HSBC - China%E2%80%99s Big Bang

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By Qu Hongbin, Sun Junwei and Ma Xiaoping

As the West wobbles, Beijing eyes sweeping reforms in the next 3-5 years

Interest rates to be liberalised, the bond market to double in size...

...and the RMB to become convertible within five years

Disclosures and Disclaimer This report must be read with the disclosures and analyst

certifications in the Disclosure appendix, and with the Disclaimer, which forms part of it

Macro

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November 2012

Chinas Big BangNew leaders ready to revolutionise the financial system
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As the West wobbles, all eyes have now turned East to see what Chinas leaders will do to stimulate the

economy. While theres little doubt that policymakers will gear up both monetary and fiscal easing, likelyleading to a modest recovery in the coming quarters, focusing on short-term stimulus misses a far more

important trend a swathe of co-ordinated reforms which we believe will revolutionalise the countrys

financial system. In fact, there are clear signs that Chinas new leaders, who will take power in early

2013, will make speeding up reform top of their policy agenda in the coming years.

This chain reaction will change the trajectory of the institutions and policies that are all intertwined

banks, bonds, interest rates, the opening of the capital account and the convertibility of the RMB

triggering a wave of deregulation that could happen much faster than many people think. We think

interest rates will be liberalised, the bond market will double in size and the RMB will become

convertible within five years. These changes would not only make capital allocation more efficient,

boosting the private sector, but also provide the middle class with greater choice about where to put their

money so they can earn a higher return and therefore spend more. This should help rebalance growth

from investment to consumption and lift the potential growth rate in the coming years.

This report looks at how this process will unfold over the next three to five years. Reforming Chinas

financial system is unlikely to be a simple process. There will be bumps in the road and perhaps an

occasional diversion. But plenty of other countries have already gone down this route and we think

Beijings policymakers can learn from what was successful and avoid repeating some of the mistakes that

were made along the way.

Banks to bonds

The debt problems of local government financing vehicles reflect the pressing need for China to shift the

burden of distributing credit from banks to capital markets. The country has witnessed the largest and

fastest migration from the countryside to the cities in history, creating massive demand for investment in

railways, roads, bridges and other infrastructure projects related to urbanisation. Money is not an issue

given the country has a domestic savings rate above 50%, the highest in the world. Yet the absence of

long-term financing instruments means the projects have had to rely on bank loans for funding, resulting

in a big mismatch between the payback period of these projects and the maturities of bank loans.

To address this problem and meet future demand for funding urbanisation, Beijing is speeding up the

development of bond markets and other long-term financing instruments. Pilot programmes for municipaland high-yield bonds have been introduced and the issuance of corporate bonds is also picking up. Given

the estimated RMB20-30trn of urbanisation-driven infrastructure investment in the next 10 years and the

Summary


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12th Five-year Plans goal to lift the ratio of direct financing to 15%, we expect the expansion of

municipal and corporate bonds to double the size of the domestic bond markets in the coming five years.

However, some daunting challenges remain, such as the unification of the fragmented bond markets, the

establishment of a single set of regulations governing new issuances and the development of a stronger

institutional framework for the market. We believe that allowing sophisticated global institutions to

participate can help improve market efficiency. A wider, deeper bond market will likely give the banks

much more incentive to focus on financing small and medium-sized enterprises (SMEs) and consumers.

And a pilot reform programme in Wenzhou should also help explore new options for funding SMEs, the

life blood of Chinas economy; according to an industry body, SMEs account for 65% of GDP, 50% of

taxes and eight out of 10 jobs.

Liberalising interest rates

The latest move by the Peoples Bank of China (PBoC) to widen the floating band of both deposit and

lending rates while cutting interest rates is a positive surprise. We see this as an indication of Beijings

determination to push forward interest rate liberalisation in the coming years. Consensus on the need to

liberalise interest rates was reached many years ago, but reform was delayed by concerns that financial

institutions were not ready. Today, all the major state banks have been restructured and are more

commercially-driven and the non-state sector takes nearly 60% of total investment. The time is now ripe

to free interest rates, especially given the pressing need to deepen capital markets. The recent adjustment

to the ceiling for deposit and lending rates by the PBoC is the first step and more moves will likely followin the coming years. Meanwhile, we also expect the PBoC to gradually create a single benchmark in the

next three years, leaving all other rates freely determined by the market.

Renminbi internationalisation is taking off

Since Beijing introduced a pilot scheme to expand the role of the RMB in cross-border trade settlement

and capital flows in 2009, the momentum has been much stronger than expected. The proportion of

Chinas total trade settled in RMB has quadrupled, topping 11% in the first three quarters of 2012,

reflecting the pent-up demand for switching from issuing invoices in USD to RMB when trading with

China. In our view, this ratio is likely to reach 30% in the next three years. In volume terms, this would

make the RMB one of the top three global trade settlement currencies. This, of course, doesnt give theRMB the status of a real global and reserve currency, as this requires full convertibility. That said, seven

foreign reserve managers are starting to invest in RMB bonds and other assets, although the amount is

relatively small.

The currency is set to become fully convertible in five years

When it comes to capital account liberalisation China is likely to adopt a gradual approach. Yet Beijing is

now more confident than ever about speeding up the process, considering that: 1) Chinas trade balance is

back on an even keel (the current account-GDP ratio has fallen below 3%) and the RMB is now close to

its market equilibrium rate; 2) domestic financial reforms have already made progress and will likely gain

momentum in the coming years; and 3) the role of the RMB in cross-border trade and investment shouldcontinue to expand quickly. Further changes in the coming years are likely to include the further

expansion of the Qualified Foreign Institutional Investor (QFII) and the Qualified Domestic Institutional


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Investor (QDII) schemes, a gradual removal of limits on foreign currency purchases by both local and

foreign individuals and increased foreign access to domestic capital markets. Combined with Chinas

policy of promoting both foreign and outward direct investment, these moves will make the RMB fully

convertible within five years, in our view. Although certain restrictions on capital inflows will likely

remain, full RMB convertibility would take Chinas financial integration with global markets to a new

level and have a profound impact on both China and the world.

The challenges

The experiences of other countries show that the road to financial reform, especially capital account

liberalisation, tends to be a bumpy one. To stay on track and to avoid major distortions, China must get

the sequence of the reforms right, that is, to strengthen its domestic banking system, liberalise interest

rates and develop a functioning bond market before making the RMB convertible. Meanwhile, the

success of the financial reforms will also depend on Beijing pushing through changes in other areas,

including fiscal and legal reforms. As people in the investment world are well aware, the term Big

Bang refers to major reforms introduced in the UK in 1986 that transformed the countrys financial

services industry from a protected species into a global powerhouse. The increase in financial activity

completely altered the structure of the market. Now its China turn.


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China: Economic and financial reforms in the pipelineExchange rate reform Opening monopoly sectors to private investment

Why:As part of the plan to make the RMB a more international currencyChina has pledged to make the exchange rate more market-oriented. In April2012 it met this commitment by expanding the daily trading band against theUSD for the first time since 2007 to 1%, up from 0.5%.

Obstacles:Concerns that a widening of the trading band would increasespeculation about currency appreciation, triggering inflows of speculativecash, appear to be fading. Some areas of the government notably theMinistry of Commerce have opposed reforms that could lead to a strongerRMB, which undermines the competitiveness of Chinas exports.

Whats happening:With a wider trading band we can expect more two-wayvolatility, less consistent appreciation, and faster internationalisation of thecurrency. Total trade settled in RMB increased four-fold in 2011 to reachRMB2.1trn (USD330bn), about 9% of Chinas total trade last year.

Timeline:A managed-floating currency within five years.

Why:Allowing private firms to invest in the countrys railways, banking, energyand healthcare sectors will boost the economy. The potentially lucrativeservices sectors could help hard-pressed private firms shift from low-endindustries.

Obstacles:State industrial giants, which received the bulk of Beijingsmassive spending package during the 2008-09 global crisis, have longenjoyed favourable positions and they are reluctant to see more competition.

