Emerging Market Debt: Throwing light on the shadows
Joseph Mariathasan looks at the little-understood world of Chinese SME non-bank financing, which is fast on its way to becoming one of the world’s most important debt markets
“The development of the local currency debt markets in China will be the most significant development in global finance in our careers,” says Jan Dehn, head of research at Ashmore.
Hyperbole? How about this, from Stratton Street Capital partner Andy Seaman: “The renmimbi moving to become the third most traded currency within the space of two years, starting from scratch, is truly a once in a lifetime event.”
Far from wild boosterism, these statements are the consensus – and the numbers don’t lie. According to the RMB tracker data from SWIFT, in January 2012 the renmimbi accounted for just 0.37% of global trade; by June that had risen by 50% and by July 2013, it reached 1%, making it the most widely traded emerging-market currency and set to overtake the Swiss franc by 2014.
The recent announcement by the Bank of England that the UK would introduce a renmimbi swap line (making it the twentieth country to have one) provides yet another stimulus to the growth of RMB as an internationally traded currency. And, as Seaman points out, the rise of the renminbi as a tradable currency is likely to act as a stimulus for RMB appreciation, irrespective of GDP growth rates.
Little attention has been paid to these developments, primarily because investor interest and analyst coverage has been dampened by capital controls requiring foreign investors to gain Qualified Foreign Institutional Investor (QFII) status to access China’s domestic markets. But the implications for China of the creation of a government bond yield curve, which would enable corporate issuers to price their bond spreads against it, are profound and transformational.
There are three groundbreaking developments that a corporate bond market will bring. First, it would prompt an unprecedented level of transparency compared with the existing system of bank lending, predominantly to state-owned enterprises (SOEs) directed by government policy initiatives.
Second, it should bring market discipline to bear on corporate and municipal bond issuers, improving efficiency. And the third development – which Dehn describes as “sheer genius” – is the impact it could have on China’s savings rates and consumption.
Currently, China has an extremely high savings rate of 30%, which families feel obliged to have to not only cater for old age, ill health and other exigencies of life, but also for the high volatility of the only investment avenues available to them – namely, Chinese equities and property. The creation of investment products with high proportions of bonds and hence lower volatility could reduce the amount that families feel obliged to save, enabling them to increase consumption.
Small and medium sized enterprises (SMEs) are currently poorly served by the local banking system compared with the SOE behemoths, even though they generate 60% of China’s GDP and 80% of its jobs.
“This rising mismatch, together with SMEs’ increasing capital demand, is driving a powerful trend in China’s financial sector reform,” says Eric Slighton, managing partner at Aktis Capital, a firm dedicated to exploiting investment opportunities in western China.
“Government policies are aggressively promoting the growth of regulated lending by licensed, non-bank financial institutions. For investors, this is an immediate and long-lasting opportunity for high returns and capital growth. These businesses are highly scalable through geographic expansion, and there are strong scale economies in individual companies.”
There are essentially three key types of domestic SME credit businesses that are worth considering by foreign investors. Small loan companies act as lenders of short-term high-yield debt. Unlike banks, they cannot take in retail deposits and their leverage is highly restricted: they can take a shareholder loan of 100% of the value of shareholder funds, alongside additional bank-loan leverage of up to 50% of shareholder funds. They are allowed to charge interest rates up to four times the PBOC policy rate (currently 6%) on loans, typically for six months or less, to finance SMEs through short-term financing requirements during periods of expansion.
The second type of entity is a guaranty company. In many cases, the banking sector is not willing to lend to SMEs without a guaranty from a reputable guaranty company, which undertakes due diligence on the borrower and provides indirect lending and advisory services. Guaranty companies are allowed to leverage up to 10 times of registered capital and generate revenue from guaranty fees and deposit interest. By providing guarantees, banks are willing to undertake secured and collateralised lending.
The activities of guaranty companies as part of the shadow banking system have come under scrutiny following the high profile collapse of one of Beijing’s most prominent guaranty companies, and evidence of fraud at some others.
“What that emphasises is that in China, like anywhere else, due diligence is critical for investment in any financial entity,” says Slighton. “But it is also easy for commentators to exaggerate the problems.”
The third and possibly the most important long-term financing vehicle for SMEs are leasing companies. Unlike small loan companies and guaranty companies, which typically have only regional licences, leasing companies have national licences. They are also able to leverage up to 10 times registered capital and generate income through leasing income, consulting fees and residual values of equipment. Like leasing companies elsewhere, they can assist their clients in lowering capital expenditure, matching cash flows and minimising taxable income.
It is also worth mentioning pawnbrokers. As in other countries, pawnbrokers originated as entities offering relatively high interest loans secured on marketable valuables, but in 2005 they were allowed to accept real estate as collateral – and this led the industry to grow at 19.5% per annum over the next seven years.
It is clear that China’s domestic debt markets warrant more attention from international investors. In a recent report, Antony Cheng, research director at Cinda International Research, suggested that expectations for growth rates in the non-bank finance sectors over the coming five years ranged from 17% to 30% per annum, significantly higher than the expected growth rate of 10.5% for commercial bank loans. But he also warns that industry players need to understand fully the financing demands of SMEs, develop diversified financing sources, and build robust risk management and bad-debt-disposal systems.
“Considering their ability to meet SME demand and likely policy changes, we forecast that the small-loan industry will grow the fastest among those subsectors, followed by financial leasing, pawn loan, and loan guaranty,” he concluded.
Few international investors are positioned to enter China’s domestic debt markets. But given their likely size and growing importance for years if not decades to come, now would be the time to start developing expertise to gain the all-important foothold for those future opportunities.
Disclosure: Joseph Mariathasan is a partner in Pangaea Finance Partners, which works with a number of local partners in the non-bank financial markets in China, including Aktis Capital