The opening of the corporate bond market is good news for many reasons. The most important reason is that people living in Beijing whose only real professional experience is in the primary and secondary international bond markets will soon enough find great job opportunities that won't require them to leave mainland China. As a member of this group, I can only applaud the foresight of the financial authorities.
But there are other reasons why this is good news. Chinese companies rely excessively on the banking system for new financing -- between 95% and 97% of new financing comes from banks, depending on which period you measure.
This is a problem because it means that the Chinese economy is hostage to adverse developments in the banking system. Given the huge (and probably growing) amounts of non-performing loans, the rigid and opaque governance structure, weak risk management, and lack of credit experience, it doesn't take much to imagine ways in which the system could seize up and contract.
As in Japan in the 1990s -- except probably to an even greater extent -- a contraction in China's banking system would immediately be transmitted into the real economy by the inability of companies, especially vibrant, young companies, to obtain financing. The consequences of a banking crisis in China, even a small one, would be pretty awful in my opinion.
The more independently-operating moving parts a financial system has, the better it is able to withstand adverse shocks. This is one of the great, and not enough acknowledged, strengths of the US financial system. When one part of it breaks down, another part almost immediately expands to replace its financing function, and so the transmission into the real economy is broken -- remember how the MBS market grew exactly when S&Ls were going under, or how the junk bond market exploded just as money center banks were reeling from the energy and LDC shocks? These were not a coincidences.
By the way this is also, perhaps, a reason to applaud the existence of informal and illegal banks in China -- to the extent that their business is uncorrelated to overall conditions in the Chinese banking system (although it is not clear that they are), the more active they are the more flexible China's financial system is. This flexibility is extremely important, and a functioning corporate bond market will diversify corporate funding in a way that will provide flexibility and so limit the impact of a banking contraction.
A corporate bond market brings other advantages. The lending decision made by Chinese banks are, often enough, driven not by economic considerations but by political ones (not to mention considerations of what economists politely call "rent seeking"). This is unlikely to change for quite a long time, if ever, and it goes a long way in explaining why the capital allocation mechanism -- one of the more, if not the most, important functions of a financial system -- works so poorly in China.
A functioning bond market would presumably do a better job of allocating capital because the management structure and the mark-to-market requirements would force fund managers to behave differently that loan managers. This can only help China achieve more sustainable long-term growth.
There are things to worry about however. One impact of a rapidly developing bond market is that money will have to be diverted from the banking system as part of the disintermediation process. Another would be a migration of better credits from the banking system to the corporate bond markets. Declining liquidity and deteriorating loan portfolios are exactly the opposite of what the banks need.
But it makes sense to put all of this in context. Let us assume that right now that bond and equity markets together account for 5% of total financing, and further assume that bond market financing grows at three times the rate of bank lending and equity issuance. After five years, if we assume that loans grow at anywhere from 10% to 20% annually (they are currently growing at over 20%, but must slow down), bond markets will still only account for 5% to 8% of total new financing. This is a good thing, of course, but it will be many years before bond markets really matter.
Michael Pettis is a professor at Peking University's Guanghua School of Management, where he specializes in Chinese financial markets. He has also taught, from 2002 to 2004, at Tsinghua University’s School of Economics and Management and, from 1992 to 2001, at Columbia University’s Graduate School of Business. He is a member of the board of directors of ABC-CA Fund Management Co., a Sino-French joint venture based in Shanghai.
Pettis has worked on Wall Street in trading, capital markets, and corporate finance since 1987, when he joined the Sovereign Debt trading team at Manufacturers Hanover (now JP Morgan). Most recently, from 1996 to 2001, Pettis worked at Bear Stearns, where he was Managing Director-Principal heading the Latin American Capital Markets and the Liability Management groups. He has also worked as a partner in a merchant banking boutique that specialized in securitizing Latin American assets and at Credit Suisse First Boston, where he headed the emerging markets trading team. Besides trading and capital markets, Pettis has been involved in sovereign advisory work, including for the Mexican government on the privatization of its banking system, the Republic of Macedonia on the restructuring of its international bank debt, and the South Korean Ministry of Finance on the restructuring of the country’s commercial bank debt.
Pettis is a member of the Institute of Latin American Studies Advisory Board at Columbia University as well as the Dean’s Advisory Board at the School of Public and International Affairs. He is the author of several books, including The Volatility Machine: Emerging Economies and the Threat of Financial Collapse (Oxford University Press, 2001). He received an MBA in Finance in 1984 and an MIA in Development Economics in 1981, both from Columbia University.
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Comments (1) for "Corporate bonds (2)"
October, 2007
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