Institutional investor, September 2009
China report – capital markets
China’s stock markets are back with a vengeance. The Shanghai Composite Index, the worst performing major market last year, has doubled since November, better than any comparable index worldwide. The initial public offering of China State Construction Engineering, which raised RMB50.2 billion in July, was the biggest in the world since March 2008. And new IPOs are in some cases trebling on debut. Which raises the question: boom or bubble?
The pace with which China’s markets have rebounded has been extraordinary, but in keeping with the behavior of one of the world’s most volatile markets. Despite the fact that China has weathered the global downturn surely better than any other major nation – many believe it is on track for 8% GDP growth in 2009 – its stock market dropped 65% in value in 2008 before this year’s rebound. By market capitalization China is now the second largest stock market in the world, overtaking Japan, but this scale has not given it stability, and the dominance of retail money has made it a particularly fiery place to be. That’s not going to change any time soon: in a single week in July, 566,937 new trading accounts were opened.
A bubble? If so, not yet, according to fund managers. Samantha Ho, investment director at Invesco and manager of many of its Greater China products, notes that the MSCI China index is trading on a price earnings multiple of about 17 times, about midway between historic lows of 10 and highs of 25 times; and that the A-share market (domestic shares which can generally be purchased only by people within China) is trading at 26 times, again in the middle of its recent range. “We’re definitely not cheap, but we’re not expensive either; we may be looking at fair valuation,” she says. “If you believe, as I do, there will be earnings growth this year, the market is not that expensive.”
There are several kinds of Chinese stocks. A-shares tend to have a higher valuation because local investors have very few investment vehicles to choose from given the capital controls that restrict most Chinese from investing outside China. That creates high demand for local stocks. Most international investors get exposure to China through H-shares, which are Chinese companies listed in Hong Kong, or red chips, which are domiciled outside China but get almost all of the revenues from China and are typically owned from the mainland.
Most of the stock market gain took place during a period in which domestic IPOs were suspended. They stayed that way for nine months until the end of June, creating pent up demand which has been reflected in some remarkable listing stories.
After two smaller issues, the first listing of note after the end of the ban was the IPO of Sichuan Expressway in Shanghai. On its first day of trading it tripled in value at one stage. Hong Kong is experiencing similar fervor for Chinese stocks (see box).
“The IPO pipeline has been building up for the better part of 18 months,” says Chris Keogh, senior advisor to the chairman at Gao Hua Securities, the Beijing partner of Goldman Sachs. Keogh says he is not concerned about the size or pipeline of the IPO market. “Yesterday [July 29] the market turned over US$60 billion – that’s more than all the other markets in the world combined,” he says. “The ability for these IPOs to come to market is certainly there. The only thing I really worry about is how much of this market is still dominated on a daily basis by retail investors. It’s about 80 to 85% and that leads to excessive intra-day volatility: as fast as the market has gone up, it can absolutely go down.”
While domestic stock markets capture the headlines, the development of the local bond market is just as significant – and is growing fast. “You’ve seen tremendous growth in all segments of the RMB bond market in China: enterprise bonds, CP [commercial paper] and MTN [medium-term note],” says Patrick Tsang, head of cross border debt capital markets at Deutsche Bank. “A couple of years back there was much growth on the equity market side, but in the last two to three years you’ve seen similar momentum in the debt markets.”
In absolute terms, bond issuance may be a lower total for 2009 than 2008, but this misses the more interesting fact, argues John Sun, executive director, fixed income for Citic Securities International. “The reason the overall number in 2009 is because there have been less treasury securities as the central bank doesn’t want to withdraw liquidity from the market,” he says. “But if you look at corporate bonds, in 2008 only about RMB85 billion was issued; in 2009 we expect it’s going to reach 500 billion, six or seven times higher.”
2008 saw the launch of a whole new type of bond, the medium term note (sometimes referred to locally as a mid-term note). The significance of this market rests with the regulators who oversee it. China’s bond markets are overseen by a labyrinthine range of regulators. The National Development and Reform Commission regulates the corporate bond market for unlisted companies; the China Securities Regulatory Commission regulates the corporate bond market for listed companies and oversees the underwriters. The People’s Bank of China regulates the structure of the industry, banks, and interest rates. The Ministry of Finance has an involvement, such as for supranational issues. And then the new MTN market is regulated by a different group altogether – a self-regulatory body, the National Association of Financial Markets Institutional Investors (NAFMII).
