Photographer: Qilai Shen/Bloomberg

How China's Capital Controls Make Bond Market Fragile

  • Banks recycling dollars enable riskier borrowers to issue
  • Asset managers are boosting their leverage to buy, Nomura says

China’s central bank can pat itself on the back for stemming outflows of capital that once spooked investors around the world. But hidden costs of the efforts involved are slowly materializing.

One of the newest is in the swelling market for dollar bonds sold by Chinese issuers. While still small relative to other financial risks in the world’s No. 2 economy, it helps to illustrate some of the weaknesses of China’s patchwork of market incentives and government controls.

The daisy chain of risks starts with limits on Chinese individuals putting money into hard currencies abroad. Instead, they’re converting into dollars at banks at home, as allowed under State Administration of Foreign Exchange rules. Banks are then taking those dollar deposits and buying bonds -- many of them sold by Chinese companies.

By buying about half of Chinese dollar-bond issuance, China’s lenders have generated dangers for other holders if they get cold feet -- read about that here.

Here’s where the story gets more complicated. With their preference for state-linked names, Chinese banks have snapped up bonds sold by government-controlled issuers including asset-management companies, some of which have then used the proceeds to buy high-yield debt, market participants say. The links from individual depositors to banks to asset-management companies to junk borrowers such as domestic property developers and local-government financing vehicles has generated a panoply of hazards.

“We are seeing the build-up of currency risk behind this phenomenon," said Qiang Liao, senior director of financial institutions at S&P Global Ratings in Beijing. "Many Chinese high yield issuers, such as property developers and LGVFs, have little or no foreign currency revenues -- and hedging of currency risk isn’t a common practice for them. If the yuan falls sharply, the repayment burden will rise significantly.”

The numbers are smallish, but they are getting bigger. Junk-bond issuers have collectively churned out a record $12.7 billion of dollar-denominated offerings so far this year, a whopping pick-up from last year’s $1.9 billion during the same period of time, according to data compiled by Bloomberg.

The fuel for the possible fire comes from foreign-currency deposits in China. Those have accelerated recently and reflect strong demand for dollars, according to Goldman Sachs Group Inc. analysts, who see "robust" demand among Chinese banks for short-duration investment-grade dollar notes as a result.

Bank Funding

Securities with that description include three-year and five-year floating rate notes that priced April 21 from China Huarong Asset Management Co., one of four central government entities set up in the late 1990s to buy bad loans. Banks took more than 60 percent of both those issues, according to people familiar with the deal.

Huarong, in turn, has been active in gobbling up high-yield dollar debt. Its subsidiary Huarong International Financial in December bought more than one-fifth of the $350 million 10-year notes sold by Country Garden Holdings Co., a mainland property developer rated below investment grade. It also took major chunks of issues from at least two other junk sellers.

Risk control at Huarong is attracting scrutiny -- read more about that here.

A Huarong official declined specific comment when asked about its investment strategy, referring to publicly filed documents.

Analysts are flagging the potential for the government to interrupt the money-go-round.

"If the government asks these banks to transfer money back onshore, such as when the foreign reserves fall substantially, the banks may need to sell their bond holdings, including those issued by AMCs," said Annisa Lee, the Hong Kong-based head of Asia ex-Japan flow credit analysis at Nomura Holdings Inc.

The bottom line for Chinese bad-loan asset managers of this effective form of credit arbitrage: "in a normal finance world, it should not happen." So says Desmond Soon, Singapore-based head of investment management Asia at Western Asset Management Co.

"If you own all these BBB bonds, you should be rated BBB," said Soon, who is "very cautious” on Chinese AMC notes.

— With assistance by Denise Wee

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