China insuring US$16 trillion deposits means more bond risk-reward

[BEIJING] China started an insurance system for its more than 100 trillion yuan (S$21.3 trillion) of bank deposits on May 1 and the bond market is already preparing for the next step: the end of interest rate controls.

Banks, which hold the majority of corporate bonds in the world's second-biggest economy, are currently limited to paying 30 per cent more than a benchmark deposit rate. That cap is very likely to be done away with this year, central bank Governor Zhou Xiaochuan said March 12.

While Premier Li Keqiang is pushing to reduce the role of the government in financial markets, he must ensure those reforms don't lead to financial contagion that worsen economic growth already the weakest since 1990. China had two landmark debt failures in April when Baoding Tianwei Group Co became the first state-owned firm to renege on onshore notes and Kaisa Group Holdings Ltd became the first property developer to default on dollar-denominated securities.

"The deposit insurance system is part of the government's preparation for more credit defaults," said Li Ning, a bond analyst in Shanghai at Haitong Securities Co, the nation's third-biggest listed brokerage. "Interest-rate liberalization may have a big impact on the bond market as banks' borrowing costs can't fall, which will in turn prevent bond yields from declining in the coming two to three years because banks are the biggest bond investors."

Here are some questions bond investors are asking:

1. How do the reforms fit into the government's strategy of allowing market forces to play a greater role in the bond market?

China's total government, corporate and household debt load as of mid-2014 was US$28 trillion, according to McKinsey & Co. That's equal to 282 percent of the country's total annual economic output. While authorities will allow failures at companies like Tianwei, they must ensure the number of firms reneging on obligations doesn't spread rapidly.

China on Dec 19 set up China Trust Protection Co, a fund to support troubled trust firms, as repayment risks accumulated in the 13 trillion yuan industry, according to the official Xinhua News Agency. The China Securities Regulatory Commission said in January corporate bonds rated less than the top grade can't be sold to individual investors with less than three million yuan in financial assets.

The CSRC's stricter requirements are also part of preparations for more defaults, along with the establishment of the deposit insurance system, according to Haitong Securities' Li. "After the launch of the deposit insurance mechanism, we may see defaults or bankruptcies of smaller banks within five years," he said.

2. As deposit rates are eventually allowed to go up, how will that affect bond yields?

The introduction of deposit insurance to shield savers was among policy makers' prerequisites for freeing up interest rates, a long-term goal that can be traced back to 1993 when the Communist Party drafted a market-oriented reform blueprint.

The central bank will probably adjust benchmark rates as it implements further reforms, with the ultimate effect of letting the market better gauge risk so that more creditworthy companies pay less for funds, according to Chen Kang, a Shanghai-based analyst at SWS Research Ltd, a unit of Shenwan Hongyuan Group Co.

"Chinese banks are likely to face higher deposit rates and therefore could invest in higher yielding assets, such as high- yield bonds," Mr Kang said. "But in reality, the People's Bank of China is likely to lower rates to smooth the transition, so banks may not in the end have to pay higher deposits. Together with other factors, including additional PBOC rate cuts, eventually we'll see lower risk free rates and higher risk premiums, which is a sign of a maturing bond market."

3. How will these reforms affect the bond-buying behaviour of banks?

More than 90 per cent of notes in China are traded on the interbank market, making lenders the dominant investors in corporate debt. In making bond investments, they draw on local- currency deposits that totaled 122 trillion yuan as of February.

As lower-tier banks have smaller loan businesses, any increase in deposits due to the assurances brought by the insurance program may flow into bond purchases, according to Standard & Poor's.

"After the deposit insurance scheme becomes effective, small city or rural banks may have less pressure to acquire deposits through aggressive pricing because depositors may feel comfortable in putting their money in those banks given the insurance," said Qiang Liao, a banking analyst at S&P in Beijing. "Together with their limited competitiveness in the loan market, this could mean those banks will have to allocate more funds in bond investments, especially in high-yield bonds."

4. Would bankruptcy of a small bank trigger systemic fallout?

The failure of a small rural bank in a remote city that has very little business with other financial institutions wouldn't trigger systematic risk, according to Moody's Investors Service.

"The Chinese government can use deposit insurance to support small depositors without bailing out the bank," said Christine Kuo, a Hong Kong-based senior credit officer at Moody's. "On the other hand, if the bank has very extensive interbank businesses, that can cause contagion." Small banks may have to pay more when they sell bonds or when they borrow money from other financial institutions, she said.

"Credit risk premium for small banks will be increasing because other financial institutions understand the failing for small banks is increasing," Ms Kuo said. "When they deal with such banks, they would require higher interest rates."

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