Whats happening:The State Council is making a fresh bid to open upsectors dominated by state giants.

Timeline:The NDRC, the main economic policy body, has pledged to publishdetails of its plan (called the New 36-Clauses) but how quickly reform will be

implemented remains uncertain.

Opening the capital account Bond market reform

Why:Liberalisation of Chinas capital account would give foreigners greateropportunity to invest in mainland capital markets and domestic investors theoption to invest overseas. Capital allocation would become more efficient asChinas financial institutions are forced to compete for funds with overseascounterparts. This would also increase pressure to introduce interest andexchange-rate reform, as large cross-border capital flows make control ofthese rates difficult to maintain.

Obstacles:The authorities believe that capital controls protected the Chineseeconomy from the volatile international capital flows that hit its Asianneighbours during the 1997-98 Asian financial crisis and again during the2008-09 global financial crisis.

Whats happening:The PBoC, Chinas central bank, this year released areport outlining a potential roadmap to capital account reform ending with fullconvertibility of the RMB.

Timeline:Gradual reforms over the next 3-5 years.

Why:A more developed bond market would increase the efficiency of capitalallocation. It would also help to reduce the current concentration of financialrisk in the banking system. The high-yield bond market and the private-placement SME bonds that Chinas securities regulator are promoting shouldwiden credit channels for small, private firms which struggle to get access tothe state-dominated financial system.

Obstacle:Bureaucratic turf battles have prevented the unification of China'stwo main bond markets and the establishment of a single set of regulationsgoverning new issuance.

Whats happening:Chinas bond market development is hindered by thefragmentation of the market. Different regulators oversee different types of

bonds, which also trade in different markets. However, a recentannouncement by the central bank indicated some progress towards greatercoordination among regulators.

Timeline:The private-placement SME bonds market was launched in June,but unification of the regulatory structure will take longer.

Interest-rate liberalisation Equity listings by overseas companies

Why:Phasing out government control of interest rates would enable marketforces to play a greater role in capital allocation, allowing capital to flow to themost dynamic sectors of the economy. This would also help shift the balanceof the economy towards consumption as higher bank deposit rates would givehouseholds more spending power, while higher lending rates would reduceexcess investment.

Obstacles:The big state-owned banks profit from the guaranteed spreadbetween lending and deposit rates. State industrial firms also benefit from

access to cheap capital. These groups are likely to oppose reform.Whats happening:Top central bank officials have said the time is ripe for

interest rate reform and that the government has a timeline forimplementation. Premier Wen Jiabao recently criticised monopoly profits bylarge banks. But no concrete measures have been announced.

Timeline:Within three years but reform is likely to be gradual.

Why:Shanghai's stock exchange is considering launching an internationalboard that will allow foreign companies and red-chip Chinese companies(those incorporated and listed overseas) to list and give Chinese investorsdirect access to foreign firms shares.

Obstacles:This is closely linked to capital-account and exchange-rate reform.Regulators are still working out which currency the shares would bedenominated in, and currency conversion restrictions would have to be revisedto enable foreign companies to transfer capital raised in China for use in other

countries.Whats happening:The regulator says it will launch the international board

when conditions mature but has given no timeline.

Timeline:1-2 years.


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Fiscal reform Financial and commodity derivatives

Why:A revised tax system would enable local governments to finance theirincreased social spending obligations healthcare, education, pensions, and low-cost housing without relying on land sales and financial help from the centralgovernment. A property valuation or transaction tax would also help to reduce over-investment in property. Allowing local governments to issue bonds directly wouldalso decrease the need to use heavily-indebted local government financing vehicles(LGFVs) to raise money.

Obstacles:The central government may be reluctant to cede revenue to localgovernments. Property developers and current homeowners oppose new propertytaxes, which could bring down the value of their assets.

Whats happening:Property-tax pilot schemes are under way in Shanghai andChongqing and may soon be expanded to Guangzhou and Nanjing. The cities ofShanghai and Shenzhen and the provinces of Guangdong and Zhejiang becamethe first local governments to issue local government bonds in late 2011, and the

Ministry of Finance expanded the quota for local-government bond issuance for2012 to RMB250bn (USD39.6bn).

Timeline:This year for expanded property tax trial and local government bonds;unknown for broader fiscal reform.

Why:China is considering launching new financial derivatives linked to theRMB exchange rate, foreign currencies, international bonds and Chinese bankinterest rates. Simulated trading of government-bond futures is under way onthe Shanghai-based China Financial Futures Exchange. Regulators have alsosaid they will gradually open up the countrys commodity exchanges to allowforeign investors to trade futures.

Obstacles:A government bond futures trading scandal in 1995 is still fresh inthe minds of many officials and traders. Such fears are supported by the factthat Chinas tightly controlled interest and exchange rates offer domesticfinancial institutions little experience in managing related risks.

Timeline:Individual products will be launched gradually.

Resource pricing, taxes Residence permit (Hukou) reform

Why:The NDRC has said it will accelerate reforms to its energy pricingsystem, which aims to make domestic fuel and gas prices closer in line withinternational rates. This would likely lead to more frequent changes in retailfuel and power prices. Senior NDRC officials said in March that Beijing will rollout tiered power pricing for residential customers by the first half of this year tocharge higher prices for heavy users.

Obstacles:Inflationary pressure could prompt authorities to hold off onintroducing reforms that would push up prices in the short term.

Timeline:Some changes are likely in the next few months.

Why: Since 2011 more than 50% of the population now lives in cities. The fullpotential of urbanisation will not be unlocked until migrants are allowed tosettle in cities permanently. The hukou system prevents people from gettingaccess to healthcare and schools for their children.

Obstacles: Chinas leaders fear that a sudden influx from the countryside intobig cities could undermine social stability and create slums.

Whats happening: The government is taking small steps to overhaul thesystem by launching pilot schemes in smaller cities.

Timeline: Unclear.

SourceReuters, Bloomberg, NDRC, HSBC.


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From banks to bonds 7

The worlds next big bondmarket 14

How to set interest rates free 22

Going global 30

The rise of the redback 37

A convertible RMB within fiveyears 44

Learning the lessons 52

Disclosure appendix 59

Disclaimer 60

Contents


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Chart 1.1 Fundraising in China {delete asterisk-Production}

0

2,000

4,000

6,000

8,000

10,000

12,000

2006 2007 2008 2009 2010 2011 2012*

(RMB bn)

0

20

40

60

80

Equity (Lhs)Bonds (Lhs)Loans (Lhs)Bonds as % of total financing (Rhs)

Source: CEIC, HSBC

Chart 1.2 Direct financing in China needs to develop

0

20

40

60

80

100

Equity Loans Bonds

(%)

China Korea

Source: CEIC, HSBC 2010-11

Chart 1.3. Loan growth and loans to GDP ratio

90

100

110

120

130

1998 2000 2002 2004 2006 2008 2010 2012f

(%)

0

5

10

15

20

25

30

35(%, yr)

Loan to GDP ratio (Lhs) Loan growth (Rhs)

Source: CEIC, HSBC

Bonding with bondsBeijing wants to significantly lift the share of

direct financing and actively promote the

development of the bond market, according to

the 12thFive-year Plan (2011-15). More

specifically, in the financial sectors 12thFive-

year Plan announced in September 2012, Beijing

wants direct financing to total at least 15% by

2015, up from 14% in 2011.

Recent policy initiatives suggest things are really

starting to move. In January the influential

National Financial Work Conference, held once

every five years, stressed the importance of

building a standardised, unified bond market (see

China: National Financial Work Conference hints

further easing and reform,8 January 2012).

Then, in April, the three bodies that oversee

different types of bonds the PBoC, the National

Development and Reform Commission (NDRC)and the China Securities Regulatory Commission

(CSRC) put together a scheme for a co-

ordinated corporate bond market, a big step

towards ending the fragmented way bonds are

regulated. We see this as a signal that Beijing is

serious about developing the bond market.

