FRBSF Economic Letter
2007-07; March 16, 2007
Prospects for China's Corporate Bond Market
Pacific Basin Notes. This series
appears on an occasional basis. It is prepared under the auspices
of the Center for Pacific
Basin Studies within the FRBSF's Economic Research Department.
While China's economic reforms have engendered much success
since they were undertaken in the late 1970s—real GDP
growth has averaged roughly 10% per year over the period—the
development of its financial system arguably lags behind.
Very high investment (over 40% of GDP) has fueled much
of the recent growth, but, as some claim, it also has generated
excess capacity in the economy, a sign of inefficient allocation
of capital. With the saving rate in China even higher than
its investment rate, the development of a financial intermediation
system that would allow more efficient allocation of capital
is key to sustaining China's economic growth.
Currently, China's banking system is the main source
of external corporate financing, and much has been done
to
reform it through the transfer of nonperforming bank
loans to specialized asset-management corporations and
through
initial public offerings by five of the six largest banks.
However, as Dobson and Kashyap (2006) argue, it is far
from being able to provide efficient capital allocation,
because it still lacks incentives for profit-maximizing
lending, it is short on competent risk analysts, and
it frequently acts as the financial agent of the government,
directing government funds to inefficient state-owned
enterprises
(SOEs).
An alternative way for firms to borrow is by issuing
corporate bonds. However, China's corporate bond market
is currently
very small. Is it likely that the bond market can develop
as an alternative to bank financing for private firms?
This Economic Letter argues that, while demand
for corporate bonds is likely to rise, both theory
and other countries'
experiences suggest that the supply of corporate bonds
is not likely to grow until the state of the banking
system improves. Thus, the bond market should not be
viewed as
a potential substitute for bank financing. Rather,
improvement in the banking system will be needed before
China's corporate
bond market can develop.
How big is China's corporate bond market?
 While China's bond market is 27% of GDP, about the same
as in other East Asian countries (excluding Japan), most
Chinese bonds are issued by the government and government-owned
policy banks. As Figure 1 shows, only 6% of bonds, including
commercial paper (CP), are issued by nonfinancial enterprises
(including SOEs). The corporate bond market provides
only 1.4% of the total financial needs of corporations
in China
(about 85% is financed by banks and about 14% by equity).
These numbers are extremely low by comparison to most
countries.
Bank lending and the bond market: Theory
There are two main reasons why firms might want to borrow
in the bond market rather than take loans from banks,
and both reflect cost advantages of the bond market. First,
as Diamond (1991) demonstrates, firms that develop a
reputation
for being either the safest or the riskiest borrowers
do not benefit from the monitoring services provided by
banks,
and therefore they are better off borrowing in the bond
market and thus avoiding the monitoring costs that banks
would pass on to them. Second, as Rajan (1992) shows,
issuing a bond disseminates information about the firm
to a large
number of lenders, which can overcome the information-based
monopoly that a bank has over the borrower, thus lowering
the information rent that banks can charge the firm.
(Both theories appear to hold empirically for U.S. firms,
as
shown, for example, in Hale and Santos 2005, 2006.)
In these theoretical models, both sources of cost advantage
require that banks price the loans they make to firms
in accordance with the firm's creditworthiness. If the
banks
do not engage in credit risk analysis or the interest
rates are not flexible, there will be no competitive forces
to
lower the cost of borrowing for the firm after it disseminates
its information in the bond market. Clearly, such conditions
are not yet fully met in China, so, as I will discuss
below, the models would predict little, if any, cost advantage
for firms to tap into that country's bond market.
Bank lending and the bond market: Global evidence
Using the data for 37 countries, excluding China, for
the period between 1995 and 2004 from the World Development
Indicators database, I find that, on average, a 10% increase
in the ratio of private sector bank lending to GDP is
associated
with an 11% increase in the ratio of bond market capitalization
to GDP. That is, countries that have larger markets for
bank loans also tend to have larger bond markets. While
this statistical relationship does not imply that larger
bank loan markets necessarily lead to larger bond markets,
it shows that these two markets are more likely to be
complements than substitutes in practice, consistent with
the implications
of the theory.
 To illustrate this result, Figure 2 shows the relationship
between bank lending to the corporate sector and the
size of the corporate bond market in selected countries
at the
end of 2004. The straight line represents the relationship
derived from the full, 37-country, 10-year analysis described
above. It is clear that countries with larger bond markets
also have more, not less, bank lending to the private
sector, which is consistent with the findings of Borensztein,
Eichengreen,
and Panizza (2006).
