Sure A Not

As Chinese tech equities rally, tensions building up in the US$20 trillion bond market risk pulling the rug out from under the sudden rush of bullish stock market sentiment.

China’s Big Tech shares are surging after Premier Li Qiang signaled a sharper pivot away from regulatory crackdowns toward championing the private sector.

Just days after letting Jack Ma’s Ant Group off with a nearly US$1 billion fine, Beijing said it’s increasing support for Tencent and other top tech platforms to raise China’s innovative game.

On July 12, Li said President Xi Jinping’s government is stepping up efforts to normalize China’s regulatory environment. The goal, Li said, is to “reduce the costs of compliance and promote the healthy development of industry.”

Li said that “on the journey of building a modern socialist country, the platform economy has great potential.”

He told tech chieftains in the audience – including officials from Alibaba Group, TikTok owner ByteDance and food delivery group Meituan – to “push to increase their international competitiveness and dare to compete on the global stage.”

To analyst Kelvin Wong at OANDA, “the latest rhetoric from the top man of China’s State Council is likely to boost positive animal spirits, in the short term at least.”

But China faces a longer-term threat to positive sentiment now shining on Asia’s biggest economy: a bond market that’s still not ready for global prime time.

Credit market strains are spreading as two large property builders reneged on a combined US$608 million worth of bond payments. Meanwhile, top mainland banks are avoiding the purchase of local notes, including in the Shanghai free trade zone.

The inclusion of Chinese government bonds in top global bond indexes, including the FTSE Russell benchmark, has pulled giant tidal waves of capital China’s way.

This opening has been a game changer — offering myriad opportunities to build diversified and resilient portfolios via new asset classes to ride the nation’s development.

The trouble is, though, China’s bond market is underpinned by a developing economy with limited liquidity and hedging tools, a giant and opaque state sector, and a rudimentary credit-rating system that often obscures risk and enables the misallocation of capital.

For all of China’s promises, this makes it more of a buyer-beware market in 2023 than many investors expected. It was 10 years ago, after all, that Xi took power pledging to let market forces play the “decisive” role in financial reform decisions.

The split screens of the last two years tell the story. On one screen, China’s inclusion in major benchmarks is luring bond giants like BlackRock Inc.

On screen No 2, the crisis of confidence among creditors of China Evergrande Group offers a stark reminder of the mainland’s opacity and excesses.

The globe’s most indebted property developer owes them more than $120 billion, potentially posing system risks.

For the rest of 2023, analysts at HSBC Holdings and Goldman Sachs recently raised projections for defaults among junk-rated property bonds to about 30%.

“If property sales remain lackluster with a lack of stimulus from the authorities, we do not rule out the possibility of a further uplift in default rates,” says HSBC analyst Keith Chan.

Chairman Yu Liang at China Vanke Co, the nation’s second-largest developer by sales, says the real estate sector is looking “worse than expected.”

The property industry is “indeed seeing pressure in the short-term,” Yu says. The “real situation,” he concluded, “is a bit worse than what was expected.”

The magnitude of the risks has many economists perplexed about why the People’s Bank of China (PBOC) central bank isn’t acting more forcefully.

Recent “easing, which focused on developer financing, is far from enough to stabilize the sector,” says economist Larry Hu at Macquarie Group. “After all, credit risk for banks would remain elevated if the housing market stays weak.”

One reason: the yuan’s nearly 4% drop this year makes it harder for higher-indebted developers to make payments on US dollar-denominated debt.

The PBOC’s restraint also could mean government steps to stabilize the property sector are soon on the way.

“Looking ahead,” Hu notes, “expect to see more easing on the demand side, such as lowering the down payment ratio and easing purchase restrictions.”

The real challenge, though, is fixing the property sector, which can generate as much as one-third of gross domestic product (GDP) in good times.

Kate Jaquet, a portfolio manager at Seafarer Capital Partners, says that “beyond the importance of this sector to the overall health of the Chinese economy, another motivation for orderly restructurings of the many troubled property developers is the extensive and opaque web of their liabilities.

“Stakeholders in the restructuring process – roughly in order of payment preference – include contractors and suppliers, banks, homebuyers, wealth management product investors and, finally, bondholders.”

Jaquet adds that “there are also off-balance sheet liabilities and other hidden debts to consider. Investors, rightly concerned over the lack of disclosures, struggle to understand some of these off-balance sheet – and largely heretofore hidden – debts. These concerns are further compounded by property developers’ failure to file audited annual results with the relevant authorities.”

The bottom line, Jaquet says, is that “hasty or ham-fisted restructurings might require write-downs by holders of these lesser-understood obligations, which could have unforeseen consequences in other parts of the Chinese economy. It seems that China’s regulators know this and are taking a careful and measured approach to property sector restructurings, particularly the big ones.”

Considering the large role that property plays in China’s economy, “a great deal hangs in the balance with respect to restructuring in the property sector,” Jaquet says. “The details of how onshore and offshore creditors fare – in absolute terms, and relative to one another – matters a lot for the future health of China’s bond markets”

Jaquet says that “hopefully the restructurings will consider corporate governance and the rights of creditors. Lack of ready access to international capital markets will take a toll on this sector. While it is increasingly clear that the days of housing driving the Chinese economy are likely over, the big question is: where do the funds come from to keep the economy on an even keel?”