Indeed, Guo Shuqing, the head of the CSRC, told

the officialPeoples Dailynewspaper in June that

international experience shows that overreliance

on bank credit in a financial system can, under

certain circumstances, lead to systemic risk,

adding that the bond market, seriously lags

behind the demands of the real economy (source:

Bloomberg, 12 June).

Since June, corporate bond issuance has started to

accelerate in tandem with efforts to stabilise growth,

such as monetary easing and the approval of a wide

range of infrastructure projects. The average

monthly issuance of corporate bonds toppedRMB173bn by September, more than 50% higher

than the monthly average of RMB113.8bn in 2011.
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issue even more long-term construction bonds on

behalf of local governments, enabling them to repay

the loans they used to fund public work projects.

This would be easy to do as it does not require

any change in the fiscal arrangements between the

central and local governments. With the money

raised by the bonds, local government could either

finance the ongoing construction projects or repay

bank lending to avoid a default.

The central government would be able to issue

debt at a lower cost of funding than local

governments. Demand for these central

government bonds should not be an issue, given

1) the huge pool of funds sitting idle in individual

deposit saving accounts (RMB38trn); 2) demand

for this type of government debt from insurance

and mutual funds in China is rising.

More importantly, Beijing has allowed certain

prosperous local governments to issue their ownbonds to service existing debt and raise funds for

new projects. The obvious advantage of this

option is that each local governments debt will be

priced by the market according to its own specific

set of credit ratings, effectively imposing market

discipline on local governments.

We expect more progress on this front but

expanding the scheme to the whole nation would

require an amendment to Chinas budget law as

well as local governments adopting much higher

accounting standards, so it may take time. Clearer

delineation between local and central government

ownership rights of state assets is also needed.

The sale of state assets by local governments to

raise funds to repay loans could also help solve

the debt problem. Local governments still own

more than 20,000 state-owned enterprises (SOEs),

of which 70% are profitable. Local governments

also own toll roads, ports and other commerciallyvaluable assets. Selling these assets would help

them to repay their debts.

These sales are also necessary if local governments

are to shift their attention away from business

activities to public services an important objective

for government reforms in the next five years.

Public listing of local SOEs would be the best way

to do this, but the real challenge here is how to

manage the sales of these assets transparently.

A bigger bond market neededto finance urbanisation

The increasing lure of urban life also has major

implications for the bond market as more financing

is required by Chinas cities and towns. For the first

time in the countrys history, more people now live

in urban areas than in the countryside.

At the end of last year, 51.3% of the population

were city dwellers, up from 20% 30 years ago

when China was just starting to open up its

economy. This implies that an average of 10m

people have left the countryside each year, a trendthat is likely to keep accelerating as China catches

up with developed countries. As Chart 1.6 shows, it

may take at least another two to three decades for

Chinas urbanisation rate to match that of the US.

Chart 1.5. The rise and rise of urbanisation

0

10

20

30

40

50

60

1950 1960 1970 1980 1990 2000 2010

(%)

-0.5

0.0

0.5

1.0

1.5

Urban population as % of total (Left ax is)

Percentage points change ev ery 5 y ears (Right ax is)

Source: CEIC, HSBC


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Chart 1.6. Urbanisation: Following in the footsteps of the US

Rural population as % of total

0

20

40

60

80

100

1840 1860 1880 1910 1930 1950 1970 1990 2010

(%)1950 1970 1990 2010

US China (upper scale)

Source: US Census Bureau, CEIC, HSBC

This means huge demand for infrastructure

investment. If history is a guide, for every new

urban citizen migrating from the countryside

investment of at least RMB100,000 in urban

infrastructure is needed (source: the China

Development and Research Foundation, a

government think tank). If we assume that an

average of 15-20m people a year settle in cities, a

number consistent with the last 10 years, this will

require annual investment of RMB2-3trn per year

(taking into account modest inflation) in the next

decade, or around 4.3-6.4% of GDP in 2011.

So, how will this be financed? The bond market is

the best way to meet the needs of the

infrastructure boom because:

The funds that banks have available to lend are

limited by the 75% loan to deposit ratio andother regulatory requirements. A deep, liquid

bond market would be able to accommodate

financing on a much larger scale.

Long-term bonds are a much better way to

fund multi-year infrastructure projects than

bank loans as they remove the problem of

duration mismatches in the banking system.

They would also meet demand from

institutional investors like long-term debt

instruments.

The cost of lending is lower than bank loans.

The role of banks will changeAs the bond market develops and the financial

markets become more competitive, banks should

be prepared to shift their focus away from big

projects and SOEs to retail customers and SMEs.

For some, this has already started. It can be seen

by the increase in the percentage share of the

assets of small and medium-sized banks (SMBs)

within the banking system (Chart 1.7). SMBs are

doing more and more business with SMEs, a trend

that is likely to continue in the coming years as

the reform process accelerates.

Banks have also widened their range of services,

selling different types of wealth management

products, which are short-term investments that

offer customers better returns than deposits.

Chart 1.7. Small and medium-sized banks gaining marketshare

40

45

50

55

2003 2004 2005 2006 2007 2008 2009 2010 2011

(%)

Small and medium-sized banks' asset as % of total

Source: CEIC, HSBC

The Wenzhou experiment

Beijing has launched an important programme of

pilot reforms in Wenzhou, a city in Chinas eastern

Zhejiang province where many small businesses ran

into serious credit problems (see box). This city of

8m has a strong tradition of entrepreneurship, so it is

not surprising that private business represents a

remarkable 82% of the local economy. The aim of

the reforms is to standardise and regulate thedevelopment of private financing and small-scale

financial institutions. Local residents are also

being allowed to make overseas investments.


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According to local media, Wenzhous local

government has submitted a proposal to the State

Council to implement Beijings plan. It wants to

increase the number of micro-finance companies

that lend small amounts of money.

There are around 35 today and the plan is set up

another 30 next year and a further 30 in 2013,

taking the total to about 100, enough to cover

Wenzhou and neighbouring towns. At the same

time, local branches of commercial banks wouldset up special departments for small companies,

the reform of rural co-operative financial

institutions should be finished by the end of this

year and village and township banks and their

subsidiaries should cover every county by 2013.

The PBoC is also playing a role in the Wenzhou

experiment by measuring lending activity. Its

Wenzhou branch has started to record the

percentage of lending made by local private lending

institutions on a monthly basis. It is using data from

30 rural co-operatives, 28 micro-lending companies,

30 guarantee companies, 50 pawn shops (which

include property among the assets they lend cash

against) and other financial services institutions.

The ratio was 20.4% in September, or 5ppts lower

than the peak in August 2011, suggesting that

demand for loans has slowed, as is the case in the

rest of the country.

This type of financial deregulation is taking place

in other regions too. Huge cities such as

Shenzhen, Shanghai and Tianjin have introduced

similar reforms and smaller places such as Li Shui

in Zhejiang province have received permission to

press ahead with change. More will follow,

setting the stage for major changes in Chinas

financial landscape.


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Why Wenzhou is so differentSome say it is the mountainous terrain that has kept

the place isolated; others point to the areas distinctive

dialect. What ever the case, Wenzhou has always been

a bit different from the rest of the country.

For decades it has been known as a hotbed of

entrepreneurship and grey-market lending. The

citys thousands of small businesses make, amongst

many other things, most of the shoes, eyewear and

cigarette lighters produced in China. Its known as

one of the richest cities in the country.

But Wenzhou recently became famous for another

reason its private companies were starved of credit

by banks as the PBoC tightened monetary policy through three rate increases and six RRR hikes in 1H 2011.

This led to businesses turning increasingly to unregulated shadow banking channels. When the economy

slowed and interest payments piled up, many went broke, threatening the financial stability of the region

late last year.

That was when Beijing stepped in. Premier Wen Jiabao visited Wenzhou and said the city would be thetesting ground for breaking the monopoly of the big state banks, which will help cash-starved private

enterprises get timely access to capital. The pilot project that is just getting started may one day become a

cornerstone of nationwide financial sector reforms.

Wenzhous financial model is much closer to that of the southern province of Guangdong, the economic

powerhouse that neighbours Hong Kong, than the government-led, debt-driven Chongqing model that

attracted negative headlines earlier this year (see China Inside Out: The Guangdong way is Chinas

future,30 April 2012).