Where does China stand?
Given China's private sector bank lending (140% of GDP
in 2004), the relationship depicted in Figure 2 predicts
that China's bond market capitalization in 2004 should
have been 16% of GDP, while, in fact, it was only 0.7%
of GDP. Indeed, though bank lending in China appears
to be on par with Japan and South Korea, its bond market
is
roughly as small as India's.
In much economic analysis, the ratio of bank lending
to GDP is interpreted as a measure of the degree of banking
sector development. However, as discussed above, both
the
quantity of bank lending and the quality of banking institutions
matter for the development of the bond market. In China,
where more than 50% of bank lending is still conducted
by the four state-controlled policy banks, the ratio
of bank lending to GDP is likely to overestimate the development
of the banking sector. If we adjust this measure by the
efficiency of bank lending, China would not appear to
be
as much of an outlier as it does in Figure 2, suggesting
that the banking system needs further improvement for
the bond market to develop.
Will the Chinese bond market develop?
 On the demand side, China still needs to develop financial
institutions willing to hold corporate bonds: insurance
companies, pension funds, investment funds, and the like.
As Figure 3 shows, over a third of China's commercial
bonds are held by banks and only 16% by security corporations
and investment funds combined. The state-controlled National
Social Security Fund is allowed to invest 10% of its
assets
in corporate bonds, but currently it does not hold any.
As these institutions develop, the demand for corporate
bonds will grow.
On the supply side, as the theory discussion illustrates,
one should not expect firms to increase bond issuance
until the banking system is functioning more competitively.
While
banking reform in China is well under way, more than
half of the loans in China are still made by four state-controlled
policy banks, which limits competition in the banking
system.
In addition, very little credit analysis is conducted
by the banks, which makes it difficult for firms to build
a reputation for repayment and also makes the interest
rates firms pay insensitive to past credit performance.
Until firms develop some reputation (either good or bad),
they are not likely to find it profitable to raise money
in the bond market. Moreover, many private firms do not
have access to bank credit and, therefore, have no means
of developing a reputation for repayment that is essential
for borrowing from the bond market.
The interest rates that banks charge their customers
are still relatively inflexible and are unlikely to vary
with
credit history or to be high enough to recover the information
rent. In addition, the secondary market for corporate
bonds, which would be needed to disseminate the information
on
the firms through the pricing of their bonds, is still
underdeveloped: currently, over 50% of corporate bonds
and 100% of commercial paper are traded in the interbank
market, which is not very liquid. Thus, it is unlikely
that firms would gain any informational advantage by
issuing bonds, because the bond market will not be able
to incorporate
the information about firms into bond prices.
Conclusion
China's corporate bond market is very small, especially
relative to the large amount of bank credit to private
firms. This is due to the small number of institutional
investors interested in purchasing corporate bonds and
to the lack of incentives for firms to issue bonds. While
the demand for bonds is expected to rise as nonbank financial
institutions develop, the supply of bonds is likely to
stagnate until the banking system becomes more competitive
and less dependent on the government. Thus, the development
of a corporate bond market should not be viewed as a
substitute for banking reform. Of course, the Chinese government
could
require state-owned enterprises to issue bonds rather
than borrow from the banks; in that case, however, the
important
informational role of the bond market would be lost. Galina Hale
Economist
References
[URLs accessed March 2007.]
Borensztein, Eduardo, Barry Eichengreen, and Ugo
Panizza. 2006. "A Tale of Two Markets: Bond Market Development
in East Asia and Latin America." Hong Kong Institute
for Monetary Research Occasional Paper No. 3.
Diamond, D.W. 1991. "Monitoring and Reputation:
The Choice between Bank Loans and Directly Placed Debt." Journal
of Political Economy 99(4), pp. 689-721.
Dobson, Wendy, and Anil Kashyap. 2006. "The Contradiction
in China's Gradualist Banking Reforms." Brookings
Papers on Economic Activity (October).
Hale, Galina, and Joao A.C. Santos. 2005. "The
Decision to First Enter the Public Bond Market: The
Role of Firm Reputation, Funding Choices, and Bank
Relationships." Yale ICF Working Paper No. 04-47.
Hale, Galina, and Joao A.C. Santos. 2006. "Evidence
on the Costs and Benefits of Bond IPOs." FRB San
Francisco Working Paper 2006-42.
Rajan, R.G. 1992. "Insiders and Outsiders: The
Choice between Informed and Arm's Length Debt." Journal
of Finance 47(4), pp. 1,367-1,400.
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