Identifier
Created
Classification
Origin
09SHANGHAI185
2009-04-23 02:14:00
UNCLASSIFIED//FOR OFFICIAL USE ONLY
Consulate Shanghai
Cable title:  

(SBU) EAST CHINA SEES CORPORATE BOND MARKET OPENING SLOWLY

Tags:  CH ECON EFIN EINV ETRD PGOV 
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RUCPDOC/DEPT OF COMMERCE WASHINGTON DC
RUEATRS/DEPT OF TREASURY WASHINGTON DC
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UNCLAS SECTION 01 OF 03 SHANGHAI 000185 

SENSITIVE
SIPDIS

STATE FOR EAP/CM, DAS DAVIES
TREASURY FOR OASIA/INA -- DOHNER/HAARSAGER/WINSHIP
TREASURY FOR IMFP -- SOBEL/CUSHMAN
USDOC FOR ITA DAS KASOFF, MELCHER, MAC/OCEA
NSC FOR LOI, SHRIER
STATE PASS CEA FOR BLOCK
STATE PASS USTR FOR STRATFORD/WINTER/MCCARTIN/KATZ/MAIN
STATE PASS CFTC FOR OIA/GORLICK

E.O. 12958: N/A
TAGS: CH ECON EFIN EINV ETRD PGOV
SUBJECT: (SBU) EAST CHINA SEES CORPORATE BOND MARKET OPENING SLOWLY

UNCLAS SECTION 01 OF 03 SHANGHAI 000185

SENSITIVE
SIPDIS

STATE FOR EAP/CM, DAS DAVIES
TREASURY FOR OASIA/INA -- DOHNER/HAARSAGER/WINSHIP
TREASURY FOR IMFP -- SOBEL/CUSHMAN
USDOC FOR ITA DAS KASOFF, MELCHER, MAC/OCEA
NSC FOR LOI, SHRIER
STATE PASS CEA FOR BLOCK
STATE PASS USTR FOR STRATFORD/WINTER/MCCARTIN/KATZ/MAIN
STATE PASS CFTC FOR OIA/GORLICK

E.O. 12958: N/A
TAGS: CH ECON EFIN EINV ETRD PGOV
SUBJECT: (SBU) EAST CHINA SEES CORPORATE BOND MARKET OPENING SLOWLY


1. (SBU) Summary. Foreign-invested banks in Shanghai generally
agree that they will take only gradual steps into local
corporate bonds traded on the interbank market. Several banks
are still studying the market conditions, although one
disappointment already is that foreign-invested banks most
likely will not initially be able to underwrite new corporate
bonds. Our contacts said that their caution regarding entering
the Chinese bond market extends from several problems with
China's bond market, including an inadequate credit rating
system, high cost of hedging, low trading volume, lack of a
yield reference curve, lack of a bond default process, and
inability to perform interest rate swaps. End summary.


2. (SBU) Background: During the fifth Strategic Economic
Dialogue, the United States and China agreed that "China will
allow foreign incorporated banks in China to trade bonds in the
inter-bank market, both for their customers or their own
accounts, on the same basis as Chinese-invested banks,"
according to the joint U.S.-China fact sheet, released on
December 5, 2008. Chinese regulators subsequently announced
that foreign-invested banks would also be able to trade and
underwrite bond issues on the inter-bank market, expanding on
the original language. Foreign banks are still unable to trade
or underwrite bonds on the bond exchange for listed companies
regulated by the China Securities Regulatory Commission (CSRC).
End background.

============================
Foreign Banks Considering Small Steps Into Bond Market
============================


3. (SBU) Our contacts among foreign-invested banks in Shanghai
in a series of meetings in recent weeks have generally agreed
that they will take only gradual steps into the local corporate
bond market. Although the China Banking Regulatory Commission

(CBRC) issued a notification in mid January potentially opening
the door for foreign-invested banks to buy, trade, and
underwrite corporate bonds, the first step for most banks will
be simply to buy and hold.


4. (SBU) Several banks are still studying the market
conditions, say our interlocutors. A Hang Seng Bank
representative took one of the most conservative positions among
our interlocutors, saying that he is pessimistic about the
market conditions and that the bank's internal risk controls
will not allow a quick move into corporate bond plays. Others
are more optimistic, including Citi-- especially interested in
trading short- and medium-term notes, which have tenors of one
to five years--HSBC, and Deutsche Bank. (Note: So far, only
one bank has purchased a non-financial corporate bond. Standard
Chartered Bank on April 6 announced that it bought commercial
paper, according to several local media reports. End note.)

============================
However, Underwriting Will Not Be Possible For Now . . .
============================


5. (SBU) Foreign-invested banks will not be able to underwrite
new bond issues by corporations in the near-term, agreed our
contacts. This excludes them from the area of the bond market
where foreign risk assessment tools would be most useful, and
potentially the fees and profits the greatest. Even should
underwriting eventually be permitted, several contacts believe
that foreign-invested banks will be required to be a part of an
underwriting group, and not the lead underwriter.


6. (SBU) The distinction between buying and trading, on the one
hand, and underwriting on the other is that the former do not
require any additional licensing from the CBRC, say our
interlocutors. A Citi representative said that he anticipates
that the CBRC Shanghai Office may ask some questions of banks

SHANGHAI 00000185 002 OF 003


interested in buying and trading corporate bonds, questions
which he implied could be quickly answered satisfactorily.


