
with money market rates acting as the benchmark
based on supply and demand. This would mean that
the central bank becoming less dependent onadministrative policy measures such as loan quotas
and the reserve requirement ratio to influence the
system. Experiences from other countries suggest
that the pace and sequence of reform will determine
the impact liberalising interest rates will have on the
financial system and whether the real economy
would suffer a negative shock.
Interest rate liberalisation is not a new concept in
China the phrase first appeared in official
documents way back in 1993. Today, after years
of step-by-step deregulation and reforms (see
Table 3.6) much progress has been made. This
gradual approach has safeguarded the banks
profit margin, while giving businesses and
households time to adjust.
Here is whats happened so far:
Capital market rates
Money market and bond market interest rates
In a market-oriented system, inter-bank interest rates
are liberalised first, followed by bond market rates.
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In 1996 the central bank abolished the upper
limit on inter-bank lending rates. It only took
from 1996-99 to fully liberalise interest rates
on the inter-bank market and bond markets.
FX and local currency lending and
deposit rates
Lending rates
The foreign currency market uses
international rates as a benchmark; lending
rates of all foreign currencies werederegulated from September 2000.
For RMB loans the upside floating limit for
SMEs was expanded from 110% of the policy
rate to 120% in 1998 in an effort to support
small business.
Over 1998-2003 the floating limit of lending
rates for RMB loans expanded to 30%, rising
to 170% from January 2004.
The upper limit of lending rates for RMB
loans was abolished in October 2004. Only
the lending rate floor 90% of the policy rate
was kept in place.
Deposit interest rates
FX rates for large deposits of over USD3m
were liberalised in September 2000.
The number of foreign currencies subject to
deposit rate regulation was reduced from seven
to four (USD, EUR, JPY, HKD) in July 2003.
Interest rates for all small FX deposits with a
maturity of more than one year were
liberalised in November 2004.
The ceiling of RMB-denominated deposit
rates has been controlled since October 2004.
The PBoC still regulates 29 types of interest rate,
including preferential interest rates for export
credits, deposit rates for small FX deposits and
loans for anti-poverty purposes (see Table 3.3).
Problems areas
These include:
The 1-year deposit rate, the central banks
benchmark interest rate, acts as an important
reference for the rating of bonds. Chinas
single tender, fixed bid system has distorted
the bond market and does not give a true
reflection of supply and demand. Thats why
interest rates for bonds are usually higher than
the benchmark deposit interest rate.
Having regulated interest rates limits the
issuing of bonds to the central government,
central bank, state-owned banks, big SOEs
and policy banks. This has hindered the
expansion of the bond market. Financial and
corporate bonds issued by policy banks and
large SOEs account for 50% of the total bond
market (this includes 40% of short-term
financing bills and medium-term notes). Most
local governments, which have great
difficulty in raising funds for local
infrastructure development, are not qualified
to issue bonds. The exceptions are Shanghai,
Shenzhen, Guangdong and Zhejiang which
were allowed to issue bonds late last year as
part of a pilot scheme.
A lack of development of related products
such as interest rate futures. Regulated
interest rates deprive market players of risk
management tools. Put another way, in
Chinas bond market theres no interest rate
risk other than policy risk.
Theres no benchmark yield curve, weakening
the markets gauge of short-term rate trends
and inflation.
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Chart 3.2 Regulated interest rates are still the marketbenchmark
0
1
2
3
4
04 05 06 07 08 09 10 11 12
%
0
2
4
6
8
10
3-month time deposit rates (LHS)Shibor: 3 month
Inter-bank 3 month money rates
Source: HSBC, CEIC
The main obstacles
The benefits from marginal changes in interest rates
in terms of improvements in banking efficiency and
allocating financial resources have come to an end.
In other words, the easy part is over.
Powerful vested interests have a lot to lose from
change especially the big banks. Experiencesfrom many other countries show that the net
interest margin (NIM) tends to narrow after
lending and deposit interest rates are liberalised.
This is because banks have to compete with each
other they attract deposits by raising deposit
rates and cutting lending rates to win business
from valued (normally big) clients.
This squeezes interest rate income and thats why
Chinas commercial banks are the main group
objecting to reform. NIM income represents 70-
80% of the banking sectors profits, so it is
understandable that the banks will try to postpone
reform for as long as possible. Market driven
interest rates would force them to grow their
businesses in other areas, particularly fee income.
Chart 3.3 Banks interest rate margin has stayed between 3-4ppts
-5
0
5
10
15
90 92 94 96 98 00 02 04 06 08 10 12
%
Interest rate margin 1-y r lending rates
1-y r time deposit rates
Source: HSBC, CEIC
But interest rate liberalisation is not just about
deregulation. It is also about power. Chinas
government-controlled banking system has long
provided the financial resources that have made thecountry the economic powerhouse that it is today.
