Tuesday, June 19, 2007

Chinese RMB Yield Curve

The yield curve adjustment in US market was the biggest event last week and the effect has rippled through to other part of the world. While China is a red hot subject nowadays, how come nobody talks about the Chinese RMB yield curve? Do you have any idea as simple as the shape of the curve?

You probably are not interested because RMB is not a freely traded currency, and you are not allowed to buy RMB bonds.

But are you investing in Chinese H-share or A-share based ETF such as Morgan Stanley A-Share Fund (CAF), iShares FTSE/Xinhua China 25 Index (FXI) or iShares FTSE/Xinhua A50 China Tracker (2823.HK) ?

Do you know all those funds are having a significant proportion of their assets invested in Chinese banks and insurance companies?

For example, the following list shows the 25 constituents of FXI, almost 40% of its assets are in Chinese banks and insurance companies

So how does this relate to the RMB yield curve?

If you are indirectly owning so much Chinese banks assets, you may be interested to know how do Chinese financial institutions manage credit risk, how do they perform mark-to-market financial assets valuations, how do they report VaR (Value-at-Risk) or CAR (Capital Adequacy Ratio) which are critical measurements of banks’ health.

In other part of the word, yield curve is the most fundamental element to derive discount rates for cash flow projection, which itself is the basis for any financial assets valuations.

However, you may be very surprised to learn that this seems to be obvious matter is a brand new policy just imposed last week ! On 15 June CBRC made an announcement that banks should make reference to RMB yield curves in financial assets valuation and reporting starting from Oct 2007. Before this is enforced Chinese banks are not referencing to RMB yield curve and they derive their own discount rates based on arbitrary and subjective measures. So there is in fact not a common point of reference when we interpret reports from different Chinese banks. Is the credit management of one bank better than the other as indicated from its annual report? I am not too sure.

It is still a very long road to a mature capital market in China. What we have seen in the A-share market is just a beginning of the overall Chinese capital market reform. Without a solid equity market foundation it would be difficult to move forward to develop a corporate debt market. RMB yield curves are in fact incomplete because secondary market for corporate bonds is inactive. Without a well developed debt market the Chinese goverment would find it difficult to solve banks’ non performing loan problems because there is not a vehicle for a more balanced distribution of risks to different classes of investors. Bank loans are currently the major source of funding for all Chinese firms. Based on PBOC statistics, in 2006 Chinese firms raised a total of RMB 4000b, of which RMB 3300b (82%) were bank loans, only 5.6% (RMB 230b) was from equity market.

My View

  1. China is speeding up in debt market development which is crucial to the overall health of Chinese economy
  2. A healthy stock market is the fundamental requirement for debt market development, I cannot believe the Chinese government will do any stupid things to destroy what they have painfully developed over the past few years. Tackling the astronomical sum of non performing bank loans and ultimately listing all banks were huge achievements. Though the system is far from perfect, it is a one way road, the Chinese market can only be healthier.

Finally, here is the RMB yield curve in case you are interested.