7. (SBU) At the same time, other interlocutors saw potential
hang-ups from other regulators before foreign-invested banks can
buy and trade corporate bonds. An HSBC representative said
that, just as with domestic banks, the People's Bank of China
(PBOC) will require that foreign-invested banks acquire PBOC
approval before buying and trading short- and medium-term notes
on the inter-bank market. To do the same on behalf of clients,
HSBC said, PBOC will require a statement of PBOC approval and a
custodial license. For the latter, there are significant
staffing and training requirements, said HSBC, and in addition,
the PBOC appears to be seeking to limit the expansion of
custodial licenses. Currently, 30-40 banks nationwide have
custodial licenses, but the PBOC has put licenses on hold while
it develops new application standards.


8. (SBU) A more significant problem in getting approval for
underwriting is probable foot dragging by the National
Association of Financial Market Institutional Investors
(NAFMII). The association is composed of the chief executive
officers or chief financial officers of China's major domestic
banks, said several of our interlocutors, and not only controls
bond issuance schedules, but also regulates which banks are
permitted to be bond underwriters. As a Deutsche Bank
representative described it, through this regulatory body,
Chinese domestic banks control access to the corporate bond
market. HSBC's representative said that NAFMII promised HSBC to
issue guidelines for applying to be a bond underwriter early
this year, but implied that it would not approve this for
foreign-invested banks for the near future. In addition,
underwriting also requires CBRC approval, which will also
require negotiations, said HSBC.


9. (SBU) As a result, our interlocutors said that the process
of getting approval for underwriting would likely take several
months. Standard Chartered's representative, for instance, said
the bank would trade bonds for several months while hoping for
approval to underwrite bond issues by September. NAFMII is
justifying its slowness on these approvals by arguing that
foreign banks will not be willing to underwrite bonds anyway,
because they are too risky in China, and that no foreign bank
has an adequate platform to support underwriting bonds,
according to HSBC's representative.

============================
. . . And Flaws in the Bond Market Are Discouraging
============================


10. (SBU) Our interlocutors admitted that foreign-invested
banks will be reluctant to jump into China's corporate bond
markets as a result of several concerns. These include:
- Inadequacy of the corporate credit rating system: JPMorgan's
representative said that it is difficult to compare risk-return
ratios across different companies, or even to evaluate a single
company. Our Hang Seng contact simply said that Chinese
companies are not rated because they have such poor credit.
- Hedging is expensive: JPMorgan's representative mentioned a
second problem related to the first. The cost of purchasing
credit debt swaps to offset some of the risk in Chinese
corporate bonds is so high that it wipes out the spread in
yields over Chinese government treasuries, making it more
remunerative to simply invest in treasuries.
- Low liquidity: Only 2 percent of Chinese bonds are "real"
corporate bonds, said a representative of joint-venture
securities firm HSBC JinTrust. Most are issued by the
government or financial institutions and are held by insurance
companies to maturity, leaving few to be traded in the market,
he noted.
- No bond yield reference curves: Hang Seng's representative

SHANGHAI 00000185 003 OF 003


said that bond coupons are not market driven--China does not
even have a market-driven government bond yield curve for a full
range of maturities. The contact described the interbank bond
market as segmented. On the one hand, bonds of maturity from
one to three months are set by market forces, in part due to an
active repo business. On the other, bonds of maturity from four
months to one year are also traded through one-off agreements
between banks--a system that has been approved by the CBRC and
PBOC--and these less-liquid markets lead to much higher interest
rates. As a result, the three-month interbank rate is 1
percent, but the one year rate is 4.5-5 percent.
- The Chinese Government discourages corporate bond defaults.
Our interlocutors all shared the observation that very few, if
any, corporate debt defaults had recently occurred in China. In
fact, regulators require that underwriters guarantee their
bonds, so that investors have recourse in case the business runs
into financial difficulty.
- Most foreign-invested banks are not permitted to carry out
interest rate swaps: Only JPMorgan is a corporate bond market
maker among the foreign-invested banks, which at first was a
position of high responsibility but little gain, said Standard
Chartered's representative. However, the CBRC in 2008 year tied
this status to approval for interest rate swap products.
Standard Chartered has since applied--and been rejected--three
times. Citi's representative agreed that corporate bond market
maker status would be useful, since with it comes access to PBOC
meetings.

============================
Bonds Will Compete With Bank Loans
============================


11. (SBU) Banks want to deal in bonds because development of
this market in China is inevitable, foreign banks are highly
restricted from underwriting and trading equities, and interest
rate controls limit the ability of foreign banks to compete with
Chinese banks on corporate loans. Our interlocutors pointed
out that bank lending and bonds are substitutes, to some extent.
For instance, the volume of bond issuance increased in the past
two years under credit quotas, but since the beginning of 2009
bond demand has fallen as lending surged, said a representative
of China Merchants Bank.

============================
Comment
============================


12. (SBU) Bond market development remains an important priority
for Chinese regulators, as a means to provide more market
oriented financing and improve the efficiency of financial
intermediation. In particular, Chinese officials hope to
emulate the experience of the U.S. and other countries by
allowing large companies to access more financing in the bond
market, thus freeing up more bank lending for small and
medium-sized enterprises. Foreign-invested banks in East China
welcome any signs of progress in financial innovation and
opening to non-domestic players, given the difficulties and
discrimination they experienced this past fall during the height
of the global financial crisis. However, our contacts among
foreign-invested banks are suspicious that their domestic
competition continues to manipulate regulatory bodies to exclude
them from potentially high-fee bond underwriting business. In
particular, CITIC and China International Capital Corporation
(CICC) appear intent on maintain their large market share for
bond underwriting. With the experience foreign-invested banks
earned pricing risk and marketing bonds in developed
economies--despite doubts raised by problems with
developed-country financial markets as a result of the ongoing
crisis--bond underwriting is an area where foreign-invested
banks could potentially bring the greatest value-added.
CAMP