Chinese regulators took a big step towards a fully-liberalised bond market this week, when they finally approved the launch of a Bond Connect scheme that will allow international investors access to onshore renminbi debt. That has been greeted with excitement, with analysts now predicting Chinese bonds being added to a variety of global indices, and a huge inflow of funds as a result.
But investors should pause for thought before they get too excited about their new access to China’s bond market. There is still plenty to fear about a market that still operates in ways that defy international standards.
There could be few better examples than the recent woes of Hongye Chemical Group, a privately-owned company based in the eastern Shandong province. The company was forced to suspend trading of its onshore renminbi bonds because of uncertainty over its operating performance, but after the suspension it emerged that some of its deals had been guaranteed by an unlikely ally.
Shandong Yuhuang Chemical Co, another private company from the same area with no apparent links to Hongye, had guaranteed Rmb1.35bn ($198.9m) of Hongye’s bonds and loans. It is potentially on the hook should Hongye default, no doubt a surprise to investors who may have naturally assumed that a chemical company would not morph into a credit guarantor overnight.
Perhaps more damning is that the situation does not appear to be an isolated case. For one thing, Hongye has similarly guaranteed some of Yuhuang Chemical’s notes — and analysts believe there are numerous other cross-guarantees in Shandong and other provinces linking firms in potentially dangerous ways.
This would be almost tolerable if China had a vibrant domestic rating sector, but it doesn’t. Onshore agencies have a reputation for doling out investment grade status to issuers without a second thought. Nor does their emphasis on government support reassure global investors who are increasingly worried about the government letting domestic firms fail.
There is a good chance that foreign investors will help improve both problems. Foreign demand for Yuhuang Chemical’s debut dollar bond in March cast a light on its issues at home. International rating agencies look set to play a great role in rating local bonds, after the People’s Bank of China said this week it would allow foreign ratings agencies to assess the credit risks of domestic debt.
That move was indicative of the wider strengths of China’s regulators. They have done an admirable job over the last few years, overcoming a tendency towards in-fighting to announce a raft of truly significant measures, including Bond Connect itself. Given the country’s explosive growth over the last three decades, it is little wonder its capital markets will suffer from teething problems.
But this does not hide the fact that China’s domestic bond market still has serious shortcomings. Investors tempted to jump into the market should do so with their eyes wide open. The opportunities are rife — but so are the risks.