China’s Bond Market Still Worries Foreign Investors

[Porker]

HONG KONG—Chinese financial regulators this year slashed red tape and laid out the welcome mat for global bond investors, hoping to lure fresh cash into the country’s $9 trillion market. But new players have been slow to accept the invitation, wary about lingering ambiguity over the rules and how they will be enforced.

“There are still too many layers of regulation,” said Jean-Charles Sambor, deputy head of emerging-market fixed income at  BNP Paribas Investment Partners in London, which manages $1.2 billion in assets. Mr. Sambor said he is interested in China’s domestic bond market, but isn’t buying yet.

Cautious investors cite a wide range of ongoing concerns, from uncertainty over tax treatment to the depth of the government’s commitment to liberalization.

Foreign bond buying has picked up since the liberalization took effect earlier this year. Between February and June, the most recent month data is available, foreign investor holdings jumped 15% to 764 billion yuan ($115 billion), according to the People’s Bank of China. That is still just 1.3% of the market, according to Bank of America Merrill Lynch.

Among the new Chinese bond investors is Robert Simpson, a fund manager at London-based Insight Investment, which manages £499 billion ($662.73 billion) and bought a small batch of government debt this summer. “It’s a market that we wanted to be at the forefront of,” Mr. Simpson said. Yet Mr. Simpson said his firm is “taking our time to build up our expertise.”

The PBOC didn’t respond to requests for comment. The National Association of Financial Market Institutional Investors, an industry body that helps oversee the bond market, declined to comment.

The changes in China, the world’s third-largest bond market, are part of Beijing’s push to open up the country’s financial system and expand international use of the yuan, while steering domestic borrowers to seek funding from markets rather than bank loans. The bond-market liberalization follows a similar opening of the country’s stock market, where foreign ownership reached $90 billion in June, about 1.5% of the domestic market.

Until this year, global fund managers had to apply for permission to buy bonds, and their purchases were limited by quotas governing how much they could buy. They could use only U.S. dollars or yuan parked outside of China’s mainland. In some cases, investors could only repatriate a capped amount each year, or had to keep their money inside the country for up to one year. The few foreign investors who were granted easy access included central banks, sovereign-wealth funds and multilateral lenders such as the World Bank.

Advertisement

‘

There are still too many layers of regulation.

’

—Jean-Charles Sambor

Now, a wider range of investors has access to Chinese bonds, including commercial banks, insurers, securities firms, mutual funds, pensions and charities. Instead of seeking regulators’ approval to invest, they can just register before buying. Regulators also lifted investment quotas and eased restrictions on repatriation, as well as limitations on the types of currencies that could be used.

China’s bond market remains undeveloped compared with the U.S. and other advanced economies. It is a relatively small source of domestic credit in the bank-dependent economy, and the pool of investors is concentrated largely among the country’s banks.

Some investors consider Chinese yields attractive, with the benchmark 10-year government bond returning 2.8%, compared with 1.6% for U.S. Treasurys, and negative yields in Japan and parts of Europe. But gauging risk is tricky, due to grade inflation by local raters, who classify more than 90% of corporate debt as investment grade.

There are still boundaries for foreigners seeking to enter the market. Investors can’t buy and sell by themselves, but rather have to work through an approved settlement agency in China to register, trade and repatriate money. By contrast, foreigners can buy bonds in emerging markets such as Thailand and Malaysia simply by placing orders with a broker.

China’s bond market also appears to be off limits to the likes of hedge funds. The PBOC said in its liberalization announcement that only “medium-to-long-term institutional investors” were qualified to register.

Many foreigners remain fearful that when things get tough, regulators will find ways to clamp down on trading. During last summer’s stock-market crash, Chinese authorities allowed thousands of listed firms to freeze stock trading, forcing locals and foreigners into holding positions while the market fell.

“There is a risk of policy reversing with some kind of capital controls being imposed,” said Luke Spajic, head of portfolio management in emerging Asia at Pacific Investment Management Co., which manages $1.5 trillion in global assets. “It could happen. Policy has been in flux.”

Some investors also worry about taxes. China’s Ministry of Finance and the State Administration of Taxation say foreigners need to pay a 10% levy on interest earned from bonds. But Chinese bond issuers don’t withhold this tax, and the regulator hasn’t spelled out who should be collecting it. The tax authority hasn’t clarified whether foreigners must pay any capital gains tax at all.

“One regulator (the PBOC) has opened up its market, but investors are still waiting for another regulator (the tax authority) to come up with rules pertinent to that development,” said TieCheng Yang, a Beijing-based lawyer with the London law firm of Clifford Chance LLP.