Wenzhou and Guangdongs economic model is moremarket-driven than Chongqings

Chongqing

Guangdong

Zhejiang

Wenzhou

Chongqing

Guangdong

Zhejiang

Wenzhou

Source: HSBC
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Ready for take-offFrom market regulation and product innovation,

to the scale of bond issuance and the growing

investor pool, it is clear that Chinas bond market

is moving into a new era. We expect its market

capitalisation to double in the next 3-5 years,

lifting it into the worlds top three bond markets.

Our confidence is based on the pace of recent

developments to deepen and broaden the market

and the growing need to fund Chinas rapidurbanisation, as millions of people continue to

move to the city from the countryside every year.

In the past there has been limited co-operation

between competing regulators but there has been

progress in a number of different areas, including:

The expansion of local government bond

issuance (the Ministry of Finance has issued

RMB250bn on behalf of local authorities this

year, up from RMB200bn in the previous

three years) and a pilot programme allowing

local governments to issue new municipal

bonds, with the option of longer maturities.

A regulatory scheme led by the PBoC toimprove co-ordination between the different

parts of the corporate bond market.

The rapid growth of credit bonds issued by

LGFVs (although Beijing is trying to make

sure this is kept under control).

The launch of private placement SME bonds

and the expected relaunch of Treasury

bond futures.

The opening up of the bond market to

overseas investors and granting quotas to

foreign central banks.

The need to play catch-up

Chinas bond market needs to catch up fast. The

worlds second-largest economy represents over

10% of world GDP, while the countrys outstanding

bonds represent 5% of the world total (3.6% if

policy bank bonds are excluded). The gap between

Chinas bond market and GDP is huge compared

with other large economies (Chart 2.1).

The worlds next big bondmarket

Chinas bond market has lagged behind the countrys spectacular

economic growthWith a wider range of products and a growing pool of investors, it

is set for rapid expansion

We expect market capitalisation to double in the next 3-5 years,

making it one of the worlds top three bond markets


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Chart 2.1 Chinas bond market needs to catch up

0

5

10

15

20

25

30

35

40

US JP FR GE CH BR UK

(As % of w orld total)

Bonds outstanding GDP

Source: ADB, World Bank, HSBC 2011 data. China bonds excl. policy bank bonds

Over the last three decades China has maintained

spectacular growth averaging 10%. Half of this is

driven by investment roads, rail, factories and

skyscrapers which runs at around 20% y-o-y in

nominal terms despite the recent slowdown.

Despite this the financial landscape remains

dominated by banks. Bond market capitalisation

accounted for 45% of GDP in 2011 (Chart 2.2),

less than half the outstanding loans to GDP ratio

(116%), down from 125% in 2010 when it was

inflated by the effects of the stimulus package.

Chart 2.2. Bond market cap dwarfed by bank lending

0

2040

60

80

100

120

140

2002 2004 2006 2008 2010 2012f

(%)

Bond market cap as % of GDP

Outstanding loans as % of GDP

Source: CEIC, HSBC estimates

Chinas bond market also lags its neighbours in

Asia. According to the Asian Development Bank,

the countrys bonds outstanding to GDP ratio

(44.8% in 2Q 2012) was 8.2ppts lower than the

average for emerging East Asia and more than

30ppts below Singapore, Malaysia and South Korea.

Chart 2.3. Chinas bond market lags Asian peers

0

50

100

150

200

VN ID PH CH EEA HK TH SG MA KR JP

(As % of GDP)

Gov ernment Corporate

Source: ADB, HSBC. EEA stands for emerging East Asia. Data as of 2Q 2012

The bond market is not only small but lacks

variety. It is dominated by treasury bonds and

other policy bonds and is light on local

government and corporate bonds. As of mid-

October 2012, 35% of total outstanding bonds

were financial bonds (mainly issued by policy

banks and state-owned banks), followed by

treasury bonds (30%), mid-term notes (11%) and

enterprise bonds (7%), see Chart 2.4. Put together,

government-backed bonds represent nearly 75%

of Chinas outstanding bonds.

Chart 2.4 Government-backed bonds dominate

0%

20%

40%

60%

80%

100%

VN JP PH ID TH CH EEA SG MA HK KR

Corporate Gov ernment

Source: ADB, HSBC. EEA stands for emerging East Asia. Data as of 2Q 2012


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Chart 2.5. A snapshot of China's bond market (outstanding)

PBoC bills

5%

CP

4%

Corporate

2%

Others

6%

Enterprise

7%

MTN

11%

Financial

35%

Treasury

30%

Source: Wind, HSBC. MTNs refers to mid-term notes; CP refers to commercial paper

Market structure

Chinas bond market has three segments: the

national interbank market, the exchange market

and the bank counters market. It has a centralised

trust and clearance system provided by China

Government Securities Depository Trust and

Clearing Company.

1)The interbank market handles over 90% of total

daily business. Established in 1997, this is also the

countrys largest over-the-counter (OTC) market.

Bond transactions are made through inquiry and

independent negotiations. As it is the most liquid

market, this allows the central bank to conduct

open market operations through central bank bills

and repos.

The interbank bond market has opened its door to

foreign banks on a trial basis, a key step towards

internationalising the RMB (see China: Onshore

RMB bond markets open up a crack,17 August

2010). Some 20 foreign institutions can now

invest in Chinas interbank bond market. These

include foreign central banks for example, the

Bank of Korea has a quota of USD3.2bn and the

Bank of Japan USD10bn.

In addition, Shanghais municipal government

aims to establish itself as global centre for RMBtrading, clearing and pricing by the end of the

12th Five- year Plan (2011-15). This means that

the expansion of the interbank market is likely to

be faster than expected.

2) The exchange market is open to various

(basically non-bank) investors on an automatic

matching trade system. Trading volume is limited

due to the lack of participation by banks. This

could change as commercial banks are to be

allowed to participate on a trial basis, according to

a joint circular by regulators.

3)Banks OTC market serves individual investors.

Treasury bonds (mainly certificate bonds and book-

entry bonds) are sold to individuals and companies.

There are four types of bonds: treasury bonds,

PBoC bills, financial bonds and credit bonds (see

Asia-Pacific Rates Guide 2012, 14 December 2011).

Treasury bonds, commonly referred to as

onshore Chinese government bonds (CGBs), are

issued by the Ministry of Finance (MoF) as the

governments main debt instrument. Maturities

typically range between 1-year and 10-year but

are increasingly available in longer-term tenors

(e.g. 15-, 20-, 30- and 50-year).

PBoC bills are issued by the PBoC to manage

liquidity and sterilise FX operations. Available

maturities range from 3 months to 3 years. Active

trading in PBoC bills makes it a useful benchmark

for money market rates.

Financial bonds are issued by financial

institutions and underwritten by banks and leading

securities firms. The main type of financial bonds

are policy bank bonds that are issued by three

policy banks backed by the government (China

Development Bank, Export-Import Bank of China

and Agricultural Development Bank of China) for

financing key national projects that are not

covered by the national budget.

Credit bonds in the interbank market includeenterprise bonds, commercial paper (CP),

medium-term notes (MTNs) and super and short-
http://www.research.hsbc.com/midas/Res/RDV?p=pdf&key=7yxQ9UAGYF&n=275799.PDFhttp://www.research.hsbc.com/midas/Res/RDV?p=pdf&key=7yxQ9UAGYF&n=275799.PDFhttp://www.research.hsbc.com/midas/Res/RDV?p=pdf&key=7yxQ9UAGYF&n=275799.PDFhttps://www.research.hsbc.com/midas/Res/RDV?p=pdf&key=n7T28t6yGk&n=315964.PDFhttps://www.research.hsbc.com/midas/Res/RDV?p=pdf&key=n7T28t6yGk&n=315964.PDFhttps://www.research.hsbc.com/midas/Res/RDV?p=pdf&key=n7T28t6yGk&n=315964.PDFhttp://www.research.hsbc.com/midas/Res/RDV?p=pdf&key=7yxQ9UAGYF&n=275799.PDFhttp://www.research.hsbc.com/midas/Res/RDV?p=pdf&key=7yxQ9UAGYF&n=275799.PDF


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term commercial paper (SCP). CP maturities are

typically 9-months and 1-year. Maturities of

MTNs vary according to business needs and

typically range between 2 and 10 years. Enterprise

bonds maturities range from 3 to 30 years. In

addition, since the end of 2010, Shanghai Clearing

House (SCH) also launched SCP with maturities

of less than 270-days. Long-dated bonds are held

mostly by insurance companies and liquidity is

limited. Only short-tenored credit bonds have

decent liquidity.

