China has the world's second largest bond market, and most of this paper is issued locally, underwritten locally, and held locally by banks and other institutional investors. As China's financial markets open wider, foreign financial institutions (FFIs) will be competing for roles in this previously closed ecosystem.

S&P Global believes the issue is not about getting in, it is about what to do afterwards. Jumping into China's enormous bond market, these FFIs will have to contend with its unique set of characteristics. They face a landscape that is dynamic and still-evolving, with fast changing rules, unfamiliar local practices, and different transparency and governance standards.

Nonetheless, we believe foreign investor holdings of Chinese domestic bonds, now worth roughly US$650 billion, has the potential to expand to US$4 trillion-US$5 trillion by 2030. Drivers include the size of the bond market, regulatory openings and yield differentials, and finally the diversification offered by the market's low correlation with other global assets (see "China's Bond Market--The Last Great Frontier," published on RatingsDirect on April 14, 2021).

In this second part of our cross-divisional series on China's domestic bond market, we look more closely at what this opening means for foreign participants. These firms will increasingly be owning domestic bonds, and seeking greater roles in the market as underwriters, distributors or marketers of wealth management products backed by bonds. We think their presence could help with reforms and advance the market's evolution.

Entering China is a big institutional commitment. Its domestic bond market has more than 6,000 issuers, most of whom are unfamiliar and less transparent to foreign investors. This alone would require a weighty investment to participate and understand this market. Added to that are fairly high hurdles in adjusting to the country's regulatory and governance issues. The market is improving as it internationalizes, but local practices will take time to change, and will pose risks to foreign participants in the meantime.

No Special Highway For Foreigners

Foreign-owned players are taking advantage of lower entry barriers to push deeper into China, in many cases dropping local partners in the process (see "How The Trade Deal Will Reshape Chinese Financial Services," Jan. 22, 2020).

With caps lifted, global banks, insurers and asset management companies are seeking greater control of their operations (see appendix for a list of FFIs expanding their presence in China since January 2020). However an expanded license to operate domestically does not by itself unlock FFIs' international advantages.

So far, foreign institutions play a small role in bringing deals to market. Foreign securities firms, for example, have a market share of about 1% in underwriting domestic bond deals. As fixed income indices increase their allocation to China's growing bond market, we expect securities firms to further strengthen debt capital market and sell-side investment banking capabilities.

Chart 1

Foreign underwriters have limited competitive advantages against their local rivals. Local competitors have wide networks, and top players have been strengthening their market positions under the backdrop of lower fee levels in favor of securing long-established client relationships. On top of this, securities firms must also compete with banks, which often maintain several touchpoints with clients in the subject of debt.

On the buy side, foreign investors may continue to struggle with local disclosure and risk pricing practices. A move to fundamentals-driven pricing may help, but it could take substantial time for these changes to take root.

Whether acting as investors, distributors or marketers of bond-backed funds, FFIs will need to balance participation with evolving market risks in China while meeting regulatory and risk management demands of their home jurisdictions. This balancing act could make the local learning curve even harder to climb, but it may also allow FFIs to leverage their deeper international experience in managing market and regulatory risks as China's domestic bond market becomes more regulated and market-driven.

Bond Markets Driven By Local Characteristics

Every country has governance and transparency issues. China is certainly no exception. Its vast market size, product and service innovation, mix of state controls and commercial enterprise, and own approach to doing things have resulted in a financial landscape that is complex, vibrant and evolving quickly.

The bond market is an exemplar of China's uniqueness, given the majority of bonds are issued on the interbank market. Elsewhere, interbank markets typically serve to even out short-term liquidity surpluses and shortages among banks. In China, the interbank market patches in non-bank financial institutions and certain corporates.

The interbank bond market is overseen by the central bank, while the China Securities Regulatory Commission (CSRC) oversees bonds issued and traded on the exchanges. This set-up may require guidance from both regulators on issues that extend to both markets; for example, how the Securities Law is applied in the interbank and the exchange markets.

Following multiple regulators across multiple markets is a challenge in itself. This is further complicated by the evolving nature of China's bond market, where new rules can be implemented very quickly and sometimes announced overnight without consultation.

Upgrading the regulatory framework requires the introduction of more effective rules. More are likely to come as the government pushes to improve the functioning of the country's bond market. FFIs that can anticipate likely regulatory changes, or implement new standards quickly, will be in a better position to compete. Increasing coordination in recent regulatory actions will also help (see tables 2 and 3), as it reinforces consistency and predictability for all market participants.

Chart 2

Policy shifts challenge visibility

Participating in China's bond markets almost always involves a read of the shifting policies. This issue is particularly prominent in the off-budget local government borrowings or loosely termed local-government financing vehicles (LGFVs), a market segment most affected by the government's stimulus policies.

