VZCZCXRO6668
RR RUEHCN RUEHGH
DE RUEHGH #0185/01 1130214
ZNR UUUUU ZZH
R 230214Z APR 09
FM AMCONSUL SHANGHAI
TO RUEHC/SECSTATE WASHDC 7860
INFO RUEHBJ/AMEMBASSY BEIJING 2721
RUEHCN/AMCONSUL CHENGDU 1928
RUCPDOC/DEPT OF COMMERCE WASHINGTON DC
RUEATRS/DEPT OF TREASURY WASHINGTON DC
RUEHGZ/AMCONSUL GUANGZHOU 0384
RUEHHK/AMCONSUL HONG KONG 2096
RUEHML/AMEMBASSY MANILA 0067
RUEHUL/AMEMBASSY SEOUL 0428
RUEHGH/AMCONSUL SHANGHAI 8505
RUEHSH/AMCONSUL SHENYANG 1919
RUEHGP/AMEMBASSY SINGAPORE 0252
RUEHIN/AIT TAIPEI 1715
RUEHKO/AMEMBASSY TOKYO 0622

UNCLAS SECTION 01 OF 03 SHANGHAI 000185 
 
SENSITIVE 
SIPDIS 
 
STATE FOR EAP/CM, DAS DAVIES 
TREASURY FOR OASIA/INA -- DOHNER/HAARSAGER/WINSHIP 
TREASURY FOR IMFP -- SOBEL/CUSHMAN 
USDOC FOR ITA DAS KASOFF, MELCHER, MAC/OCEA 
NSC FOR LOI, SHRIER 
STATE PASS CEA FOR BLOCK 
STATE PASS USTR FOR STRATFORD/WINTER/MCCARTIN/KATZ/MAIN 
STATE PASS CFTC FOR OIA/GORLICK 
 
E.O. 12958: N/A 
TAGS: CH ECON EFIN EINV ETRD PGOV
SUBJECT: (SBU) EAST CHINA SEES CORPORATE BOND MARKET OPENING SLOWLY 
 
¶1.  (SBU) Summary. Foreign-invested banks in Shanghai generally 
agree that they will take only gradual steps into local 
corporate bonds traded on the interbank market.   Several banks 
are still studying the market conditions, although one 
disappointment already is that foreign-invested banks most 
likely will not initially be able to underwrite new corporate 
bonds.  Our contacts said that their caution regarding entering 
the Chinese bond market extends from several problems with 
China's bond market, including an inadequate credit rating 
system, high cost of hedging, low trading volume, lack of a 
yield reference curve, lack of a bond default process, and 
inability to perform interest rate swaps.  End summary. 
 
¶2.  (SBU) Background:  During the fifth Strategic Economic 
Dialogue, the United States and China agreed that "China will 
allow foreign incorporated banks in China to trade bonds in the 
inter-bank market, both for their customers or their own 
accounts, on the same basis as Chinese-invested banks," 
according to the joint U.S.-China fact sheet, released on 
December 5, 2008.  Chinese regulators subsequently announced 
that foreign-invested banks would also be able to trade and 
underwrite bond issues on the inter-bank market, expanding on 
the original language.  Foreign banks are still unable to trade 
or underwrite bonds on the bond exchange for listed companies 
regulated by the China Securities Regulatory Commission (CSRC). 
End background. 
 
============================ 
Foreign Banks Considering Small Steps Into Bond Market 
============================ 
 
¶3.  (SBU) Our contacts among foreign-invested banks in Shanghai 
in a series of meetings in recent weeks have generally agreed 
that they will take only gradual steps into the local corporate 
bond market.  Although the China Banking Regulatory Commission 
(CBRC) issued a notification in mid January potentially opening 
the door for foreign-invested banks to buy, trade, and 
underwrite corporate bonds, the first step for most banks will 
be simply to buy and hold. 
 