Table 2.1 Bond products in China

Type of bond Issuing entities

Treasury bonds Ministry of FinancePolicy bank financial bonds Policy banks, i.e., China

Development Bank, AgricultureDevelopment Bank, EXIM Bank

PBoC bills PBoCLocal government bonds Ministry of Finance on behalf of

local governmentsEnterprise bonds Unlisted enterprisesCorporate bonds Listed companiesCommercial paper and mid-term

note

Non-financial firms

Convertible bonds, bonds withwarrants

Listed companies

Source: HSBC

Local government financing

Chinas local governments are deeply in debt

RMB10.7trn (23% of 2011 GDP) by the latest

conservative estimates. How did they get into this

situation when the economy has been booming for

so long? Its a long story.

In the early 1990s, Beijing launched a major fiscal

reform programme aimed at centralising tax

revenue. This resulted in the central governments

share of total fiscal revenue rising from less than

30% in the early 1990s to more than 50%, at the

expense of local governments.

The problem is that local governments still

shoulder a large part of the burden of funding

infrastructure. With insufficient revenue, most

local governments, which are not allowed to

borrow directly from banks, chose to access credit

from the banking system through what are known

as LGFVs. It is no surprise that most LGFVs have

been accumulating debt since the early 1990s, and

the pace has accelerated since the financial crisis.

Bank loans to LGFVs are made under the name of

the company responsible for the construction

project. They generally have the explicit or

implicated guarantee of local governments i.e.

local governments are responsible for their debts.

The Shanghai Securities News reported in

February that at least 65% of these loans werefully covered by cash flows.

As we mentioned in the previous chapter, to help

stimulate the economy in 2009 Beijing started

issuing RMB200bn of bonds annually on behalf

of provincial governments to support local

projects (raised to RMB250bn this year, with the

option of a longer maturity period).

While this will help local governments in the

short term, it wont fix the problem completely.However, Beijing may have found another

solution. In 4Q 2011 it started a municipal bond

trial programme, which allowed the wealthy cities

of Shanghai and Shenzhen, along with prosperous

Guangdong and Zhejiang provinces, to issue a

total of RMB22.9bn municipal bonds with 3 or 5-

year maturity.

We believe this trial programme is likely to be

rolled out in other parts of the country in the

coming quarters. All this sends a strong signal that

Beijing sees these new local government

municipal bonds as the way to solve the liquidity

problem facing LGFVs, while at the same time

providing long-term financing for public housing

and infrastructure projects. This is particularly

important at a time when the economy is slowing

and there are calls for additional easing measures.


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The surge of LGFV bondsApart from bank loans, the local governments

have found another way to get themselves into

financial difficulties LGFV bonds. Strictly

speaking, local governments are not allowed to

issue bonds but they found a way round the

regulations. LGFVs started to issue mainly credit

bonds in the late 1990s (for example, the

RMB500bn Pudong construction bond to build

the subway in Shanghai in 1999).

The volume of bonds issued by LGFVs has grown

rapidly. In 2009, urban infrastructure construction

investment companies issued bonds totalling

RMB233bn, up from RMB60bn in 2008.

Despite Beijings efforts to start cleaning up local

government debt in 2H 2010, bond issuance

bounced again in 2011 and is up 160% y-o-y in the

first half of 2012 as market confidence was restored

after the last-minute bailout of Shandong Helon.This debt-laden fibre company almost became the

first company in China to default on a corporate

bond, pushing up high-yield spreads to record

levels (seeDefault dynamics, 7 March 2012).

LGFV bonds are usually only thinly traded in

comparison with mainstream products such as

government bonds, central bank bills and debt

issued by large corporations. They also tend to

trade at high yields, given the concerns over the

risk of default.

Chart 2.6. LGFV bond issuance since 2009

0

100

200

300

400

500

2002 2004 2006 2008 2010 2012*

(RMB bn)

Source: Wind, HSBC * As of end Oct 2012

Corporate bonds need a boostThe corporate bond market is very

underdeveloped in both the primary and

secondary markets.

Broadly speaking, there are three types of

corporate bonds. They are regulated by different

authorities and trade in different markets.

Enterprise bonds: Mainly issued by unlisted

companies regulated by the NDRC, the main

economic policy body. First issued back in

the early 1980s, these bonds are mainly issued

by SOEs but private enterprises are

increasingly using them to raise funds. Most

enterprise bonds are traded on the interbank

market, with the exchange market handling

the balance. Insurance companies,

commercial banks and mutual funds are the

main investors.

Corporate bonds:Issued by listed

companies regulated by the CSRC and traded

on the exchange market. Their market cap is

much smaller than enterprise bonds (about

25% of enterprise bonds). Investors are

mutual funds, insurance companies, enterprise

annuity funds and commercial banks.

Corporate mid-term notes and commercial

paper:Regulated by the National Association

of Financial Market Institutional Investors(NAFMII), a PBoC agency, and mainly

traded in the interbank market. The approval

process is easier than for enterprise and listed

companies bonds (a credit rating is needed

but there is no requirement for a bank

guarantee). These bonds were first issued in

2008 and have proved to be very popular.

Outstanding mid-term notes stood at

RMB2.7trn as of October 2012, more than the

combined amount of enterprises andcorporate bonds.Commercial banks and

mutual funds are the main investors.
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We believe corporate bonds should play a larger

role in direct financing. They provide long-term

capital at a lower cost than bank loans and unlike

equities bonds dont dilute the shareholders

interests. And, more importantly, they will help

broaden the financing channels for SMEs. Today,

corporate (and enterprise) bonds account for only

9% of outstanding bonds, excluding mid-term

notes and commercial paper. The market is still

dominated by SOEs and large companies.

However, two recent policy initiatives suggest the

pace of development is speeding up.

For the first time Beijing set up a

consolidation scheme (led by the PBoC

working with the CSRC and NDRC) in April.

Few details are available but this move is

expected to eventually lead to the

consolidation of Chinas bond market, which

should boost liquidity and issuance.

The Shenzhen Stock Exchange launched

private placement SME bonds from June

2012. This should help to ease financing

difficulties for SMEs.

Asset securitisation stillminimal

China launched the first asset backed security (ABS)

in 2005. Development has been very slow due to: 1)

a lack of co-ordination among policymakers; 2) thefragmented nature of the interbank and exchange

markets; and 3) the ABS market was suspended

during the global financial crisis.

ABS issuance resumed in 2012 when three

financial regulators the PBoC, the China

Banking Regulatory Committee and the Ministry

of Finance issued a joint notice to promote ABS.

Banks are allowed to issue up to a combined

RMB50bn in these types of securities. China

Development Bank (CDB) made the first ABS

issuance of RMB10.2bn, marking the resumption

of this process. However, outstanding ABS

represented just 0.1% of total outstanding bonds

as of end October 2012.

Chart 2.7 Outstanding asset-backed securities still minimal

0

10

20

30

40

50

60

2005 2006 2007 2008 2009 2010 2011 2012*

(RMB bn)

Source: Wind, HSBC * As of end Oct 2012

Plenty of demand

Demand for bonds is not a problem. Insurance,

pension and mutual funds as well as the large pool

of household savings are all looking for long-term

investment instruments. Chinas households andcompanies have generally high savings rates,

which require effective investment channels. The

bond market provides long-term investment

instruments with fixed returns, a sharp contrast to

the more volatile and riskier equity market.

