China's bond market: Running on demand

Offshore market

We think this year offshore RMB bond market will softly recover. Two reasons support our view:

First, RMB’s exchange rate has recently become stable. Since last November when RMB was approved by the International Monetary Fund to join its Special Drawing Rights (SDR) basket as a fifth reserve currency, joining the dollar, euro, pound sterling and yen, many investors have gradually build their own RMB asset pool. For the past 12 months, offshore RMB bonds were mainly issued by foreign entities. Owing to low interest rate environment in onshore RMB bond market, most Chinese issuers focused on issuing bonds in onshore market and did not have much issuance activities in offshore RMB bond market. As a result, offshore RMB bond issuance has experienced negative year-on-year growth since Q3 2015. Since the beginning of this year, the default events in onshore bond market have widened the interest rate spread. Consequently, the cost advantage in onshore market for some issuers has faded out. Some Chinese issuers have begun to reconsider the offshore bond market to diversify their funding sources and investor base.

Second, Belt and Road Initiative would definitely bolster more RMB bond issuances to fund the related projects. And in the short term, the offshore market is still the main driving force behind the internationalization of RMB. While previously Hong Kong accounted for lion’s share, Shanghai Free Trade Zone could gradually catch up pending the launch of pilot RMB bond issuance to offshore investors.

The total outstanding volume of offshore RMB bond market is still relatively small, amounting to RMB559 billion as at the end of March 2016. So even at a faster growth rate it can hardly be comparable to the volume onshore RMB bond market with outstanding bonds totaling over RMB52.6 trillion at end of March 2016. With the further opening of domestic capital market, China may no longer need offshore RMB market any more, although that might take four or five years to happen.

(2)Recently an interview with an “authoritative insider” who claimed that the Chinese economy is likely to follow L-shaped path rather than U-shaped or V-shaped generated lots of attention. How do you interpret the view and its influences on bond market?

We can see authority’s firm determination to carry out structural reform. The government needs to maintain balance between reform and stability. Saying that the economic growth would be L-shape means government would bear short-term pain, allowing the market to fluctuate at this stage, in order to solve some long-term problems.

It means bond pricing would reflect more closely the level of risks, instead of unbiased expectation of government intervention to support the market and individual issuers. Because the authorities have already made it clear that they can afford to let defaults happen in SOEs, there are both opportunities and challenges. The companies with relatively weak fundamentals in overcapacity industries may be faced with even more tough situations. On the other hand, some emerging industries should seize the chance as supportive polices and resources that used to go to traditional industries could be available for them now.