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China’s Financial Reform: ‘Making Progress While Maintaining Stability’

Chinese Premier Wen Jiabao (front) attends the National Financial Work Conference in Beijing, Jan. 7, 2012. (Xinhua Photo)

There were no great expectations of the fourth quinquennial national financial work conference that has just ended in Beijing. And it seems to have met them.

These two-day meetings set broad policy objectives for the coming five years. In the past they have provided a blueprint for significant financial-system reform. But with a leadership transition already underway, the start of a new five-year plan and growing nervousness among policymakers and political leaders about the volatile outlook for the global economy and the potential implications for China’s growth, there is no great appetite for much beyond keeping a steady ship.

“Risk-aversion should be the lifeline of our financial work,” said Prime Minister Wen Jiabao, seen in the Xinhua photo above arriving for the start of meeting with the men and woman in whose hands so much rests. Wen also said that there would be greater supervision of the banks, which, he said needed to improve their governance and risk management.

Risk control and prudent macroeconomic management were the order of the day, as they were at last month’s annual economic work meeting. “Making progress while maintaining stability,” is the mantra. The emphasis is currently on the stability.

More detail about the financial work meeting will likely drip out over the coming days. The post-meeting statement dealt in generalities, but two leading topics of discussion were the currency and interest rates. Moves towards more market oriented interest rate mechanisms are necessary if China is to become more efficient at capital allocation, as it needs to be as its economy develops from its invest and export model of the past three decades. But steps have been tentative in the face of some vested interests who have thrived on cheap and ready bank loans. We expect the equally tentative steps to develop bond markets to be given priority over interest rate liberalization, with provincial and local governments being given more scope to sell bonds to firm up their finances. However, when it comes to developing a corporate bond market, don’t underestimate the political task in getting the big state owned enterprises to be supportive of a new source of credit that will be more demanding of their performance.

The internationalization of the yuan is also likely to continue at a measured pace, while the exchange rate against the dollar won’t be allowed to drift much higher. Policymakers feel that with the trade surplus shrinking the currency is at the right sort of level. It has risen by a third since the peg with the U.S. dollar was first broken seven years ago. Wen said China “will steadily proceed with efforts to make the renminbi convertible under capital account to improve its management of the foreign-exchange reserves”–though that is pretty much boilerplate.

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China’s Muni-Bond Market Brought Back To Life

This Bystander noted last year that moves were afoot to develop a municipal bond market as a way to put the financing of provincial and local governments on a more transparent footing, and to wean it from the off-balance sheet financing via captive investment vehicles that local authorities have resorted to get round restrictions on official borrowings. As of June, 2010, these captive investment vehicles accounted for 7.7 trillion yuan of local government borrowings (more than three-quarters of the total), and had become some of the most riskiest parts of local government finances in the eyes of the finance ministry.

Now, Zhejiang and Guangdong provinces and the municipalities of Shanghai and Shenzen have been given permission by the ministry to issue three- and five-year bonds on a trial basis. It is the first such direct muni-bond issuance sanctioned in 17 years.  Collectively the quartet are expected to be capped at 20 billion-30 billion yuan first time round. (Update: Shanghai, 7.1 billion yuan; Guangdong, 6.9 billion yuan; Zhejiang, 6.7 billion; and Shenzhen 2.2 billion yuan.) That would be one-tenth of the annual issuance now made by the finance ministry on behalf of local governments to help meet funding shortfalls.

Though the bonds will issued by the four authorities, they will be closely supervised by the ministry. The proceeds of the sales will be kept in a special account at the ministry, which will oversee the payment of interest and principal, and, in effect, guarantee the bonds. The ministry will also have a big say in what the money raised can be used for. Zhejiang is expected to be first out of the gate, raising funds for infrastructure projects. If all goes well, other provincial and city governments will be allowed to follow suit.

Beijing banned local governments from selling their own bonds–and from running deficits, come to that– in 1994 when it became concerned local authorities were running up huge debts they wouldn’t be able to pay. Now policymakers are concerned that local authorities have again borrowed too heavily in the wake of China’s post-2008 global financial crisis stimulus, and that in a slowing economy and cooling property market they will again struggle to repay their loans. Worse, that could trigger a banking crisis.

While the immediate priority is to clean up and deflate the local government debt bubble before it can go damagingly pop, the development of a local-government bond market is in Bejing’s long-term plan for developing its domestic financial markets. Beijing is moving cautiously, however. It remains wary of giving provinces more control over their own development, at the expense of central control. The initial quartet are trustees, so to speak, and financially sound enough to test the waters without too great a risk of mishap.

