When You Buy Chinese Bonds, You're Investing in Communism
Who owns China's bond market?
Investors around the world have their eyes on China’s bond market, which is the third largest in the world. But it’s undeveloped and operates like no bond market you’ve ever seen before. To safely expose your portfolio to the world’s most exciting marketplace, you need to know who controls the bonds and what they want.
When the sponsors of Yizheng Chemical Fiber project approached the Chinese government for funding in 1980, they didn’t realize they were kick-starting the country’s bond market.
The ambitious development project desperately needed capital. At that time in China, the only sources of funding were from state-owned banks or the Ministry of Finance. But neither government-owned entities had enough money.
The only option was to go abroad for funding. This was highly controversial – even considered counter-revolutionary – in twentieth-century communist China.
China’s “Red Capitalist”, Rong Yiren, was from a successful pre-revolution Shanghai industrial family and despite being skeptical of communism, led the country to issue its first international bond in Japan, raising US$50 million for the project in Yizheng.
The point is that such a small amount could not be sourced from banks alone, even for a critically needed project. This is why bond markets develop and are an important alternate source of capital in an economy.
Since the first foreign bond was issued in the 1980s, mainland China’s bond market has grown into the third largest in the world, behind the U.S. and Japan. It’s now worth US$9 trillion. A good portion of that is available to foreign investors, which is turning heads worldwide.
But before you jump headfirst into China’s newly opened bond market, you need to understand that it hasn’t changed much from its original objective, which was to fund government development projects. This is very different from other parts of the world and creates unique risks and opportunities.
Who issues bonds in China?
In a state-controlled economy like China, it should come as no surprise that government-linked entities issue most of the bonds in the market.
Despite corporates issuing over RMB 15 trillion worth of bonds (around US$2.2 trillion), the Chinese government, which includes policy banks, the central government, and local governments, accounts for over RMB 35 trillion (around US$5.3 trillion). And that doesn’t include the other RMB 16 plus trillion (about US$2.4 trillion) in the debt market, much of which includes debt from state-owned enterprises.
You can see the full spread of bond issuers by type in China in the graph below.
So if you buy a Chinese bond, you’re likely going to hold the government’s debt.
Who buys bonds in China?
While government-linked entities issue the most bonds, commercial banks end up buying the majority of them. As you can see below, they hold nearly three-quarters of Chinese government bonds.
On average, government bonds at the four largest banks in China – China Construction Bank (CCB), Industrial and Commercial Bank of China (ICBC), Bank of China (BOC) and Agricultural Bank of China (ABC) – account for over 26 percent of their total assets, as the graph shows below.
ABC leads the “Big Four” with as much as 27 percent of its assets allocated to government bonds.
Compared to advanced economies, Chinese banks hold an outsized amount of government bonds. In the U.S., for example, less than 5 percent of government bonds are held by domestic commercial banks.
So not only are commercial banks the largest holders of Chinese bonds, but they also hold the most government debt – by a landslide. This pattern holds true across Northeast Asia.
Why do commercial banks favor government debt?
Commercial banks that hold government debt have a unique advantage in the market.
On the most basic level, banks are financial middlemen that raise funds from one person and lend that amount (with interest) to someone else. The interest rate spread (the difference between what the bank pays a person to deposit and the amount of interest charged to borrowers) generates revenue for a bank.
But they must time their fixed-income investments (bonds, ETFs, money market funds, etc.) with the maturity of initial deposits. If they don’t, there will be a “run” on the bank.
To avoid “runs” and financial crisis, a country’s central bank requires domestic commercial banks to maintain a certain level of liquid assets. (Liquid assets are easy to sell and convert to cash.)
Government bonds help banks meet this requirement. They can be easily sold and converted into cash. Liquidity is always an issue in China’s undeveloped capital markets, so holding government bonds helps commercial banks solve this problem.
What’s more, government bonds are considered less risky than corporate debt, because information about the government’s debt capacity is easier to find and more transparent than corporate debts.
Bonds: A symbiotic relationship between public and private
In Asia, banks have a special relationship with their central governments.
First, the government owns most commercial banks.
And second, as we’ve written before, governments exert quite a bit of control over commercial banking activities through window guidance (via central banks).
Since the commercial banks purchase most of the bonds issued by the government (through the central bank), it means that most of the central banks’ assets are government-issued bonds.
This arrangement is symbiotic.
Commercial banks help the government transfer its debt to the central bank’s balance sheet. In return, commercial banks get liquid assets (government debt). And the government’s debt now is financed with the additional money that has been pumped into the economy – improving overall liquidity.
Broadly speaking, when you buy bonds in China – especially government bonds – you are financing government development projects. In Asian terms, that means you are financing economic growth.
So investing in Chinese bonds is a win-win. You’re getting a low risk investment (government-backed bonds) and at the same time, your money is being invested in development projects that propel the economy forward, increasing the chance that you’ll be paid back.