China-US Audit Deal Has Room For Many A Slip

BEIJING AND WASHINGTON have reached a preliminary deal to allow US inspectors to review audit documents of Chinese businesses that trade on US exchanges, a first step toward avoiding the delisting of about 200 Chinese firms from New York exchanges.

This is the latest attempt to resolve a more-than-a-decade-long standoff over mutually incompatible auditing regulations. As the two headlines from the official announcements (above) indicate, it is progress towards a resolution, not the resolution itself.

So that regulators can ‘audit the auditors’ of companies listed on US exchanges, US securities rules require Chinese firms listed in the United States to allow access to documents that Chinese restrictions prevent them from disclosing.

China and Hong Kong are the sole foreign jurisdictions that have not allowed inspections by the Public Company Accounting Oversight Board (PCAOB), the US agency that audits the auditors. All companies listed in the United States must submit to PCAOB inspections under the Sarbanes-Oxley Act of 2002. Beijing cited national security and confidentiality concerns as its grounds for refusing.

Since the US Congress passed the Holding Foreign Companies Accountable (HFCA) Act in 2020, putting a three-year time limit on uncompliant companies coming into compliance, some 200 Chinese firms with a market value of more than USD1tn have been potentially at risk of mandatory delisting if they do not do so.

Under the new agreement, the PCAOB will start inspections in Hong Kong in mid-September. Its inspectors are not travelling to the mainland for health safety reasons, but the agreement stipulates that all the documents they request will be made available to them in Hong Kong.

Towards the end of the year, the PCAOB will determine if they have had the access they require to affirm whether Chinese firms listed in the United States are in compliance with US rules. If not, the US Securities and Exchange Commission (SEC) will determine if the delistings process will go ahead under the HFCA.

The deadline is tight. PCAOB inspections can take months, and the agency will need an army of inspectors to conduct a sufficient sample of audits in parallel.

This is the most detailed and prescriptive agreement on this issue that the two sides have reached, but it is not the first. China’s record of making commitments in principle but then stalling on honouring them in practice advises caution. The success of this deal will be determined by its implementation. There is many a slip between cup and lip, as the old saw has it.

The public announcements of the agreement on both sides underscore the need for caution, with the China Securities Regulatory Commission calling it a ‘cooperation framework’ and the PCAOB, ‘a first step’.

The recently announced intent of several prominent Chinese firms to delist voluntarily from the New York exchanges also suggests that Beijing may be comfortable with a managed withdrawal from US capital markets in favour of primary listings in Hong Kong.

Building Out China’s Bond Markets

The ambitious urbanization plans of new leader Xi Jinping will provide the next stimulus for developing China’s nascent bond market, we read in a Reuters report. Beijing has been taking ever larger steps in expanding its municipal and corporate bond markets as part of broader reforms of both the financial system and of local government finances.

The latter are teetering under the burden of more than 10 trillion yuan of debt, a large chunk of which already strained banks have recently had to roll over. Much of it is a consequence of the stimulus spending in the wake of the 2008 global financial crisis with a booster from last year’s spending to reverse the economic slowdown. Central government policy makers aren’t shy in laying down grand plans for local government to build out and pay for.

The finance ministry, which since the 1994 local government reforms has handled what bond issuance their has been on behalf of local governments, has been cautiously lifting the ceilings of permitted amounts and expanding the list of provinces that can do to the markets directly. As well as trying to let down China’s local-government debt bubble before it can go damagingly pop, an expanded muni-bond market also pushes provincial and municipal governments in three other desirable directions: less reliance of land sales to raise revenue; less need to repair to the shadow banking system to get round restrictions on official borrowings; and more transparency generally about their finances.

The scale of the proposed urbanization bond issuance is likely to be on scale unlike anything seem before, though. The current quota for local government bond issuance is 250 billion yuan ($40 billion). The domestic non-financial corporate bond market is larger; the Shanghai Securities News reported it had reached 3.45 trillion yuan for the year to date by November last year, three quarters as much again as a year earlier. The urbanization program is being pegged at upwards of 40 trillion yuan over 10 years.

Potentially doubling the size of the bond markets over that time will demand not just a fully-functioning muni-bond market, but also more robust corporate and high-yield bond issuance that can pull in foreign capital. It will also require the development of a secondary market in the issues. Otherwise, if held to maturity,  bonds become just a variant of bank lending, and will do little to divert risk from the state-owned banking system that now provides three quarters of China’s credit.

There is much other structural work to be done beyond that, including further consolidation of the three regulatory agencies that now have responsibility for various bond issuance, and a lifting of restrictions in the qualified foreign institutional investor rules that limit bond funds’ investment in bonds. Most of all it will need the government to let a few issues default so investors realize that the government won’t always bailout troubled issuers and that there is a risk to be priced in. That may be the most difficult change of all.

Beijing Calls A Halt To Direct Local Bond Issuance

China has called a halt to an experiment launched last October that let local authorities issue bonds directly. The provision permitting it was dropped from the draft budget law for its second reading earlier this week. State media quote Hong Hu, deputy director of the National People’s Congress’s law committee saying, “Considering the rapidly growing scale of local debt, attention must be paid to the accompanying problems and potential risks.”