Beijing will still have to guarantee the debt of many provinces for sometime to come, and there is a real risk that some of the weaker provinces won’t able to maintain their debt service. As Liu Mingkang, head of the banking regulator, noted earlier this week, there are serious concerns about the levels of local government debt. “We cannot deny that local government financing platforms have not been managed well,” he said.

A quick glance west to Greece or east to California reveals the trouble fiscally wayward and heavily indebted national and local governments can get into. Having prided itself on avoiding the worst excesses of the prelude to the recent global financial crisis, Beijing doesn’t want to go there in its aftermath.



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Chinese Bond Yields Flashing Good Market Signals

China’s bond markets are now sufficiently good leading indicators of growth and inflation that China’s central bank could switch from using quantitative targets and administrative controls to money-market interest rates to execute monetary policy, according to a new IMF Working Paper by Nuno Cassola and Nathan Porter. The two say that “while  bond yields are not fully efficient—reflecting regulation, liquidity, and segmentation—we find they contain considerable information about the state of the economy as well as evidence of an emerging transmission channel: changes in [People’s Bank of China] rates influence the structure of Treasury, financial, and corporate bond yield curves.”

Cassola and Porter, who are with the European Central Bank and International Monetary Fund respectively, also say there is strong evidence that regulated retail interest rates significantly affect bond yields, making this regulation one likely cause of pricing inefficiencies. The two say that further liberalization across bond markets (their study looked at four interbank bond markets and the retail markets for exchange-traded Treasury bonds) will strengthen both efficiency and transmission, and that necessary elements to move towards market-based monetary policy are in place.

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Looks Like China is Still Buying U.S. Debt

The U.S. Treasury has upped its estimate of China’s holdings of U.S. securities last year, to $1.61 trillion as of June 30th, of which $1.48 trillion was long-term debt, typically Treasury bills with an original term-to-maturity of more than one year. The change is a function of the way the U.S. Treasury collects the statistics as much as anything, of which more later.

The preliminary data, as this revision is known, suggests that any thoughts that Beijing is divesting itself of U.S. financial assets are wide of the mark. Final data is due to be published towards the end of  April.

China accounts for one seventh of the foreign holdings of U.S. securities and more than one fifth of the foreign holdings of America’s long-term debt, on the basis of these latest numbers. It has long been believed that the U.S. Treasury undercounts China’s holdings of U.S. securities. Chinese purchases made through international financial centers, notably London, and held by a custodian there, show up under the third country’s ledger, the U.K. in this case. This custody bias, as it is known, is a methodological problem that affects more purchasing countries and financial centers than just China and London. The successive rounds of estimates are intended to minimize it and thus give a truer picture of who really owns what.

The numbers are further distorted by the U.S. Treasury’s way of getting round the time lag in reporting purchases of long-term securities by adding monthly net transactions to the number established at the previous annual report. Most of the trading of long-term securities takes place in international financial centers and netting out transactions between them doesn’t necessarily reflect the nationality of the ultimate buyers and sellers.

A final wrinkle in the numbers is that short-term bill holdings are reported to the U.S. Treasury at face value but the numbers for long-term securities are collected at market value and non-marketable securities at current value. Thus the table of Major Foreign Holders of U.S. Securities is a hybrid of market and face values. (More on the methodology from a 2006 paper that is as good and long now as it was then, here; and from a shorter though no more contemporary note, here.)

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McDonald’s Raises Yuan As China’s Capital Markets Creak Open

Back in February, China said foreign companies could issue yuan-denominated debt in Hong Kong. The intention was to bolster the Hong Kong market and promote the internationalization of the yuan. Now McDonald’s, the U.S. burger joint group, has become the first non-financial company to do so, raising 200 million yuan ($29 million) via 3% notes due  in Sept. 2013. The money is to be used to open more McDonald’s outlets in China.

Such a small issue is a toe in the water but one being watched closely by other companies. Investors snapped up the issue. For one, 3% is a better rate than a yuan would earn sitting in a deposit account, for another expectations that the yuan will rise against the U.S. dollar makes the issue a currency play. Wal-Mart, the U.S. retailer with extensive operations in China, is said to be weighing an issue, too, with a slew of other companies to come in its wake as Beijing moves steadily to give foreign investors greater access to its capital markets.

