Corporate investors in China have experienced enormous changes over the past twelve months. The combination of slower economic growth, rapid regulatory changes and unpredictable investment markets has created an environment of uncertainty and volatility making it difficult to determine which of the myriad perceived risks are genuine and in turn, how these can best be managed. To help, this article outlines the five key risks that corporate treasurers should consider when operating and investing cash in China.
Market risk
While China’s economic growth rate remains strong and continues to outpace most other economies, the recent slowdown from the rapid pace of growth seen in the last three decades has inevitably caused concern for investors – especially given China’s economic importance. The size and magnitude of the slowdown and potential impact on domestic demand and corporate investment plans remain key questions. However, a slowdown was inevitable and is consistent with China’s increasing economic maturity. Furthermore, slower, more sustainable economic growth should lead to greater resilience and transparency and as such, economic risks should not be overstated.
The government and People’s Bank of China (PBoC) are actively focused on achieving a ‘soft landing’, using a combination of fiscal policy and easier monetary policy to stabilise the slowdown in growth. The government is also continuing its programme of regulatory reform at a rapid rate in order to create a more stable foundation for future economic growth and development.
There are other positive factors too. For example, China’s services sector continues to grow strongly, representing approximately 55% of China’s GDP and recently replacing the manufacturing and export sectors as the largest driver of economic growth. Both Chinese corporations and foreign multinationals operating in the services sector are experiencing strong growth opportunities.
Currency risk
The recent decline in the value of the Chinese renminbi (CNY), most notably against the USD has been a definite cause for concern amongst foreign corporates operating in China. After China ended the renminbi’s strict peg to the USD in 2005, the currency appreciated steadily for almost a decade, offering foreign corporate investors positive returns with limited downside risks. However, since early 2014, the value of renminbi holdings has declined and currency volatility has increased, most notably in the off-shore renminbi (CNH) market and in the difference between the PBoC FX spot and fixing rates.
The increasingly rapid pace of currency depreciation in recent months has fuelled speculation of further declines. However, the depreciation of the renminbi also needs to be seen in a wider context. No currency can appreciate indefinitely and increased volatility is the inevitable consequence of currency liberalisation.
As the USD continues to appreciate, driven by stronger US growth and expectations of higher Federal Reserve interest rates, the renminbi, along with many other global currencies will depreciate against it; however, it should be worth noting that the renminbi’s depreciation against the dollar over the past two years has been less than other major currencies.
Furthermore, renminbi is maturing as a currency: its inclusion in the International Monetary Fund (IMF)’s special drawing rights (SDR) basket, alongside USD, EUR, JPY and GBP is prestigious and an international vote of confidence in the reminbi. Currently the renminbi only represents 1% of global reserves while the on-shore Chinese bond market has grown into the third largest in the world. Both should benefit as international central banks and investors reallocate their investments to these new asset classes.
The change in the renminbi’s value and prospects creates very different conditions for corporate treasurers compared with just two years ago. Previously, China’s closed capital account was not a significant concern for foreign corporations, who were willing to let cash balances build up in China for extended periods to enjoy higher interest rates and currency appreciation. Today, with the value of the renminbi declining, corporate treasurers in China should optimise their cash balances to fulfil their entity’s investment and working capital requirements. Fortunately, this task should be easier to achieve now that China has committed to opening up its capital account, resulting in cash being less ‘trapped’ in China. That said, corporate investors in China should be mindful that challenges relating to free flow of capital will still remain in the short term.
Regulatory risk
Treasurers are becoming increasingly adept at assessing and managing regulatory risk; however, China offers particular complexities. Firstly, there are a number of different regulators that often have conflicting and/or overlapping objectives, so it is important to understand the role and objectives of each agency. Secondly, the pace of regulatory change has accelerated over the past two years, with substantial reforms, including the introduction of a deposit guarantee scheme, freeing up the interest rate mechanism, and opening up the intra-bank bond market to foreign investors. Both individually and collectively, these reforms have had, and will continue to have, a profound effect on the investment environment in China.
[[[PAGE]]]
For example, since banks are now free to compete on interest rates, the range of time deposit and other investment options available have increased rapidly. This should allow treasurers to diversify their risk more effectively; however, the removal of the implicit government guarantee on all bank products now compels corporate investors to weigh up risks and returns in a way which they have not been required do before, giving careful evaluation and analysis to each counterparty and instrument.
The money market funds (MMF) industry in China is still young, but it has proved to be a great success, with MMFs popular amongst both retail and corporate investors, attracted by their higher returns and good liquidity. However, a lack of disclosure and relatively loose guidelines compared to international MMF standards has caused unease for some foreign corporate clients. Fortunately, in 2016, the China Securities Regulatory Commission (CSRC) published new rules to improve the resilience of MMFs and bring them more closely in line with Western money market fund practices. For example, weighted average maturities limits have been reduced, while minimum fund liquidity and diversification requirements have been increased. Although these changes make it more difficult for fund managers to achieve high yields, this should be offset by greater investor confidence in security and liquidity.
