Zhou Xiaochuan: Learn lessons from the past for the benefit of future
endeavour
Speech by Mr Zhou Xiaochuan, Governor of the People's Bank of China, at the China Bond Market
Development Summit, Beijing, 20 October 2005.
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Ladies and Gentlemen,
It is a pleasure to attend the China Bond Market Development Summit. Let me focus on China's
corporate debt and briefly summarize lessons from past experiences.
Corporate bond includes, among others, enterprise debt. The development of enterprise bond market
has always had the attention of many. In the past, we made quite some mistakes in this field. Thus our
corporate bond market has been very sluggish. Compared with some other financial instruments, and
in the backdrop of a high savings rate and high proportion of M2 in GDP, China's corporate bond
market has been developing very slowly, and its role in economic growth has been rather limited. Such
lack of development has also distorted financing structure and produced considerable implicit risks,
whose consequences may be grave for social and economic development. Of course, past setbacks
and mistakes had their roots in the specific circumstances of that time, i.e. in the early days of the
transition when the economy was more planned than market-driven and market economy had yet to
establish itself as a way of thinking and a general environment. Therefore, a review of the past is not
to find fault with anybody, but to draw lessons. The Decisions on Several Issues of Improving the
Socialist Market Economic System adopted by the 3rd Plenum of the 16th CPC Central Committee
has provided for enhancing direct financing, establishing a multi-layered capital market system,
expanding debt market and encouraging the growth of institutional investors. Only by thoroughly
understanding and clearly analyzing the problems and mistakes in the past, can we find an effective
solution and implement the Decisions in a concrete manner.
I. Problems in enterprise bond development
A number of serious mistakes were made in the early days of enterprise bond development, i.e. from
the end of 80s until the first half of 90s. As a result, the development was wrought with setbacks and
never fully recovered. A thorough discussion on this issue is necessary. Here, I made a list of a dozen
mistakes.
1. Issue quota and number of issuers were planned and allocated. Enterprise bond was not
issued on a market basis. For example, quota was allocated by the government to the next
level of government, from the state to the province, and then to the localities.
2. Administrative allocation of issue quota usually followed a principle of helping the poor.
Enterprises in difficulties or poorly managed were more likely to get quota.
3. The absence of a bond rating system made it impossible for investors to get a clear idea of
risks.
4. Information was not disclosed to the investors. On the one hand, accounting standards in
China were not up to the international standards. Neither accounting practice by the
enterprises nor external audit was proper and provided little information. One the other hand,
information disclosure was not emphasized. Thorough analysis of the disclosed information
was part of the decision making process.
5. Price was set administratively and price ceiling was controlled. Such pricing did not factor in
risks and made effective risk management by issuers and buyers impossible.
6. Administrative rules required bank guarantee for enterprise bond issue. This is closely
related to the problems mentioned just now. Since bond issue quota was administratively
allocated and price controlled, and neither information disclosure nor credit rating was
available, bank guarantee seemed to be the natural solution. However, once guaranteed by
a bank, the product was no longer a standard enterprise debt.
7. Bond was issued to individual investors, whereas the international practice is to institutional
investors with analyzing capability, i.e. qualified institutional investors. Individual investors
usually do not have sufficient market analysis ability or risk bearing capability.
8. Effective constraint by market was not established. Market mechanism can constrain the
issue and transaction of corporate bond because investors form a judgment on and choose
from products. That is, it is up to the market to determine what enterprise debts fare well and
what don't, prices of products and consequences of default. If the market does not exercise
effective constraint, we will have to use administrative and supervisory means for constraint,
ensuing a series of problems. Alongside market constraint, a transaction mode should be
established for OTC to play a dominant role, to enable measuring of counter party risks and
flexibilities in price judgment.
9. Investor education was not sufficient. To a large extent, many investors at that time treated
enterprise bond as a variation of savings product. Whenever default occurred, they would
bring the problem to government agencies and request redemption from underwriters.