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China’s Nascent Local-Government Bond Market

Since Beijing took greater central control over tax revenues in 1994, there has been fiscal-system asymmetry between the centralized administration of revenue, which is parceled up and sent back to local authorities as transfer payments, and the decentralized responsibility for spending that had been given to the provinces in the 1980s. More than two-thirds of spending is in the hands of provinces, prefectures, counties and townships, with central government controlling the balance. The transfer payments subsidize some of that spending in all provinces, up to half of it in the poorer ones.  It is a rudimentary way of managing public finances and one that has left a mish-mash of local-government financing vehicles to circumvent the system, including captive commercial investment companies though which local governments borrow. There are an estimated 3,000 of these across the country, some on creakier footings than others.

Provinces have been given only limited authority to tap capital markets. In the Asian financial crisis and again during the 2008/09 global financial crisis Beijing sold bonds through the finance ministry on the provinces’ behalf. Last year 200 billion yuan ($29 billion)-worth of bonds were issued by provinces such as Anhui, Guangxi, Heilongjiang, Inner Mongolia and Jilin. Beijing funded less than a third of its 4 trillion yuan stimulus package directly and relied on the provinces to find the rest. The size of each bond issue was determined by the capital needs of each province, which favored central and western provinces, which would not have been the case if conventional credit scoring had been employed.

Reports in the 21st Century Business Herald (via Bloomberg) say that provincial governments are to be given more freedom to access capital markets under new rules being drafted by the State Council. These have partly been inspired by Beijing’s growing concern about local-government borrowing growing out of control.  Two-fifths of last year’s  9.6 trillion yuan in new bank loans went to local governments. And there are similar concerns about the fast growth of non-loan debt. Thus greater freedom to issue bonds will  come at a price: tight restrictions on extra-system financing through local governments’ investment units.

While the immediate priority is to clean up and rein in local government debt growth before it becomes another bubble, the development of a local-government bond market is in Bejing’s long-term plan for developing financial markets. However, it will move slowly. Beijing is wary of giving provinces more control over their own development, at the expense of central control. It will still have to guarantee the debt of many provinces for sometime to come, and there is a real risk that some of the weaker provinces won’t able to maintain their debt service. A quick glance west to Greece or east to California reveals the trouble fiscally wayward and heavily indebted national and local governments can get into. Having prided itself on avoiding the worst excesses of the prelude to the recent global financial crisis, Beijing doesn’t want to go there.


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A Call For U.S. To Issue Yuan-Denominated Bonds

The call by Guo Shuqing, chairman of state-controlled China Construction Bank, for the U.S. to issue yuan-denominated bonds can be interpreted two ways. One reading suggests this is another sign of Chinese nervousness about the risk of a plunging dollar further devaluing China’s extensive and already dinged dollar-denominated assets. An alternative view is that this is a another gentle shove of the yuan towards a role as a reserve currency (and China has been talking up a lot of such shoving this year, some of it gentle, some not so much.

Guo’s remarks, which cam in an interview with Reuters, said it was in America’s interests to see the yuan become a currency that is traded across the globe. That is a bit disingenuous; it is more in China’s interest, but given most Americans’ patriotism towards their currency a bit of soft-soft probably doesn’t go awry.

If nothing else, yuan-denominated bonds from the U.S. government and the World Bank, which Guo also suggested, would help develop Hong Kong and Shanghai’s debt markets. China has only recently given permission for foreign banks to issue yuan-denominated bonds, but sovereign debt  would be something else again.

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China Announces 30-Point Financing Plan To Stimulate Economy

The to-dos from the recent high level economic policy planning meeting are starting to emerge. The State Council has announced a broad range of measures to make sure that there is plenty of liquidity in the economy next year and that consumers, companies and infrastructure projects get the loans they need so their spending can boost domestic economic activity.

Among the 30-point mandate (in Chinese):

  • a 17% target increase in money supply in 2009, a substantial increase from the 15% annual rate in November (M2: bank and cash deposits);
  • a suspension of government issuance of three year bills and fewer one-year and three month bills, which were used to sop up liquidity when inflation was the problem;
  • a loosening of bank lending rules;
  • more state directed lending to projects that fall into the 4 trillion yuan stimulus package;
  • keeping the yuan stable;
  • new steel and grain futures markets, an expanded corporate bond market and a Nasdaq-like market for start-ups.

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