“My view is this new entity [MTN market] will become a much more popular method of issuing bonds in future,” says Sun. “The regulator is an association, and the application procedure is much simpler compared with other routes.” Also, Sun says, it doesn’t have the short-term limitations that the term MTN infers in international markets: issues can go as long as 10 years in tenor, although so far they have tended to stop at five.
There is, though, a sense of whether the domestic bond market could be more than it is. “On the demand side, institutional investors in China are absolutely dying for longer duration, higher yielding debt investments, which suggests seven to 10 year maturity and corporate credit,” says Keogh. Insurers, for example, are obvious buyers: they have lots of excess RMB capital to invest, and they need long-dated instruments to match the length of their policies. “But this demand is unsatiated even with the increase in issuance, because the increase has been in CP or the new MTN market – the shorter end of the curve.”
An interesting question is whether a panda bond market could be developed in China. This term refers to non-Chinese issues launching bonds in renminbi, onshore in China. This has two obvious attractions: it provides another source of funding to foreign issuers at a time when credit markets remain shut or at least difficult for many of them; and it provides a home for the vast liquidity in China’s domestic markets.
The idea of the panda bond market was first attempted in 2005 when two multilaterals, International Finance Corporation and the Asian Development Bank, issued them, on the strict understanding that the proceeds remained in China for development purposes. Much has been discussed since then but the idea didn’t really progress until July 2008 when China published a draft revision expanding the scope of panda bonds from development institutions to foreign banks and corporations with operations in China.
Standard Chartered is likely to be the first such issuer, although even then it will be through an entity that is incorporated in China, so one could argue it is not strictly speaking a panda bond. Other groups, notably HSBC and Bank of East Asia, plan to tap a different market again – issuing RMB denominated bonds in Hong Kong, a method which sources the significant retail deposits held in Hong Kong.
There’s no shortage of willing borrowers. “You would find issuers from General Motors to Walmart to any of a number of multinationals with liabilities or sourcing requirements in renminbi, who would want to issue tranches in renminbi as they already do in yen or euros,” says Keogh.
For sovereigns, too, there is potential, and this could benefit China itself. “We now have over US$2 trillion in foreign reserves, and about 70% of it is US bonds or assets,” says Yifan Hu, chief economist at Citic Securities International. This creates a clear exposure risk, particularly if one fears for the future performance of the US dollar. “The panda bond could be a short term solution. The US has to issue government bonds to support its economy; it could issue panda bonds to raise RMB, then buy US dollars from the central bank. In this way China continues to increase the US debt, and avoids the exchange risk.” In her view, “The Chinese will be more interested than the Americans, because the US would have more risk than China.”
Whatever form it takes, the debt markets have a big future in China, and one can already see international investment banks trying to take part in underwriting them – first Goldman Sachs and UBS through their pioneer ventures (see banking article), and more recently with the licenses granted to local joint ventures involving Credit Suisse and Deutsche. “It makes sense that China should have a vibrant RMB domestic debt market, and the government has taken the right steps in developing that market,” says Tsang at Deutsche. “I believe this will be an area of focus for us and other investment banks.”
THE ROLE OF HONG KONG
In recent years there has been a trend for China to encourage its companies to list on the A-share markets of Shanghai and Shenzhen, rather than just following the pattern of previous years and trekking to Hong Kong.
This raised doubts about Hong Kong’s continuing viability as a listing venue for Chinese companies. But recent weeks suggest there’s not much to worry about yet. At the end of April, China Zhongwang raised US$1.27billion in a Hong Kong IPO, in what remains the second largest IPO globally in 2009 at the time of writing; when Beijing-based building materials manufacturer BBMG came to the markets in July, raising US$884 million, its retail tranche was oversubscribed 800 times and its institutional side 200 times. “That’s something we haven’t seen since 2007,” says Kester Ng, head of equity capital and derivatives markets at JP Morgan.
While China’s stock markets may threaten Hong Kong in the long run, for the moment they are very different. “China is a closed market,” says Ng. “Unlike New York or London where money flows in and out and an investor in Hong Kong can buy shares in New York or vice versa, in China you cannot buy Chinese shares from overseas unless you have a quota.”
“I don’t currently think about a Hong Kong versus Shanghai discussion,” says Ng. “They cater for very different investors. Until that investor base converges, it’s not Hong Kong versus Shanghai.”