Fully-liberalised interest rates would certainly
diminish the level of government control.
During the 2008-09 global financial crisis the
states control of the banking sector helped
Chinas strong economic recovery. In 2009 the
banks pumped RMB9.6trn of new loans into the
economy as Europe and the US floundered. We
believe it is this deep-seated fear of the
diminution of power that is the biggest obstacle tobe overcome.
Table 3.3 Interest rates currently under PBoC regulation
Interest rates Numbers of rates under regulation
Deposit rates Deposit rates (demand deposit, 3-month, 6-month, 1 year, 2 years, 3years, 5 years), negotiated deposits (upper limit restriction), savings forpersonal housing funds and other small deposit accounts
10
Lending rates Lending rates (6-month, 1 year, 3 years, 5 years, more than 5 years),personal housing loans
7
Preferential lendingrates
Export credits (China Import and Export Bank), anti-poverty 8
Small foreign currencydeposits
Deposits with maturity of less than 1-year deposits of USD, EUR, JPY,HKD
4
Total 29
Source: PBoC, HSBC
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We suggest policymakers think about this in a
different way financial repression and the
misallocation of financial resources could
ultimately threaten the sustainability of Chinas
economic growth.
It would be far better if commercial banks can
work together at an industry level to build a co-
ordinated mechanism to set a benchmark interest
rate. This, under the supervision of the central
bank during a transition period, could helpcushion the potential nasty shock of free interest
rates on the sector and, in turn, the real economy.
Chinas Banking Association, which works under
the CBRC, is already researching the best way to
set up this mechanism.
As Yi Gang, the PBoC vice governor, wrote in his
2009 book On the Financial Reform of China,
only when a market-oriented benchmark interest
rate is properly pricing lending and deposits will
the PBoC be able to exit its role of setting
benchmark interest rates.
Chart 3.4 Around 70% of total bank loans were lent atinterest rates higher than the central bank benchmark
0
20
40
60
80
08 09 10 11 12
%
Below benchmark, 10%
Above benchmark, 10% up to 170%
Source: HSBC, Wind
SHIBOR, an emerging benchmark
Before the PBoC can give up its role of setting
interest rates a market-oriented benchmark
interest rate needs to be in place.
The Shanghai Interbank Offered Rate (SHIBOR),
introduced in January 2007, already acts as a good
reference for short-term (less than 3-month)
money supply and demand. SHIBOR is now
widely accepted as the benchmark rate for
discount bills, wealth management products and
asset management.
However, there is still too big a difference between
offer and transaction prices for more than three-
month funding, which suggests that factors other
than supply and demand are at work between
market counterparties. Theres more work to do to
enhance SHIBORs role as a pricing benchmark.
Chart 3.5 SHIBOR, an emerging RMB rate benchmark
-1
1
3
5
7
9
00 01 02 03 04 05 06 07 08 09 10 11 12
%
SHIBOR1M USD LIBOR1M HIBOR1M
Source: HSBC, CEIC
Latest developments
China took another step towards liberalising
interest rates on 8 June when it cut borrowing
costs for the first time since 2008 and loosened
controls on banks lending and deposit rates. The
one-year lending rate was lowered 0.25ppts to
6.31% and the one-year deposit rate fell the same
amount, to 3.25%. Banks could offer a 20%
discount to the key lending rate after the move, up
from 10% previously. They will also for the first
time be able to offer savers deposit rates that are
up to 10% higher than the benchmark.
Currently around 70% of total bank loans are lent
at interest rates higher than the central bank
benchmark (see Chart 3.4), implying that Beijing
thought it was a good time to expand the floatingrange as it eliminates the risk of irrational
competition between financial institutions.
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Less than a month later the PBoC acted again,
asymmetrically cutting the benchmark 1-year
lending rate by 31bps to 6% and the 1-year
deposit rate by 25bps to 3%, effective 6 July. The
central bank has also announced it was further
reducing the lower limit from 80% to 70% of the
benchmark lending rate. This change is not
applicable to mortgage rates as the central bank
reiterated that property tightening measures would
stay in place.
By cutting the lending rate more aggressively than
the deposit rate, and allowing a higher discount
against benchmark lending rates, the authority is
trying to lift private sector investment demand
amid the current economic downturn.
The next steps
In September the State Council approved the 12th
Five-year Plan for Financial Sector Development
and Reform, jointly formulated by the PBoC, and
other key regulators. According to the plan,
market-based interest rate reform will progress
during the 12thFive-year Plan (2011-15). We
expect to see the following measures:
Further expansion of the floating band for
lending and deposit rates.
The number of lending rates categories under
regulation to fall from five to three and finally
to only one the benchmark lending rate.