Further development of the bond market will

provide the middle class with greater choices

about where to put their money so they can earn a

higher return and therefore spend more.

Moreover, the number of institutional investors is

on the rise. By the end of September 2012, there

were 411,711 institutional investor accounts on

the Shanghai A-share market compared with

around 200,000 in early 2005. Fund management

companies, securities companies, insurance

companies and social security funds are all

important investors.


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Second, the market is increasingly open to foreign

investors. By the end of September 2012, 188

institutions had received QFII licences with an

investment quota of USD30.8bn. China is now

planning to lower the entry barrier for foreign

institutional investors as part of reforms to add depth

to the countrys capital markets. The government

will cut the minimum requirement on assets under

management to USD500m from USD5bn for

companies seeking a QFII licence, the CSRC

announced on 19 June 2012 (source: Bloomberg).

The regulator also said it will allow the QFII

funds to invest in the countrys interbank bond

market. Under the new rules foreign investors will

be required to have at least two years of

operational experience, compared with the current

minimum of five years. The CSRC hopes that

introducing more long-term funds from abroad

will help improve market confidence and promote

stable growth in Chinas capital markets.

Chart 2.8. QFII investors expanding

0

20

40

6080

100120

140160

04 05 06 07 08 09 10 11 12

0

10

20

30

40(USDbn)

No. of institutions approved (Lhs)

Approved inv estment accumulated (Rhs)

Source: CEIC, HSBC

But a stronger institutionalframework is needed

An efficient, well-supervised bond market would

reduce transition costs and lower risks in the

financial system. We believe corporate

governance, the legal framework and regulatory

supervision all need to be improved. We think the

following are needed to build the right

institutional framework:

Information disclosure: Better transparency

is needed to accelerate the development of the

local government bond market. The balance

sheets of many local governments lack clarity

and need higher accounting standards. The

current accounting law only applies to

companies it should also be applied to local

governments. This will help price the risk of

local government bonds.

A credit evaluation system: A proper creditratings system is vital, especially in a market

which has a short history (the four major

domestic rating agencies are inexperienced)

and lacks statistics on default ratios.

Consolidationof the fragmented bond

markets, but this will take time. The current

segmentation splits liquidity and prevents the

formation of a complete yield curve.

Improving yield curves: A properly-functioning yield curve provides the benchmark

for pricing risk. Chinas yield curves need

further improvement through: 1) the

strengthening of market makers; 2) more

diversified products and maturity; 3) deeper

liquidity; and 4) interest rate liberalisation.

Bringing in global playerswould help

There are many ways Beijing can strengthen theinstitutional framework of Chinas bond market

enhance regulation, increase co-operation with

overseas exchanges and regulatory authorities and

nurture domestic investors and rating agencies.

But for us the best option would be to attract top

global institutional investors who are more

capable of identifying, pricing and managing risks.

Their active participation would encourage

companies to improve the quality of disclosure

and help domestic rating agencies raise their

standards to international levels.


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This can be achieved by expanding the current

QFII and RQFII schemes and further opening

bond markets to foreign central banks and

international organisations. There are signs that

this is already starting to happen.

On top of the increase in the QFII quota from

USD30bn to USD80bn, as mentioned earlier the

CSRC is considering further relaxing QFIIs

investment rules. This includes allowing QFIIs to

invest in the interbank bond market and changingthe rule that no less than 50% of QFII

investment must be in equities. Meanwhile, the

fact that Bank of Japan and Bank of Korea have

recently received approval to invest in the

interbank market is another positive sign (see the

chapter: A convertible RMB within five years).

Increased participation by sophisticated global

investors will accelerate the pace of building a

more transparent and liquid bond market one

that matches Chinas rapid economic growth.


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Ready for action

Zhou Xiaochuan, governor of the central bank, the

PBoC, made his point very clearly. Writing in the

March issue of China Finance magazine, he

stated that conditions were basically ripe for

liberalising domestic interest-rate policies. His is a

powerful voice he has held that important job

since 2002.

Interest rate liberalisation lies at the heart of

Chinas financial reforms and much needs

changing. Under the current system the PBoC setsa ceiling for bank deposit rates and a floor for

lending rates, creating a high spread that generates

fat bank profits. It also means that the returns

savers earn on their deposits are below the level of

inflation, so they are effectively losing money. As

The Economistmagazine put it recently: A

banks depositors, in effect, pay the bank to

borrow their money from them.

This, in turn, works against the governments

policy to make consumption a bigger driver ofeconomic growth. Consumption in China was

51.6% of gross domestic product in 2011,

compared with about 70% in the US.

Chart 3.1 Real interest rates in China

-5

-4

-3

-2

-10

1

23

4

5

00 01 02 03 04 05 06 07 08 09 10 11 12

%

Real interest rate Long-term av erage

Source: CEIC, HSBC

Reformers like Mr Zhou believe that liberalising

interest rates is vital for other reasons too it

would help to develop the bond market and make

it easier to lift capital controls and internationalise

the RMB. Importantly, interest-rate liberalisation

is now official government policy as it is part of

Chinas 12th Five-year Plan, which runs from

2011 to 2015. Mr Zhou believes it should be

possible to make considerable progress during this

period for a number of reasons, including:

How to set interest ratesfree

The governor of Chinas central bank says the time is ripe for

liberalising interest rate policies

The powerful state-owned banks stand to lose the most from

reform, but there is little they can do to buck the trend

In our view, liberalising interest rates will be a step-by-step

process that could be completed within three years


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The process of financial restructuring and

listing the major domestic commercial banks

is largely complete. The banks should be able

to stand on their own feet.

The ability of financial institutions to price

interest rates and manage risk has improved

significantly.

The central bank has become more proficient

at adjusting market interest rates through open

market operations (buying and selling

government securities to expand or contract

the amount of money in the banking system).

The Shanghai Interbank Offered Rate

(SHIBOR) is now an established benchmark

for pricing financial products.

A deposit insurance system and a survival of

the fittest mechanism to weed out weak

financial institutions are being established.

However, the problem is that reform in China is all

about timing and the order in which changes should

be made. Beijing likes to test the water by rolling

out pilot schemes in certain cities or provinces. But

this is not practical for interest rates and thats why

they were not part of the Wenzhou reforms. With

the global economy still weak and China facing the

risk of an economic slowdown at home, liberalising

interest rates cannot be rushed. We think it will be a

step-by-step process that can be completed withinthree years.

Our confidence is based on a number of factors.

Firstly, Mr Zhou is not a lone voice. In October, it

was announced that three bodies that regulate

banks, equities and insurance would all be led by

former PBoC vice-governors; Shang Fulin at the

China Banking Regulatory Commission (CBRC),

Guo Shuqing at the CSRC and Xiang Junbo at the

China Insurance Regulatory Commission (CIRC).

They are proven reform-minded problem solvers and

protgs of former premier and economic reformer

Zhu Rongji, who did much to change China in the

late 1980s and early 1990s. For more details see

China Investment Atlas, Issue 37, The markets

driving forces in 2012, 18 November 2011.

Then, in January, the powerful National Financial

Working Conference (NFWC), that meets every

five years, came out strongly in favour of a string

of broad based financial reforms.

More evidence of change came in February with

the release of the China 2030report by the World

Bank and the Development Research Center, a

think tank with links to the State Council, the

countrys top executive body. This presented a

sweeping reform agenda, including interest-rate

liberalisation and limits on the power of SOEs.

Then came Mr Zhous comments in March. In

addition, Premier Wen Jiabao has also stated

Chinas road to reform cannot be changed and

separately called for the power of the state banksto be reined in.

So what happens next? In the next three years or

so we think the pace of deregulation will be

guided by a series of small changes that make

both lenders and borrowers more responsive to the

cost of funding.

An assessment by the PBoC suggests that all

commercial banks and rural credit units already

have interest rates pricing systems based on costof funding and risks in place, ready to be rolled

out. Chinas financial institutions appear to be

ready for the complete liberalisation of

benchmark lending and deposit rates.

