• Despite widespread talk of financial system deleveraging, bond issuance in China surged in July and August.
  • Regulators had little choice: with maturities at record levels this quarter, the alternative was a wave of defaults.
  • We believe this is a temporary pause in the government’s drive to curtail debt — authorities are squeamish about financial instability ahead of the 19th Communist Party Congress.

A surge in bond issuance in July and August smacks of a climbdown by Chinese regulators from their earlier commitment to tackling debt in the financial system. We believe the pressing need to roll over massive amounts of maturing issuance in the third quarter prompted the authorities to quietly allow banks, corporations and local government financing vehicles to resume bond sales to contain defaults and maintain financial system stability (see chart).

Issuance began rising from June and hit a record Rmb4.4tn ($673.2bn) in August, including the rollover of Rmb600bn in 10-year finance ministry bonds sold to fund the establishment of China Investment Corporation in 2007. The outstanding stock of bonds in August was up 18.4 per cent year on year to Rmb71.4tn. This was a surprising outcome given that official eagerness to clean up financial system excess in effect ended a near two-year bond market rally last year.

This surge in issuance was not due to bond pricing suddenly becoming more attractive. In fact, the cost of bond financing rose above that of bank loans this year for the first time since at least 2006. The average yield on five-year triple A rated enterprise bonds rose to 4.96 per cent in May, up from 3.32 per cent last November.

Instead, the trend has been driven by the need to roll over maturing issuance into new bonds to avoid default. For example, the use of negotiable certificates of deposit (NCDs), a bond-like tool for banks in the interbank market to raise funds, has rebounded since June. Back in April, market participants were speculating these instruments would be a key target of regulators, in their newfound zeal to clean up the system. Instead, with Rmb5tn in NCDs due to mature this quarter, the authorities have allowed banks to increase issuance (see chart). Pressure will return before the end of the year: 63.5 per cent of outstanding NCDs are set to mature in three months or less.

Sales of bonds by companies in overcapacity industries also surged over the summer. After the default of China Shanshui Cement Group in November 2015, issuance by firms in sectors such as coal and steel withered. Companies in these sectors raised just Rmb285.32bn via the bond market in the first half, 16.8 per cent less than during the same period last year. But the pressure to roll over debt has prompted a jump in bond sales; Rmb184bn was issued in the three months to the end of August. With 62.2 per cent of paper sold so far this year set to mature within 12 months, these companies are merely delaying their day of reckoning.

In fact, issuance of all corporate paper — corporate bonds, enterprise bonds that are generally sold by unlisted state firms, medium-term notes, short-term commercial paper and privately placed notes — rebounded in July and August.

Bonds sold by local government financing vehicles (LGFVs), also known as chengtou bonds, have surged in recent months. Enterprise bonds — of which LGFVs account for about 80 per cent of issuance — hit Rmb71.1bn in July and Rmb77.9bn in August, well above the monthly average of Rmb14.9bn seen in the first half of 2017. LGFVs accounted for 27.2 per cent of all corporate bond sales in the first eight months, up from 25.2 per cent during the same period last year. These companies have wasted no opportunity to issue new bonds as the regulators backed off.

This leniency was not expected. We previously forecast greater tolerance for defaults by LGFVs, in part to increase the centre’s control over the provinces and to bring spendthrift local governments to heel. Indeed, in the wake of this latest surge in issuance, the government once more signalled the limits to its tolerance: regulators in mid-August warned local governments about this type of financing, again forbidding them to provide even implicit guarantees on such bonds.

Delaying the inevitable

A summer surge in bond issuance should not be taken to mean the government has gone soft. Regulators may have had little choice but to loosen their stance as maturities peaked. Despite April’s “regulatory windstorm” and the National Financial Work Conference held in July — during which President Xi Jinping in effect identified financial system risk as a threat to national security — the bureaucracy has been under pressure to maintain stability in the run-up to the party congress, scheduled for October 18.

Deleveraging was never going to mean straight-line progress. Apart from slightly higher interbank market rates, the most visible impact of the campaign has been the curtailed offshore activities of private financial groups and the domestic activities of asset managers. Meanwhile, institutions continue to borrow aggressively in the interbank market. Moody’s Investors Service last week downgraded Bank of Communications, the country’s fifth-largest lender, to junk status, citing its reliance on wholesale funding from this market.

The authorities are clearly in a bind. They were talking tough back in April but were unprepared for the wave of defaults implied by their new regulations. As we expected then, liquidity was provided as soon as the market showed signs of stress (although we did not expect such a sudden response — the central bank was pumping in funding just weeks later to avoid a midyear credit crunch).

Perhaps financial institutions no longer consider the government’s many missives to carry much weight because every spasm in market rates is met with fresh support. After the party congress the environment may be much tougher for China’s financial markets. It will need to be, because piling up debt makes the game of rolling over maturities harder and brings the day of reckoning closer.

FT Confidential Research is an independent research service from the Financial Times, providing in-depth analysis of and statistical insight into China and Southeast Asia. Our team of researchers in these key markets combine findings from our proprietary surveys with on-the-ground research to provide predictive analysis for investors.