One ever-present time bomb: China’s $9 trillion-plus market in local-government financing vehicles (LGFVs) that opaquely finance everything from airports to power grids to roads and rarely raise enough to cover their obligations.

That requires bigger capital injections from municipalities that should be using the funds to build bigger social safety nets and invest in human capital.

China’s ongoing real estate crisis made matters worse. Cash flow pressures weighing on local governments have state-owned banking giants struggling to stave off a credit crunch. If China’s bond markets were more developed and robust, authorities would have more options to defuse blowups in credit markets.

The dearth of alternatives means that when, say, state pension entities sell off weaker bond holdings, it destabilizes the broader market. That, in turn, adds to the headwinds faced by LGFVs and property developers, causing new sentiment-killing feedback effects.

While offloading weaker bonds may help the state pension protect the value of its investments, it risks heightening market concerns about the health of LGFVs and developers at a time when Beijing is trying to restore confidence in the world’s second-largest economy.

Now, both LGFVs and developers are shortening the time intervals for extending credit and demanding higher borrowing costs.

“The most important variables impacting China’s economic growth over the next two years will be the success or failure of local government debt restructuring, and Beijing’s approach to the role of local government investment within China’s economy in the future,” analysts at Rhodium Group write in a new report. “A collapse in local government investment would be comparable to the economic impact of the crisis in the property market.”

All this has Beijing mulling fresh moves to support cash-strapped cities and counties around the nation. According to local press reports, this could entail green-lighting municipalities to boost bond issuance programs to finance the clearing away of hidden debt.

Reducing the prevalence of new LGFVs has never been more important. At the start of 2023, S&P Global Ratings estimated these schemes amounted to 40% of China’s non-financial corporate bond market.

The prevalence of LGFVs can be a major turnoff for foreign bond funds. Not only are they opaque and difficult to analyze, their fingerprints touch the operations of everything from commercial banks’ wealth management units to mutual funds to hedge funds to insurers to the gamut of securities companies.

Hence the urgent need for deeper bond markets. And, of course, for regulators in Beijing to avoid steps that spook global markets anew. Among recent missteps by Xi’s Community Party: this year’s clampdown on foreign consultancy firms on which global investors and multinational firms rely to navigate their way through China’s opaque companies and systems.

The move, supposedly part of a nationwide anti-espionage campaign, reduced the appetite for investment from overseas firms. When US Treasury Secretary Janet Yellen recently visited Beijing, the consultancy policy was among the examples of “non-market” practices and “coercive actions” against American firms her team highlighted.

Deeper debt markets would help sort out the cart-before-the-horse problem that afflicts China’s economy.

During the Xi era and before it, China too often believed that pulling in more foreign capital was a reform all its own. However, it’s been slower to strengthen China’s financial system to efficiently absorb those waves of overseas capital.

For example, China’s inclusion in the World Trade Organization in 2001 did less to recalibrate its growth engines than to remake the global economic system to its advantage.

The 2016 inclusion of the yuan in the International Monetary Fund’s “special drawing rights” didn’t stop Beijing from imposing capital controls or accelerate capital liberalization nearly as much as hoped.

In 2019, A-share stocks’ addition to the MSCI index didn’t suddenly make China’s financial system sounder, the government more transparent, companies more shareholder-friendly or the ginormous shadow-banking world any less of a menace.

Strengthening China Inc. requires significant heavy lifting to curb the dominance of state-owned enterprises, increase economic space for the private sector and eliminate the risk of dueling bubbles in debt, credit and assets.

The key now, says Li Yunze, head of the National Financial Regulatory Administration, is for vibrant debt capital markets to help catalyze growth of all sectors, but particularly those in the high-tech space — the realm Premier Li has been at least rhetorically elevating in recent months.

While it’s important Beijing ends the regulatory volatility of recent years, he adds, more efficient capital markets would accelerate China’s move upmarket.

One priority should be building a big and liquid mortgage-backed securities (MBS) market. The good news is that interest in securitized mortgage loans used to finance residential and commercial buildings is growing, particularly in the green space, says Fitch Ratings analyst Jingwei Jia.

This comes, Jia says, “as the Chinese government prioritizes construction of environmentally friendly buildings to meet its climate targets.”

As Jian Chen, an analyst at MSCI, notes, China’s residential MBS market is growing as global investors eye its relatively high yields and seek diversification options for fixed-income portfolios.

However, he adds, “attracting new foreign investment to Chinese RMBS may depend on improving credit ratings and transparency in data and pricing.”

Another positive sign could be the ways in which LGFVs may be pivoting to issuing more infrastructure real estate investment trusts (REITs). This, says analyst Sherry Zhao, also at Fitch, follows “the authorities’ latest reiteration of the significance of selling infrastructure assets to improve capital efficiency and reduce public-sector leverage.”

Zhao notes that “this is especially for infrastructure assets closely aligned with LGFVs’ public policy roles, such as transportation, public rental housing, urban utilities, and industrial parks, among others.”

When it comes to the direction of reform, the need for a deeper bond market must be goal No 1. The financial opening that Xi and Li claim to be pursuing suggests they are scaling back China’s command economy. This alone should reassure foreign investors.

But the opening China really needs is deeper capital markets, in particular more transparent debt markets. Boosting support for – and loans to – the property sector are fine for today. China coming into its own as a top and productive economy, though, requires a serious bonding experience.

Follow William Pesek on Twitter at @WilliamPesek

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