Indeed, Chinas Banking Association is working

on setting up a mechanism to decide benchmark

deposit and lending rates. We think the sector is

preparing for the final push towards interest rate

liberalisation. It is likely to start with rates for

long maturity, large deposits before moving to

short- term small deposits.
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As theAsian Wall Street Journalreported on

20 March 2012, the PBoCs Mr Zhou and others

are also calling for the creation of a government

deposit insurance system, similar to the US and

other developed countries. This would put Chinas

banking system on a more solid footing and

ensure that depositors money would be safe even

if some banks shut down because of the

increased competition.

The next stepsMr Zhou has laid out a widely reported two-stage

roadmap for liberalising interest rates by 2015.

First, four preconditions must be met, followed by

a six-step reform process. The preconditions are:

1) China has a competitive financial market with

diversified financial institutions that can price

market risks at different levels depending on their

funding costs and financial strength. Current

status:Some of the stronger commercial banksalready have pricing power.

2) Commercial banks, which operate in a tougher

environment than policy banks, are to be given

more price setting power. Current status:

Competition has strengthened since the banks

were restructured and floated.

3) Chinas banks still see market share as the most

important factor when it comes to competition.

This mindset needs to change. Current status:Commercial banks are becoming increasingly

focused on promoting financial services.

4) Commercial banks need to reduce their reliance

on interest rate income. Prices of other financial

services also need to be deregulated. Current

status:The contribution of interest rate income at

the big four banks has declined significantly in the

past few years.

Where are we nowChina, like many developing countries, has kept

interest rates artificially low to increase industrial

output growth and reduce financing costs for large

state-run companies. The net interest rate margins

for Chinas banks were negative during the

majority of the first two decades of economic

development (1978-1996).

The downside is that this financial repression,

as it is known, has slowed the development of

financial services and reduced the efficiency of

allocating funds to businesses. In simple terms,

credit does not always get to where it is needed

most. For example, it is easy for big SOEs to get

credit while many SMEs are starved of funds.

The aim is to establish a market-oriented structure,

with money market rates acting as the benchmark

based on supply and demand. This would mean that

the central bank becoming less dependent onadministrative policy measures such as loan quotas

and the reserve requirement ratio to influence the

system. Experiences from other countries suggest

that the pace and sequence of reform will determine

the impact liberalising interest rates will have on the

financial system and whether the real economy

would suffer a negative shock.

Interest rate liberalisation is not a new concept in

China the phrase first appeared in official

documents way back in 1993. Today, after years

of step-by-step deregulation and reforms (see

Table 3.6) much progress has been made. This

gradual approach has safeguarded the banks

profit margin, while giving businesses and

households time to adjust.

Here is whats happened so far:

Capital market rates

Money market and bond market interest rates

In a market-oriented system, inter-bank interest rates

are liberalised first, followed by bond market rates.


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In 1996 the central bank abolished the upper

limit on inter-bank lending rates. It only took

from 1996-99 to fully liberalise interest rates

on the inter-bank market and bond markets.

FX and local currency lending and

deposit rates

Lending rates

The foreign currency market uses

international rates as a benchmark; lending

rates of all foreign currencies werederegulated from September 2000.

For RMB loans the upside floating limit for

SMEs was expanded from 110% of the policy

rate to 120% in 1998 in an effort to support

small business.

Over 1998-2003 the floating limit of lending

rates for RMB loans expanded to 30%, rising

to 170% from January 2004.

The upper limit of lending rates for RMB

loans was abolished in October 2004. Only

the lending rate floor 90% of the policy rate

was kept in place.

Deposit interest rates

FX rates for large deposits of over USD3m

were liberalised in September 2000.

The number of foreign currencies subject to

deposit rate regulation was reduced from seven

to four (USD, EUR, JPY, HKD) in July 2003.

Interest rates for all small FX deposits with a

maturity of more than one year were

liberalised in November 2004.

The ceiling of RMB-denominated deposit

rates has been controlled since October 2004.

The PBoC still regulates 29 types of interest rate,

including preferential interest rates for export

credits, deposit rates for small FX deposits and

loans for anti-poverty purposes (see Table 3.3).

Problems areas

These include:

The 1-year deposit rate, the central banks

benchmark interest rate, acts as an important

reference for the rating of bonds. Chinas

single tender, fixed bid system has distorted

the bond market and does not give a true

reflection of supply and demand. Thats why

interest rates for bonds are usually higher than

the benchmark deposit interest rate.

Having regulated interest rates limits the

issuing of bonds to the central government,

central bank, state-owned banks, big SOEs

and policy banks. This has hindered the

expansion of the bond market. Financial and

corporate bonds issued by policy banks and

large SOEs account for 50% of the total bond

market (this includes 40% of short-term

financing bills and medium-term notes). Most

local governments, which have great

difficulty in raising funds for local

infrastructure development, are not qualified

to issue bonds. The exceptions are Shanghai,

Shenzhen, Guangdong and Zhejiang which

were allowed to issue bonds late last year as

part of a pilot scheme.

A lack of development of related products

such as interest rate futures. Regulated

interest rates deprive market players of risk

management tools. Put another way, in

Chinas bond market theres no interest rate

risk other than policy risk.

Theres no benchmark yield curve, weakening

the markets gauge of short-term rate trends

and inflation.


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Chart 3.2 Regulated interest rates are still the marketbenchmark

0

1

2

3

4

04 05 06 07 08 09 10 11 12

%

0

2

4

6

8

10

3-month time deposit rates (LHS)Shibor: 3 month

Inter-bank 3 month money rates

Source: HSBC, CEIC

The main obstacles

The benefits from marginal changes in interest rates

in terms of improvements in banking efficiency and

allocating financial resources have come to an end.

In other words, the easy part is over.

Powerful vested interests have a lot to lose from

change especially the big banks. Experiencesfrom many other countries show that the net

interest margin (NIM) tends to narrow after

lending and deposit interest rates are liberalised.

This is because banks have to compete with each

other they attract deposits by raising deposit

rates and cutting lending rates to win business

from valued (normally big) clients.

This squeezes interest rate income and thats why

Chinas commercial banks are the main group

objecting to reform. NIM income represents 70-

80% of the banking sectors profits, so it is

understandable that the banks will try to postpone

reform for as long as possible. Market driven

interest rates would force them to grow their

businesses in other areas, particularly fee income.

Chart 3.3 Banks interest rate margin has stayed between 3-4ppts

-5

0

5

10

15

90 92 94 96 98 00 02 04 06 08 10 12

%

Interest rate margin 1-y r lending rates

1-y r time deposit rates

Source: HSBC, CEIC

But interest rate liberalisation is not just about

deregulation. It is also about power. Chinas

government-controlled banking system has long

provided the financial resources that have made thecountry the economic powerhouse that it is today.

Fully-liberalised interest rates would certainly

diminish the level of government control.

During the 2008-09 global financial crisis the

states control of the banking sector helped

Chinas strong economic recovery. In 2009 the

banks pumped RMB9.6trn of new loans into the

economy as Europe and the US floundered. We

believe it is this deep-seated fear of the

diminution of power that is the biggest obstacle tobe overcome.

Table 3.3 Interest rates currently under PBoC regulation

Interest rates Numbers of rates under regulation

Deposit rates Deposit rates (demand deposit, 3-month, 6-month, 1 year, 2 years, 3years, 5 years), negotiated deposits (upper limit restriction), savings forpersonal housing funds and other small deposit accounts

10

Lending rates Lending rates (6-month, 1 year, 3 years, 5 years, more than 5 years),personal housing loans

7

Preferential lendingrates

Export credits (China Import and Export Bank), anti-poverty 8

Small foreign currencydeposits

Deposits with maturity of less than 1-year deposits of USD, EUR, JPY,HKD

4

Total 29

Source: PBoC, HSBC


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We suggest policymakers think about this in a

different way financial repression and the

misallocation of financial resources could

ultimately threaten the sustainability of Chinas

economic growth.