10. A proper bankruptcy law was absent. In case of default, the existing Bankruptcy Law cannot
use bankruptcy as the last resort of deterrence to restrain the enterprise in question. As a
result, creditors' rights and interests as provided for by the Bankruptcy Law usually cannot
be protected. In case of bankruptcy, at least the residual assets of the failed enterprise can
be claimed. But in China, the reality is many enterprises' residual assets disappeared without
a trace and some enterprise issuers disappeared without going through any legal
procedures.
11. Underwriter's role was not properly defined. In the past, underwriting and redeeming was
planned and thus became the target of administrative intervention. An underwriter, which
was expected to provide redemption, was liable when the enterprise failed to do so. In fact,
the roles of the underwriter, sales agent, redemption agent and that of the redemption body
are different and have different legal implications. These definitions were not clearly provided
for, giving rise to many difficult problems later on.
12. When a default case was handled, the approach was more about administrative intervention.
More often than not, default of an issuing enterprise was not dealt with according to market
principle. Rather, through administrative intervention, the underwriter was requested to make
a follow on offering. Thus, default obligations of the issuing enterprise were transferred to the
underwriter and bogged the latter down. Recently, some securities companies have incurred
problems and undergone liquidation or restructuring. The causes of these cases can be
traced back to historical burden of defaulted enterprises.
II. An analysis of the past mistakes
The above mistakes are inter-related. We should look at them in a comprehensive manner, and
identify major themes of analysis. To me, there are three major themes:
The first is people's mindset. When the economy was in transition, command economy mentality was
at play in our economic sphere. We tended to follow the planned economy approach to deal with any
problems. Thus, when first emerged, some problems did not get proper attention. Some elements of
our previous approach, such as administrative allocation of quota, price control, mis-definition of roles,
lack of information, and handling of default, were products of command economy mindset. People did
not know enough about how a market economy would operate or the environment it would need. More
study and efforts should have been made then. Today, when looking at issues, we should try our best
not to simplify them and avoid a repetition of command economy approach.
The second is about logic. Ultimately, a series of mistakes related to enterprise bond was caused by
lack of institutional design in market operation. Normally, the intended buyer of corporate bond is QIBs
(qualified institutional buyers), who are strong in market analysis and risk taking. Corporate bond issue
usually follows a simple procedure and can be done quickly. Individual investors, weak in market
analysis and risk taking, tend to rely on government. Therefore, governments may require bank
guarantee for bond issue. Also, lack of pricing ability may cause administrative pricing. In case of
default, individual investors lacking proper means of self-protection tend to hold the government
accountable; the government in turn may make the underwriter take over the responsibility through
administrative intervention. A follow-on issue thus takes place, giving rise to many distortions and even
more serious consequences. If we had QIBs as corporate bond investors, these inter-related problems
would have been avoided. From a logic point of view, identifying a proper investor base is the key.
When launching a new financial product, we should take individual investors into account and aim at
diversifying their investment choices. However, not all products are suitable to these investors. We
need to develop or introduce financial products for them. In the future, more sophisticated financial
derivatives are likely to be introduced. But, these products are not at all suitable choices of individual
investors.
In developed countries, corporate debts are mainly issued to QIBs and mostly transacted through
OTC. Counter party risks are emphasized and the two parties decide the price. A small amount of
high-grade bonds with low default risks are transacted at organized exchanges. Organized exchanges
usually impose a volume limit on corporate bond transaction. Large volume is all done through OTC.
Take the U.S. market, a highly developed bond market, as an example. Institutional investors hold
about 90% of outstanding bond and individual investors hold the balance. These very wealthy
individuals, more like institutional investors in nature, usually hold high-grade corporate debt. A very
small amount of low-grade bond is in the hand of individual investors because bonds are downgraded
as a result of declining corporate performance.
From a logical point of view, QIBs and OTC are the defining features of corporate bond market. If we
fail to follow this logic, things will get problematic.