Local authorities’ debt was 10.7 trillion yuan ($1.7 trillion), approaching 30% of GDP, as of the end of 2010, according to a June 2011 official audit, the first time the numbers were made pubic. While China’s local government debt bomb has concerned central government for some time, the roll-back follows a review of local government’s captive commercial investment companies. These take local government obligations off-balance sheet, and mostly put them in a murky world of local property development. These investment vehicles have raised 330 billion by issuing corporate bonds so far this year, compared to total new issuance of 300 billion yuan in the whole of last year.

With 28% of the local-government debt issued as part of the stimulus introduced in the wake of the 2008 global financial crisis falling due this year and next, Beijing is increasingly aware of the risks of bond defaults, particularly at a time when it is seeking to expand its capital markets, including the muni-bond market, as part of broader financial reform. The World Bank has warned of systemic risk.

The finance ministry will continue to issue bonds on local authorities behalf. That issuance will reportedly increase fivefold to 250 billion yuan this year. The draft budget law includes a loophole that would let local authorities issue bonds with specific permission from the ministry, an indication that direct issuance will be reconsidered once the clear and present danger has passed.

Qatar Recycles Its China Earnings

As an exercise in financial recycling, it is intriguing. Qatar is applying for a license to invest $5 billion of its earnings from selling liquefied gas to China in Chinese equities, including initial public offerings. Beijing likes the idea, promising to fast track the application of Qatar’s  sovereign wealth fund to be a qualified foreign institutional investor (QFII), despite the fact that such investors are currently subject to an investment quota of $1 billion.

That cap is anyway expected to be raised as part of Beijing’s step-by-step opening of the capital account. Some 37 QFIIs have applications pending to increase their quotas by an average of $340 million, following a increase in the aggregate quota to $80 billion from $50 billion. The stake that QFIIs could hold in a Chinese listed company collectively is also expected to be raised to 30% from 20%. As of mid-April, China had issued 170 QFII licences with 127 of them granted a combined quota of $25.2 billion. The requested increases in quota plus Qatar’s ask–which would make it the biggest foreign investor in China’s stock and bond markets–could potentially inject more than $17 billion into China’s sagging equity and debt markets. Do we hear the sound of fools rushing in?

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.)

World Bank Issues First Yuan-Denominated Bond

The long march to the internationalization of the yuan has taken a step forward with the World Bank’s issuance of its first yuan-denominated bond. The Bank is raising 500 million yuan ($76 million) through its International Bank for Reconstruction and Development, with the AAA-rated bond maturing in 2013 and carrying a coupon of 0.95%. Doris Herrera-Pol, Global Head of Capital Markets at the World Bank says,

“This is a landmark transaction for the World Bank as it is the first World Bank issuance in RMB, and signals the strong interest of the World Bank in supporting the development of the RMB market.”

Last year, more than 40 billion yuan of yuan denominated bonds, so called dim sum bonds, were issued in Hong Kong as the market, established only the previous year, took off from virtually scratch. Some 30 issuers in 2010 ranged from the Chinese government and the China Development Bank to the Asian Development Bank and multinationals such as McDonald’s and Caterpillar.

In December, HSBC, the second largest foreign underwriter of dim-sum bonds, forecast that new issuance would more than double this year to 80 billion yuan. Another World Bank issue, to raise 100 million yuan for its private investment arm, International Finance Corp., is reported to be in the pipeline.

Fixing China’s Local-Government Finances, Part II

Attentive readers may remember that in March this year our eye was caught by some references in the World Bank’s quarterly update on China’s economy to the strain on local government finances, and particularly on the way provincial and municipal officials were using captive commercial investment companies to get round  prohibitions on borrowing. Going off-budget via these urban development and investment corporations that can borrow for their own account has helped finance large-scale urban infrastructure across the country, but also amounts to a potentially large and sketchy pool of debt that is exacerbating fears about bad debt in the banking system.

The concern is that these investment getarounds, of which there are an estimated 3,000, won’t generate sufficient returns to pay operating and interest costs or to repay the loans taken on, leading to a rise in non-performing bank loans, especially at smaller (and weaker) regional and local banks, or leaving local governments holding the can. One estimate the World Bank quoted puts the size off this murky off-budget liability at 9 trillion yuan ($1.4 trillion) equivalent to nearly 30% of GDP.

Beijing has been trying to tighten up administratively on such circumnavigational financing but has also been experimenting with provincial government bond issuance to bring this borrowing into the light and subject it so the disciplines of the markets. A working paper from the World Bank, seemingly published internally in April, as it happens, but now being made public, outlines a new regulatory framework for doing so.

It is a detailed, technical read, addressing the rules and market structures necessary to improve fiscal transparency, impose sound budget and financial management, lessen credit and macoeconomic risks and deal with insolvencies. But it does give a clear view of what a China munibond market could, and may well, look like.

We are convinced it will happen. Sales of land-development leases are a larger source of revenue than taxes for most local governments. That is an unsustainable way to develop the country’s infrastructure. The need  to increase and diversify the revenue of local governments so they are less reliant on volatile land transactions is pressing. Beijing doesn’t have the tax money  to hand over. That means giving provinces and municipalities more direct access to capital markets.

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.

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.

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.