LGFVs sprouted up to meet legitimate needs. In the absence of a framework for municipal bonds (introduced only six years ago under the new budget rules), local governments adopted a market-based solution: They incorporated financing vehicles, which then borrowed, including issuing bonds that were assumed to be supported by the local government. The debt raised was considered as off-budget to local governments.

As LGFV financing remains critical to local infrastructure development and is directly affected by stimulus policies and China's economic conditions, issuance activities blow hot and cold. Last year the government tolerated LGFV issuance growth to help boost investments in the face of a pandemic, but we believe this is temporary. Policymakers are already shifting back to the long-term trend of tightening LGFV borrowing. This is consistent with the recent "traffic light" system reportedly being contemplated to control leverage levels.

The absence of official announcements on important policy updates such as this challenges visibility in China's bond market. That said, rules-based systems such as the "traffic lights" for local governments and the "three red lines" for property developers can provide more transparency if progress of implementations are communicated effectively. While the growing pains of developing and implementing such rules could last for some time, the effort should bear fruit over the longer term.

Chart 3

Invalid credit enhancements

Historically, debt issued by most SOEs was largely priced with government support expectations. We believe, however, some weaker local governments are becoming more selective in supporting their SOEs under stress scenarios.

Invalid credit enhancements by the state add to the complexity of evaluating any support. The enforceability of certain credit enhancements remains uncertain. For example, Article 5 of the Interpretation of the Supreme People's Court on the Application of the Guarantee System released in late 2020 continues to invalidate any guarantee provided by an organ of the state [1].

Market players face penalties if they contravene the rules against providing finance to LGFVs largely based on guarantees or commitment by local governments. A number of financial institutions have been fined for accepting guarantees or commitments from local governments that were deemed to be a violation of regulations. Last year, China Minsheng Banking Corp. Ltd. was fined Chinese renminbi (RMB) 107 million for 30 violations, and China Guangfa Bank was fined RMB2 million for 21 violations, and in both cases, some of the violations related to requesting and accepting guarantees or commitments from local governments in their provision of financing services.

These and other ineffective credit enhancements hurt lenders and the overall credit risk profile of a bond issuer. Waning confidence from creditors could make refinancing more burdensome and costly, and these pressures are being reflected in China's rising default rates (see "China Defaults Flag Provincial Risks," March 11, 2021). Continued regulatory actions against invalid enhancements should reduce their occurrence and help build investor comfort with valid credit structures.

Tackling Reporting and Documentation Risks

China's rapid growth has allowed market practices to spring up ahead of the regulatory infrastructure. This flexibility has helped meet financing needs and test various financial instruments. Unsurprisingly, fast-growing markets may also create risks relating to documentation and reported information, which can range from regulatory evasion (see appendix) to fraud.

Government push for market integrity

Fraudulent and misleading reporting are hard to detect, and high-profile incidents can harm market confidence. This is an ongoing battle for Chinese regulators and financial institutions.

With the capital market recently moving to a registration system from an approval system, the emphasis is increasingly on information disclosure and market discipline. Accompanying this framework, rules are likely to be further refined and wrongdoers face increasing penalties.

In April 2021, the China Securities Regulatory Commission released a circular summarizing its annual investigations on financial statement fraud of listed companies: including inflated earnings, fake contracts, invoices and other documents. This follows circulars on integrity violations on certain securities funds, and internal controls issues found at audit and valuation companies earlier in the year. Rules around behavioral integrity have stepped up in recent years with the securities regulator also putting out related ordinances on securities and futures businesses.

Financial institutions look to improve controls

For Chinese banks and non-bank financial institutions, fraudulent documentation, such as fake stamps and falsified bank bills, have been a challenge over recent years (see "Ineffective Risk Governance Could Hurt China's Bond Market," Jan. 12, 2017).

Some cases can involve multiple types of institutions such as the landmark case of high yielding bonds issued privately by Chinese phone maker, Cosun Group.

While internal controls have improved, efforts are ongoing, as these types of transactions are difficult for banks and financial institutions to catch, and even harder for accountants to identify.

Regulatory response holds the key

We see the heightened scrutiny on these activities as positive for China's bond market. Such cases occur across all jurisdictions, but the regulatory response may differ by country. The government's push for market integrity and reliable reporting in China will improve transparency and help build investor confidence over time. Greater efforts by lenders to reduce such occurrences will also deliver similar benefits, in our view

Market Practices to Navigate

Direct and indirect self-subscription of bonds

The practice typically involves the issuer or a related party to the issuer purchasing a portion of the bonds through an asset management product, thereby inflating the deal size and potentially lowering the cost of funding.

This may mislead investors on the actual deal size and raise associated risks, including potential loss. As these transactions lack disclosure, they exacerbate transparency risks in the market.

Late last year, the National Association of Financial Market Institution Investors (NAFMII) banned such behavior and fined certain financial institutions (see "Regulatory Action Has Limited Financial Implications For Haitong Securities," April 1, 2021).

While it may take time to fully root out such practices, heightened scrutiny by NAFMII and other regulators should help, as should improving controls and risk management among market participants.