¶4.  (SBU) Several banks are still studying the market 
conditions, say our interlocutors.  A Hang Seng Bank 
representative took one of the most conservative positions among 
our interlocutors, saying that he is pessimistic about the 
market conditions and that the bank's internal risk controls 
will not allow a quick move into corporate bond plays.  Others 
are more optimistic, including Citi-- especially interested in 
trading short- and medium-term notes, which have tenors of one 
to five years--HSBC, and Deutsche Bank.  (Note:  So far, only 
one bank has purchased a non-financial corporate bond.  Standard 
Chartered Bank on April 6 announced that it bought commercial 
paper, according to several local media reports.  End note.) 
 
============================ 
However, Underwriting Will Not Be Possible For Now . . . 
============================ 
 
¶5.  (SBU) Foreign-invested banks will not be able to underwrite 
new bond issues by corporations in the near-term, agreed our 
contacts.  This excludes them from the area of the bond market 
where foreign risk assessment tools would be most useful, and 
potentially the fees and profits the greatest.  Even should 
underwriting eventually be permitted, several contacts believe 
that foreign-invested banks will be required to be a part of an 
underwriting group, and not the lead underwriter. 
 
¶6.  (SBU) The distinction between buying and trading, on the one 
hand, and underwriting on the other is that the former do not 
require any additional licensing from the CBRC, say our 
interlocutors.  A Citi representative said that he anticipates 
that the CBRC Shanghai Office may ask some questions of banks 
 
SHANGHAI 00000185  002 OF 003 
 
 
interested in buying and trading corporate bonds, questions 
which he implied could be quickly answered satisfactorily. 
 
¶7.  (SBU) At the same time, other interlocutors saw potential 
hang-ups from other regulators before foreign-invested banks can 
buy and trade corporate bonds.  An HSBC representative said 
that, just as with domestic banks, the People's Bank of China 
(PBOC) will require that foreign-invested banks acquire PBOC 
approval before buying and trading short- and medium-term notes 
on the inter-bank market.  To do the same on behalf of clients, 
HSBC said, PBOC will require a statement of PBOC approval and a 
custodial license.  For the latter, there are significant 
staffing and training requirements, said HSBC, and in addition, 
the PBOC appears to be seeking to limit the expansion of 
custodial licenses.  Currently, 30-40 banks nationwide have 
custodial licenses, but the PBOC has put licenses on hold while 
it develops new application standards. 
 
¶8.  (SBU) A more significant problem in getting approval for 
underwriting is probable foot dragging by the National 
Association of Financial Market Institutional Investors 
(NAFMII).  The association is composed of the chief executive 
officers or chief financial officers of China's major domestic 
banks, said several of our interlocutors, and not only controls 
bond issuance schedules, but also regulates which banks are 
permitted to be bond underwriters.  As a Deutsche Bank 
representative described it, through this regulatory body, 
Chinese domestic banks control access to the corporate bond 
market.  HSBC's representative said that NAFMII promised HSBC to 
issue guidelines for applying to be a bond underwriter early 
this year, but implied that it would not approve this for 
foreign-invested banks for the near future.  In addition, 
underwriting also requires CBRC approval, which will also 
require negotiations, said HSBC. 
 
¶9.  (SBU) As a result, our interlocutors said that the process 
of getting approval for underwriting would likely take several 
months.  Standard Chartered's representative, for instance, said 
the bank would trade bonds for several months while hoping for 
approval to underwrite bond issues by September.  NAFMII is 
justifying its slowness on these approvals by arguing that 
foreign banks will not be willing to underwrite bonds anyway, 
because they are too risky in China, and that no foreign bank 
has an adequate platform to support underwriting bonds, 
according to HSBC's representative. 
 