It would be far better if commercial banks can

work together at an industry level to build a co-

ordinated mechanism to set a benchmark interest

rate. This, under the supervision of the central

bank during a transition period, could helpcushion the potential nasty shock of free interest

rates on the sector and, in turn, the real economy.

Chinas Banking Association, which works under

the CBRC, is already researching the best way to

set up this mechanism.

As Yi Gang, the PBoC vice governor, wrote in his

2009 book On the Financial Reform of China,

only when a market-oriented benchmark interest

rate is properly pricing lending and deposits will

the PBoC be able to exit its role of setting

benchmark interest rates.

Chart 3.4 Around 70% of total bank loans were lent atinterest rates higher than the central bank benchmark

0

20

40

60

80

08 09 10 11 12

%

Below benchmark, 10%

Above benchmark, 10% up to 170%

Source: HSBC, Wind

SHIBOR, an emerging benchmark

Before the PBoC can give up its role of setting

interest rates a market-oriented benchmark

interest rate needs to be in place.

The Shanghai Interbank Offered Rate (SHIBOR),

introduced in January 2007, already acts as a good

reference for short-term (less than 3-month)

money supply and demand. SHIBOR is now

widely accepted as the benchmark rate for

discount bills, wealth management products and

asset management.

However, there is still too big a difference between

offer and transaction prices for more than three-

month funding, which suggests that factors other

than supply and demand are at work between

market counterparties. Theres more work to do to

enhance SHIBORs role as a pricing benchmark.

Chart 3.5 SHIBOR, an emerging RMB rate benchmark

-1

1

3

5

7

9

00 01 02 03 04 05 06 07 08 09 10 11 12

%

SHIBOR1M USD LIBOR1M HIBOR1M

Source: HSBC, CEIC

Latest developments

China took another step towards liberalising

interest rates on 8 June when it cut borrowing

costs for the first time since 2008 and loosened

controls on banks lending and deposit rates. The

one-year lending rate was lowered 0.25ppts to

6.31% and the one-year deposit rate fell the same

amount, to 3.25%. Banks could offer a 20%

discount to the key lending rate after the move, up

from 10% previously. They will also for the first

time be able to offer savers deposit rates that are

up to 10% higher than the benchmark.

Currently around 70% of total bank loans are lent

at interest rates higher than the central bank

benchmark (see Chart 3.4), implying that Beijing

thought it was a good time to expand the floatingrange as it eliminates the risk of irrational

competition between financial institutions.


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Less than a month later the PBoC acted again,

asymmetrically cutting the benchmark 1-year

lending rate by 31bps to 6% and the 1-year

deposit rate by 25bps to 3%, effective 6 July. The

central bank has also announced it was further

reducing the lower limit from 80% to 70% of the

benchmark lending rate. This change is not

applicable to mortgage rates as the central bank

reiterated that property tightening measures would

stay in place.

By cutting the lending rate more aggressively than

the deposit rate, and allowing a higher discount

against benchmark lending rates, the authority is

trying to lift private sector investment demand

amid the current economic downturn.

The next steps

In September the State Council approved the 12th

Five-year Plan for Financial Sector Development

and Reform, jointly formulated by the PBoC, and

other key regulators. According to the plan,

market-based interest rate reform will progress

during the 12thFive-year Plan (2011-15). We

expect to see the following measures:

Further expansion of the floating band for

lending and deposit rates.

The number of lending rates categories under

regulation to fall from five to three and finally

to only one the benchmark lending rate.

The reduction of regulated deposit interest

rate categories from seven to five or fewer.

The long-term deposit rate is likely to be

liberalised first and the demand deposit rate,

which accounts for about 50% of total

liabilities in the banking system, last.

Eventually, the ceiling on the interest rate for

deposits will be removed, letting bank rates

float freely.

ConclusionInterest rate liberalisation lies at the heart of

Chinas financial reforms. Given the latest move

on 6 July, we expect the process to accelerate

along with reforms in other areas such as the

RMB exchange rate and capital account

liberalisation. We expect the full liberalisation of

interest rates to be completed within three years.


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Table 3.6. Interest rate liberalisation milestones in China

Category Year Event

Money market interest rate and bond marketinterest rates

1996 PBoC abolishes upper limit on inter-bank lending rates.1996 MoF adopts interest rate and yield bidding in treasury bond

issuance (exchange platform).1997 Liberalised repo rates in interbank markets.1999 MoF issues treasury bonds in the interbank market for the first

time.Lending rates 1998 Upside floating limit for SMEs expanded from 10% to 20%;

lending rate upper limit for rural credit units increased from40% to 50%, while limit for bid enterprises unchanged at 10%.

2003 Pilot scheme for reforming credit unit launched. Upper limit oflending rates for rural credit units included in the schemeexpanded to 200%.

2004 Removed ceiling for all lending rates, except interest rates forhousing mortgage loans, and credit units for urban and ruralareas (upper limits were increased to 230%).

2012 Lending rate floor lowered from 90% to 70% of benchmark.Deposit rates 1999 PBoC allowed negotiated wholesale deposits for insurance

company clients.2000 FX lending rates fully liberalised; deposit rates freed for

USD3m deposits2003 PBoC expands number of institutions that can apply to

negotiate wholesale deposits.2004 Floor for all deposit rates removed.2004 All FX deposit rates with maturity above 1-year liberalised2012 Deposit rate ceiling was expanded to 110% of benchmark.

Source: PBoC, HSBC


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Banks face big challenges

Chinas companies are going global. Faced with

tougher competition in domestic markets and slow

growth in the developed world, they are exploring

new markets, acquiring advanced technology to

sharpen their competitiveness and securing much-

needed raw materials.

The result has been a spectacular rise in Chinas

overseas direct investment (ODI) since 2002, when

the government encouraged businesses to go out.

China is now the worlds sixth biggest source of

ODI; its non-financial ODI1totalled USD68bn in

2011 and this figure is likely to double in the

coming 3-5 years. By 2011, there were over 13,500

Chinese companies and institutions making ODI inmore than 18,000 foreign companies across 177

countries and regions.

1There are two categories of China ODI: financial and

non-financial. The former refers to domestic financial

institutions investment in overseas financial

institutions; the latter refers to domestic non-financial

institutions investment in overseas non-financial

institutions.

This has important implications for Chinas

banks. As more Chinese enterprises extend their

global reach they will need an increasingly wide

range of sophisticated financial services. The

banks need to follow in the footsteps of their

clients. Chinese enterprises now have investmentsin more than 170 countries but the focus of the

countrys banks remains overwhelmingly

domestic in terms of networks, assets, business

models and human capital. The large state banks

will have to raise their game if they want to keep

pace with this surge of overseas investment.

Going global

Chinas ODI is set to double in the next 3-5 years

as Chinese companies venture overseas to acquire natural

resources, markets and technology

The firms will require sophisticated financial services; domestic

banks need to raise their game if they want to keep their business


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Domestic financing alone will no longer be able

to meet the increasing funding needs of these

adventurous Chinese companies. More cross-

border funding will be needed and credit could be

much cheaper on international markets and incurrencies such as the USD. The domestic banks,

long used to funding the big state-owned

companies, lack experience on the global banking

stage and will find it difficult to provide all the

services these companies need.

For example, demand for the following cross-

border banking products will increase:

M&A advice: According to Dealogic, China

leads M&A activity in Asia, representingnearly 7% of global M&A over the past three

years. In 2011, 37% of Chinas ODI flows

went to M&A.

Bank loans and debt issuance in

offshore markets.

Transaction banking for payments and cash

management, trade finance, supply chain and

securities services.

FX risk management: The increasing global

presence of Chinese companies implies rising

demand for currency settlement and risk

management. This demand will be

strengthened as RMB internationalisation

gathers pace; eventually it will be cross-

traded against most other global currencies.

Playing catch-up

Chinas banks are still very much domestic

businesses. While this was helpful during the

Chart 4.1 Chinas outward direct investment

0

10

20

30

40

50

60

70

80

1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011

(USD bn)

0

1

2

3

4

5

6

China's annual ODI flows (Lhs) China's annual ODI flows as % of world total(Rhs)

Source: UNC

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