Informal hard underwriting and low fees

Bond market underwriting is very competitive in China, and fees have been on the decline. Banks dominate this space. Securities firms also crowd this market. In terms of the fee structure, for some issuers seen as very high in credit-quality, the fees could be as low as a few basis points. The fees typically increase with credit risk premium, as credits seen as riskier are also more difficult to sell, particularly with rising bond defaults as the ongoing backdrop.

Committed underwriting is uncommon in the Chinese bond market. Having said this, informal agreements do sometimes exist. For example, high-grade issuers unwilling to pay high prices may use their negotiating power to push for such a deal, which can help lower prices for other borrowings. Other motivations include the policy push for more direct financing.

In addition, bond positions may allow holders to avert rules pertaining to certain sector loan concentrations and limits, and more easily convert its loan-like wealth management balances into NAV products ("China Banks May Still Have RMB3 Trillion In Shadow Assets By Year-End Deadline," April 26, 2021). Interestingly, a reasonable number of bonds have only one applicant and one valid purchaser, which may be connected to such informal agreements.

Regulatory Response To Improve Market Discipline

As part of the opening of its bond markets, the Chinese government has been pushing for enhanced regulatory frameworks that improve market discipline.

These efforts were accelerated by prominent and unexpected defaults such as Yongcheng Coal & Electricity Holdings Group (Yongmei; see table 2 in appendix). Other high-profile cases, such as Kangde Xin Composite Material Group Co. Ltd. and Kangmei Pharmaceutical Co. Ltd. have also brought a range of regulatory responses and penalties on market participants.

These sanctions were imposed by a range of relevant regulators, including the Shanghai and Shenzhen stock exchanges, the central bank (PBOC), the CSRC, and the NAFMII, indicating a broad-based and coordinated regulatory response.

Penalties include three to 12 month bans on the offending market participant's business lines--e.g. bond underwriting and advisory, rating services, auditing services. They also include monetary fines and compensation to bond holders.

On the issuer side (see table 3), these regulators have handed out disciplinary actions on offending issuers, for actions ranging from inadequate disclosure, lack of timely notification of major insolvency events, improper asset transfers prior to defaults, change in use of bond proceeds, and delayed financial reporting. The severity of these penalties ranges from warning, to public censure, to ban from bond issuance. These actions reflect the recognition that shortfalls are occurring among both market participants and bond issuers, and associated inadequacies need to be addressed on both sides for the proper functioning of the market.

We expect these penalties to be escalated and broadened as the regulatory will to institute market discipline deepens and bears fruit. For FFIs, this will make the landscape easier to navigate and risks more manageable over time.

Transparency Will Boost Foreign Participation

Governance and transparency issues can engulf even the largest companies. A recent example is the centrally owned SOE, China Huarong Asset Management, which set off market jitters when it announced a delay of its results on March 31, 2021, the reporting deadline. The distressed asset manager has had governance and transparency issues for years, and has been fined in the past, including last year, for financial misconduct.

That a relevant transaction can hold up a major SOE's results is, on one level, a reminder that checks and balances are evolving, and oversight is strengthening. Yet critical gaps remain. Market practices still develop ahead of rules and regulations on governance. While large market size, low correlation and real yield differentials make Chinese bonds attractive to foreigners, opportunities also come with risks. Authorities in China are forcefully addressing governance and transparency issues. Although the market is evolving quickly as a result, this battle could be drawn out over several years.

Unaddressed governance and transparency issues can reduce investment appetite in China and undermine foreign participation. However, continued regulatory efforts could mitigate associated risks and build investor confidence over time. The government's recent actions indicate that the balance is tipping to the latter, even if the horizon remains long and the work remains challenging.

Editor: Cathy Holcombe

Digital Design: Halie Mennen

Notes

[1] According to the State Council website: "The state organs of the People's Republic of China include the National People's Congress, the President, the State Council, the Central Military Commission, local people's congresses and local people's governments at various levels, organs of self-government in national autonomous regions, the people's courts and the people's procuratorates."

Appendix

Table 1

Chart 4

Table 2

Table 3

Related Research

• China Banks May Still Have RMB3 Trillion In Shadow Assets By Year-End Deadline, April 26, 2021
• Huarong Flags China Transparency And State Support Risks, April 21, 2021
• China's Bond Market--The Last Great Frontier, April 14, 2021
• Regulatory Action Has Limited Financial Implications For Haitong Securities, April 1, 2021
• China Defaults Flag Provincial Risks, March 11, 2021
• China Insurance 2021: Balancing Growth With Governance, Feb. 2, 2021
• How The Trade Deal Will Reshape Chinese Financial Services, Jan. 22, 2020
• No Hiding Off-Budget Risk For China's Local Governments, Dec. 2, 2020
• China Defaults: What To Expect When, Dec. 1, 2020

• Ineffective Risk Governance Could Hurt China's Bond Market, Jan. 12, 2017