============================ 
. . . And Flaws in the Bond Market Are Discouraging 
============================ 
 
¶10.  (SBU) Our interlocutors admitted that foreign-invested 
banks will be reluctant to jump into China's corporate bond 
markets as a result of several concerns.  These include: 
 - Inadequacy of the corporate credit rating system: JPMorgan's 
representative said that it is difficult to compare risk-return 
ratios across different companies, or even to evaluate a single 
company.  Our Hang Seng contact simply said that Chinese 
companies are not rated because they have such poor credit. 
-  Hedging is expensive:  JPMorgan's representative mentioned a 
second problem related to the first.  The cost of purchasing 
credit debt swaps to offset some of the risk in Chinese 
corporate bonds is so high that it wipes out the spread in 
yields over Chinese government treasuries, making it more 
remunerative to simply invest in treasuries. 
 -  Low liquidity:  Only 2 percent of Chinese bonds are "real" 
corporate bonds, said a representative of joint-venture 
securities firm HSBC JinTrust.  Most are issued by the 
government or financial institutions and are held by insurance 
companies to maturity, leaving few to be traded in the market, 
he noted. 
 - No bond yield reference curves:  Hang Seng's representative 
 
SHANGHAI 00000185  003 OF 003 
 
 
said that bond coupons are not market driven--China does not 
even have a market-driven government bond yield curve for a full 
range of maturities.  The contact described the interbank bond 
market as segmented.  On the one hand, bonds of maturity from 
one to three months are set by market forces, in part due to an 
active repo business.  On the other, bonds of maturity from four 
months to one year are also traded through one-off agreements 
between banks--a system that has been approved by the CBRC and 
PBOC--and these less-liquid markets lead to much higher interest 
rates.  As a result, the three-month interbank rate is 1 
percent, but the one year rate is 4.5-5 percent. 
 - The Chinese Government discourages corporate bond defaults. 
Our interlocutors all shared the observation that very few, if 
any, corporate debt defaults had recently occurred in China.  In 
fact, regulators require that underwriters guarantee their 
bonds, so that investors have recourse in case the business runs 
into financial difficulty. 
 - Most foreign-invested banks are not permitted to carry out 
interest rate swaps: Only JPMorgan is a corporate bond market 
maker among the foreign-invested banks, which at first was a 
position of high responsibility but little gain, said Standard 
Chartered's representative.  However, the CBRC in 2008 year tied 
this status to approval for interest rate swap products. 
Standard Chartered has since applied--and been rejected--three 
times.  Citi's representative agreed that corporate bond market 
maker status would be useful, since with it comes access to PBOC 
meetings. 
 
============================ 
Bonds Will Compete With Bank Loans 
============================ 
 
¶11.  (SBU) Banks want to deal in bonds because development of 
this market in China is inevitable, foreign banks are highly 
restricted from underwriting and trading equities, and interest 
rate controls limit the ability of foreign banks to compete with 
Chinese banks on corporate loans.    Our interlocutors pointed 
out that bank lending and bonds are substitutes, to some extent. 
 For instance, the volume of bond issuance increased in the past 
two years under credit quotas, but since the beginning of 2009 
bond demand has fallen as lending surged, said a representative 
of China Merchants Bank. 
 
============================ 
Comment 
============================ 
 
¶12.  (SBU) Bond market development remains an important priority 
for Chinese regulators, as a means to provide more market 
oriented financing and improve the efficiency of financial 
intermediation.  In particular, Chinese officials hope to 
emulate the experience of the U.S. and other countries by 
allowing large companies to access more financing in the bond 
market, thus freeing up more bank lending for small and 
medium-sized enterprises.  Foreign-invested banks in East China 
welcome any signs of progress in financial innovation and 
opening to non-domestic players, given the difficulties and 
discrimination they experienced this past fall during the height 
of the global financial crisis.  However, our contacts among 
foreign-invested banks are suspicious that their domestic 
competition continues to manipulate regulatory bodies to exclude 
them from potentially high-fee bond underwriting business.  In 
particular, CITIC and China International Capital Corporation 
(CICC) appear intent on maintain their large market share for 
bond underwriting.  With the experience foreign-invested banks 
earned pricing risk and marketing bonds in developed 
economies--despite doubts raised by problems with 
developed-country financial markets as a result of the ongoing 
crisis--bond underwriting  is an area where foreign-invested 
banks could potentially bring the greatest value-added. 
CAMP