The third is about environment. Corporate debts need an appropriate eco-environment, which includes
institutional set-up, such as good laws and regulations (that provide clear legal definition), an improved
accounting system (that provides all the necessary information to investors without misleading them),
regulation of information disclosure, and improved bankruptcy law, etc.
If we have the right mindset, logic and environment, without a heavy dose of control, QIBs and OTC
transaction will foster the development of corporate debt, because market will exercise fairly strong
constraint. Supervisory workload will be lighter as well. When SMEs, innovative and start-up
enterprises issue bond by a large scale, the supervisors will have to work harder because some of
innovative SMEs go public after relying on bond financing in its early stage of development. Often the
process suffers from lack of transparency, no disclosure and cover-ups. The story of junk bond in the
U.S. can provide some reference in this regard.
III. Possible solutions
A clear understanding of the problems helps us to find solutions.
First of all, we must adopt a market-oriented way of thinking. If the past practice of allocation,
administrative approval and intervention continues, the prospect of bond market will not look bright. At
the same time, old-fashioned command economy mindset must be put aside when we analyze what
went wrong. Some cited non-fundamental, minor or even secondary problems as the root cause.
Therefore, it is helpful to thoroughly discuss and understand these questions in a meeting like today's.
Second, we need to get the logic right when solving problems. The best starting-point is to have QIBs
and OTCs, so that institutions with strong analytical and risk management capability can play a big
role. This will simplify administrative approval and control because it relies on information disclosure
and market restraint, rather than the judgment of approving authority. Guarantee by commercial banks
is not necessary either. Even in the case of worsening performance or default of issuing company,
institutional investors have the capacity to make a judgment and manage the risks in due time. The
government does not need to worry too much about them.
Third, strengthening environmental and institutional setting and improving eco-environment. We have
to do this job continuously. Indeed, things have improved greatly, but we still need to work hard on it.
In recent years, our accounting standards have been more and more consistent with international best
practice; requirements on disclosure and disclosure oversight have been enhanced; the Bankruptcy
Law is being amended and expected to better protect creditors' interests.
In short, a key starting point is to develop QIBs and OTC as the best way to foster market
development.
In this regard, a related matter is SMEs financing. People have come to understand the importance of
developing SMEs and paid a lot of attention to their financing difficulties. How to look at this issue? We
should avoid simplifying it. Usually there are two ways to develop bond market and provide SMEs with
financing.
One is to develop external constraint and bring commercial banks' attention to SMEs. International
experiences have shown that, when large companies and high-quality enterprises increasingly use
bond market financing, banks will naturally provide financing services to SMEs. That is to say, market
differentiation is a result of competition. At the moment, commercial banks lend to large and well-run
enterprises as a way to improve asset quality and reduce NPLs. There is nothing wrong with this
approach. However, once large and well-run enterprises has a preference for bond market,
commercial banks will get the signal, divert more of their resources to study SMEs financing and
establish a SMEs department.
Another way is to issue SMEs bond. Such bond is usually high-yield and high-risk bond. Without
sufficient preparation, without a proper investor base and pricing mechanism, issuing SMEs bond is
likely to be problematic. This is related to the general awareness of corporate debt. Is it feasible to
launch non-investment-grade products at the early stage of market development? This is the
sequencing issue of corporate bond market development. Should we develop low-grade bond after a
high-grade corporate bond market is fully developed or foster the growth of both at the same time? We
need to do more research. Many countries in the world have yet to have a mature SMEs bond market.
Even in the U.S., which seems to be a success story, the Michael Milken incident had both positive
and negative impacts. I think this experience deserves a careful study if we are to develop a SMEs
bond market.
In conclusion, bond market represents the direction of market development and we have to make our
best effort to get the job done. One precondition is to have a thorough understanding of past
experiences. I welcome comments on my remarks and look forward to a lively discussion.