Record bond issuance out of China set to persist

Wed Dec 18, 2013 8:35am EST

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* Bank lending constrained by liquidity and rules

* Loan-to-deposit ratios near regulatory cap

* Accounting treatment more favourable for bonds

By Christopher Langner

SINGAPORE, Dec 18 (IFR) - Dollar bond issuance from Chinese companies reached a record US$68.5bn this year, and bankers and investors say the trend will extend into 2014 as local market dynamics continue to push financing abroad.

Perhaps the most important driver behind the issuance surge is tighter liquidity conditions onshore for Chinese banks this year. Higher money market rates - which reached 30% at one point in June - have led to higher funding costs for banks, and that in turn has impacted lending.

Bankers say this was also a reason behind a flood of bonds backed by standby letters of credit.

"It is simple: they could still get the loan fees but did not have to fund the loan, so it was perfect for tight liquidity," said one banker.

That route will soon be closed, though, as regulators have stopped approving new SBLCs. Banks also have realized that their own bond spreads have widened as a result of providing the guarantees. Still, no one expects the supply of Chinese issues in foreign markets to be affected, just that the supply will come without SBLCs.

One reason banks were motivated to offer SBLCs was to avoid bumping into a regulatory cap set by the People's Bank of China, which limits banks' loan-to-deposit ratios to 75%.

It is no coincidence that the vast majority of SBLCs for foreign bonds issued in the past year were given by Bank of China. The country's largest lender is closest to breaching that limit established by the regulator, with its loan-to-deposit ratio standing at 72.23% at the end of the third quarter.

Most of the other large banks in China are not as near the cap, but at least one, Bank of Communications, has already breached 70%. Moreover, the average ratio across the sector hit 68.7% at the end of last year, up 3.7 percentage points from the end of 2008.

Another factor supporting the rise in offshore issuance is that Chinese banks are now under Basel III capital regulations, which means riskier loans take a higher toll on their capital. The offshore bond market, however, has proven an easy alternative financing source given the combination of tight liquidity, more stringent banking rules and lending caps on the mainland.

Perhaps not surprisingly, many of the bonds issued by Chinese companies this year saw strong demand from Chinese lenders. Recent examples include an US$800m three-year deal from China State Shipbuilding Corporation, 57% of which was bought by onshore banks. But the trend started much earlier in the year, in April, when several unrated Chinese companies with ties to local governments issued dollar bonds that ended up mostly with local lenders.

That onshore bid ensured that dollar deals got printed throughout the market hiccup in the summer, when most dollar issuance in Asia struggled to find buyers among international investors.

Bankers involved in deals that saw heavy take-up from onshore lenders said these banks know the credits and feel comfortable buying their dollar bonds at the yields they were offered - which often represent a premium to what they would get for lending directly to the companies onshore. Moreover, they said, selling down publicly traded dollar bonds is easier than unloading loans.

While that makes sense, a few cynical investors have been questioning the true reasons behind the offshore issuance drive. One hedge fund manager speculated that proceeds of some of these deals were repatriated as foreign direct investments, helping local governments meet foreign investment quotas set by Beijing.

Another hedge fund manager noted that bonds get different accounting treatment, reducing capital charges, and also do not count towards loan-to-deposit ratios. As for the choice of issuing abroad instead of selling local bonds that could be bought by the banks in the same way, he suggested that the regulatory hurdles are lower for a foreign bond issued via a foreign subsidiary than in the domestic market.

A banking analyst said that while both factors could indeed be at work, the reason may instead be related to hard currency funding costs. These costs for Chinese, Indian and Taiwanese banks have all spiked to more than Libor plus 100bp, meaning that any dollar lending by Chinese banks has just become a lot less profitable.

How that plays into buying the bonds of these issuers is still unclear. But all parties interviewed agreed that Chinese banks will continue to buy foreign bonds of Chinese issuers.

The good news for investors is that there is a captive buyer base for the large amount of bonds expected to be issued by China next year.

"More and more Asia is depending on its own money, and that is good," said the second hedge fund manager.

The bad news is that the record issuance seen this year by China will likely be surpassed next year. So far, this has not put any pressure on spreads - in fact, Chinese spreads are on average 40bp tighter than where they started the year. Eventually, though, the laws of supply and demand may come into play.

Even demand from Chinese banks for the bonds of the companies they know has a limit. (Reporting By Christopher Langner, additional reporting by Edison Yong, editing by Abby Schultz, Julian Baker)

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