Interest rate risk
In the past, when bank deposits were the only investment product available and when the PBoC set official rates for all borrowing and lending tenors regardless of counterparty risk, determining the best investment choice was relatively easy. The proliferation of interest rates and new investment products triggered by interest rate liberalisation offers the potential for higher returns, but also greater uncertainty and risk as corporate investors consider the characteristics of different instruments and the value of different interest rates from a variety of different banks.
In addition, attempting to understand the PBoC’s objectives and foreseeing the future direction of interest rates has also become more challenging as the central bank alters its focus from manipulating the cost of funding via policy rates to the quantity of funding via open market operations. However, with a robust investment decision-making process, it is possible for corporate investors to achieve higher returns without significantly increasing risk.
Credit risk
This is arguably the most important, yet currently one of the least understood risks in China. Although the speed of economic growth has slowed, levels of outstanding debt have continued to increase at a rapid pace. Meanwhile, credit spreads have been tightening substantially as investors hunt for yield, despite the deterioration in issuer profitability and less ability to repay debts.
This is compounded by the fact that credit ratings issued by domestic Chinese credit rating agencies are not as insightful or consistent as the international rating agencies, and may offer investors a false sense of security regarding the credit quality of the issuer. Although international ratings are deemed to be more credible, only a small proportion of Chinese bond issuers apply for them. For example, while the largest 200 banks in China are rated ‘AA-‘ or better by local agencies, only the largest five banks in China are rated ‘A-‘ or better by international rating agencies.
Meanwhile, concerns about grade inflation by domestic rating agencies are common, with over 70% of Chinese corporate bonds rated ‘AAA’ by domestic rating agencies.
Historically, this lack of rating clarity and poor bond issuer profitability was not a major concern for investors; but these concerns cannot remain as the status quo, especially since corporate bond issuers in China first began to default in 2014 – previously an unprecedented event across the entire 65 year history of the People’s Republic of China. The increasing number of corporate defaults over the past two years has created a major challenge for foreign and domestic investors: namely, how best to analyse credit quality given that only a minority of institutions have international ratings.
To combat these issues corporate treasurers should establish a two-pronged approach to credit research. Firstly, they need to review the financial profile of the counterparty on a standalone basis, including its willingness and ability to repay debts, in the same way as conducting credit analysis in any other country. Secondly, it is important to analyse the likely level of government support in the event of a potential default, including specific information on the systemic importance of the issuer and the government’s ownership. For example, major utilities and priority industries with strong links to the central government are more likely to be supported than companies that are linked to smaller regional or local government entities.
[[[PAGE]]]
From risks to opportunities
Despite the challenges, there is a wealth of opportunities for investment in China, so long as treasurers are able to dedicate the necessary skills and resources to evaluating risks associated with corporate cash investment in China. This is difficult in practice, given that most treasury functions comprise small teams, particularly so for regional treasury centres. Consequently, a growing number of both Chinese and foreign corporations are choosing to outsource their investment management in order to access specialist knowledge and dedicated resources. Having a liquidity solutions partner such as J.P. Morgan Asset Management (JPMAM) gives corporate treasurers better assurance that thorough credit analysis, policy compliance and transaction management are being conducted in accordance with international best practices. J.P. Morgan Global Liquidity (part of JPMAM) provides corporate and institutional cash investors in China with access to the valuable investment insights and local market expertise of one of the world’s leading money market fund providers.
China is a challenging market with both similarities to and differences from other investment markets globally. That said, corporate treasurers who are able to fully grasp China’s evolving market and regulatory conditions, and adapt their investment behaviour accordingly, are most likely to be one step ahead of their industry peers.
Aidan Shevlin Aidan Shevlin, Managing Director, is Head of Asia Pacific Liquidity Fund Management for J.P. Morgan Asset Management. Based in Hong Kong since 2005, he is a member of the global liquidity fund management group and is responsible for managing all Asian liquidity funds and short duration bond funds. During his time in Asia, a key responsibility for Aidan has been the development, launch and management of local currency money market funds across the region. Aidan originally joined J.P. Morgan Asset Management's International Fixed Income group in London in 1997. In that group, He had a wide range of responsibilities including managing short duration credit portfolios, European liquidity funds and Libor-based strategies. He was also previously an analyst in the fixed income quantitative research team. Aidan obtained a B.A. in Banking & Finance from the University of Ulster. He holds an M.Sc. in Finance and an M.Sc. in Computer Science, both from the Queen’s University of Belfast. He is also a CFA charterholder. |
