China: Policy And Fundamentals Converge by Hayden Briscoe, AllianceBernstein

We recently commented on the improving trends in China’s property industry. It’s not widely understood, however, how the country’s various economic reforms are combining to create a base for future growth. A case in point concerns the property sector and capital market liberalization.

One of the key drivers of change in China is government policy, the overall thrust of which is to ensure that China avoids falling into the middle-income trap. The strategy is to rebalance the economy so that domestic consumption plays a greater role alongside the traditional growth engines of investment and heavy industry.

This requires a range of reforms to stimulate private investment (foreign and domestic) and more efficient pricing of capital, and the liberalization of capital markets is a key step in the process. Hence policy accounts for much of the recent growth in the corporate bond market.

These developments have broad implications, as a bond market can help fuel economic growth and, from a balance-sheet risk-management perspective, lead to a more efficient matching of assets and liabilities.

The link between the bond market’s growth and property lies in the extent of bond market participation on the part of property developers which, until relatively recently, were obliged to borrow offshore and repatriate the proceeds for investment onshore.

Property Concerns Ease on Bond Finance

Since the law changed, a dramatic transformation has taken place, as captured by Wind Information, a financial data services company based in Shanghai. According to Wind, onshore corporate debt issuance in China totalled RMB232 billion (US$36.5 billion) in August. Property developers accounted for nearly 45% of the total.

It’s also worth noting that, of the 55 developers that have issued in the onshore market, only one is rated AA– by onshore agencies, while the others are all rated AA or higher. The market is also becoming better at evaluating risk, with a number of issuers with the same rating being priced differently, based on fundamentals.

Not so long ago, the property sector was a major concern for investors and regulators. That concern has eased since it’s become evident that developers can diversify their funding sources and reduce their borrowing costs by issuing in the bond market. This benign trend is likely to continue, with bond market participants expecting issuance to grow for the rest of the year.

The coincidence between bond market growth and improved property-sector trends is further evidence in our view that China’s reforms, in some areas at least, are starting to synch with economic fundamentals, to the advantage of both.

China Risk Is Overpriced

Another example of the intersection between policy and the real economy is the budgetary law passed earlier this year, which forced local governments to switch their borrowing from banks to the bond markets. This gave rise to the municipal bond sector, which raised RMB1.7 trillion (US$267 billion) in its first three months of operation.

It also lowered systemic risk, by removing the concentration risk of local-government exposure from the banking system, and by enabling local governments to lengthen the term of their borrowings. And it put local government debt into a form that can be purchased by institutions, thus creating better risk-sharing opportunities outside the banking sector.

We expect that, once the central government announces its 13th Five-Year Plan this month, this pool of municipal bond liquidity will be channeled into infrastructure and other activities which will provide a boost to the economy late this year and well into 2016.

All these factors combined serve to strengthen our conviction that current risk pricing in China’s markets is far too conservative.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.

The Impact Of China's Currency Devaluation Infographic