The reduction of regulated deposit interest
rate categories from seven to five or fewer.
The long-term deposit rate is likely to be
liberalised first and the demand deposit rate,
which accounts for about 50% of total
liabilities in the banking system, last.
Eventually, the ceiling on the interest rate for
deposits will be removed, letting bank rates
float freely.
ConclusionInterest rate liberalisation lies at the heart of
Chinas financial reforms. Given the latest move
on 6 July, we expect the process to accelerate
along with reforms in other areas such as the
RMB exchange rate and capital account
liberalisation. We expect the full liberalisation of
interest rates to be completed within three years.
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Table 3.6. Interest rate liberalisation milestones in China
Category Year Event
Money market interest rate and bond marketinterest rates
1996 PBoC abolishes upper limit on inter-bank lending rates.1996 MoF adopts interest rate and yield bidding in treasury bond
issuance (exchange platform).1997 Liberalised repo rates in interbank markets.1999 MoF issues treasury bonds in the interbank market for the first
time.Lending rates 1998 Upside floating limit for SMEs expanded from 10% to 20%;
lending rate upper limit for rural credit units increased from40% to 50%, while limit for bid enterprises unchanged at 10%.
2003 Pilot scheme for reforming credit unit launched. Upper limit oflending rates for rural credit units included in the schemeexpanded to 200%.
2004 Removed ceiling for all lending rates, except interest rates forhousing mortgage loans, and credit units for urban and ruralareas (upper limits were increased to 230%).
2012 Lending rate floor lowered from 90% to 70% of benchmark.Deposit rates 1999 PBoC allowed negotiated wholesale deposits for insurance
company clients.2000 FX lending rates fully liberalised; deposit rates freed for
USD3m deposits2003 PBoC expands number of institutions that can apply to
negotiate wholesale deposits.2004 Floor for all deposit rates removed.2004 All FX deposit rates with maturity above 1-year liberalised2012 Deposit rate ceiling was expanded to 110% of benchmark.
Source: PBoC, HSBC
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Banks face big challenges
Chinas companies are going global. Faced with
tougher competition in domestic markets and slow
growth in the developed world, they are exploring
new markets, acquiring advanced technology to
sharpen their competitiveness and securing much-
needed raw materials.
The result has been a spectacular rise in Chinas
overseas direct investment (ODI) since 2002, when
the government encouraged businesses to go out.
China is now the worlds sixth biggest source of
ODI; its non-financial ODI1totalled USD68bn in
2011 and this figure is likely to double in the
coming 3-5 years. By 2011, there were over 13,500
Chinese companies and institutions making ODI inmore than 18,000 foreign companies across 177
countries and regions.
1There are two categories of China ODI: financial and
non-financial. The former refers to domestic financial
institutions investment in overseas financial
institutions; the latter refers to domestic non-financial
institutions investment in overseas non-financial
institutions.
This has important implications for Chinas
banks. As more Chinese enterprises extend their
global reach they will need an increasingly wide
range of sophisticated financial services. The
banks need to follow in the footsteps of their
clients. Chinese enterprises now have investmentsin more than 170 countries but the focus of the
countrys banks remains overwhelmingly
domestic in terms of networks, assets, business
models and human capital. The large state banks
will have to raise their game if they want to keep
pace with this surge of overseas investment.
Going global
Chinas ODI is set to double in the next 3-5 years
as Chinese companies venture overseas to acquire natural
resources, markets and technology
The firms will require sophisticated financial services; domestic
banks need to raise their game if they want to keep their business
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Domestic financing alone will no longer be able
to meet the increasing funding needs of these
adventurous Chinese companies. More cross-
border funding will be needed and credit could be
much cheaper on international markets and incurrencies such as the USD. The domestic banks,
long used to funding the big state-owned
companies, lack experience on the global banking
stage and will find it difficult to provide all the
services these companies need.
For example, demand for the following cross-
border banking products will increase:
M&A advice: According to Dealogic, China
leads M&A activity in Asia, representingnearly 7% of global M&A over the past three
years. In 2011, 37% of Chinas ODI flows
went to M&A.
Bank loans and debt issuance in
offshore markets.
Transaction banking for payments and cash
management, trade finance, supply chain and
securities services.
FX risk management: The increasing global
presence of Chinese companies implies rising
demand for currency settlement and risk
management. This demand will be
strengthened as RMB internationalisation
gathers pace; eventually it will be cross-
traded against most other global currencies.
Playing catch-up
Chinas banks are still very much domestic
businesses. While this was helpful during the
Chart 4.1 Chinas outward direct investment
0
10
20
30
40
50
60
70
80
1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011
(USD bn)
0
1
2
3
4
5
6
China's annual ODI flows (Lhs) China's annual ODI flows as % of world total(Rhs)
Source: UNC