China's `House of Cards' Bond Market

If China really wants to internationalize the economy, shouldn't the first step be to establish a true bond market?
Photographer: Tomohiro Ohsumi/Bloomberg

The default of Shanghai Chaori Solar Energy Science & Technology Co. this month is being heralded as a watershed moment for China's bond market. The government's willingness to allow a company to miss a bond payment for the first time suggested policy makers were serious about modernizing the financial system.

But if China really wants to internationalize the economy, shouldn't the first step be to establish a true bond market?

QuickTake China's Managed Markets

This question may seem odd. Of course the world's second-biggest economy has a debt market. Corporate debt outstanding reached almost $1.4 trillion last year, up from about $81 billion at the end of 2005. Yet China's bond market is a manufactured, stage-managed and surreal affair.

"The term 'bond market' conjures up the cut-and-thrust of a developed economy, but in the Chinese context it means something very different," says Diana Choyleva of Lombard Street Research in Hong Kong. "The market is distorted and fails to price risk. To start with, the authorities determine the risk-free cost of capital in the government bond market."

The bulk of Chinese government debt is held by state-owned banks. which are under great pressure to keep it until maturity. Trading in the secondary market is negligible because incentives to sell the debt are almost nonexistent. China Inc. operates so well because the government uses banks as ATMs to bankroll stimulus efforts without having to worry about risk, volatility or capital flight. And for their obedience, banks are assured a stable return. This sounds more like a family business than a globally important bond market.

Nor is the corporate-debt realm the stuff of Adam Smith. Bonds get stuffed onto the balance sheets of banks and insurance companies and in fund-manager portfolios with far less turnover than is needed to know how to price risk effectively. How can credit risks of state-owned companies, or debt deals in general, be accurately assessed?

"This artificially constructed bond market hides a large degree of risk borne by the banks and, ultimately, the state," Choyleva says. "As long as inflation remains under control, the banks will be happy to hold government bonds to maturity. But if inflation spins out of control, banks will take a hit to their balance sheets and capital because of their large holdings. This encourages speculation at every level, including the banks. The system is a house of cards that will collapse without change over the next few years."

So it's great that Shanghai Chaori Solar was allowed to default on a $15 million interest payment on March 7. But if China is truly going to reform its financial system the way Premier Li Keqiang has promised, the government has to address this cart-before-the-horse dilemma. Before China can get its credit bubbles under control and clamp down on excessive borrowing, it needs to build a bond market to underpin it all. Only then will it become a stable and truly global economy.

(William Pesek is a Bloomberg View columnist. Follow him on Twitter at @williampesek.)

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.