In early July, under the “Bond Connect” program, the Chinese corporate bonds market opened its doors to foreign investors. Valued at almost U.S. $10 trillion and with high growth potential, China’s capital market represents a significant opportunity for international financial institutions.
However, since the Shanghai Chaori Solar Energy Science & Technology’s landmark payment default in 2014, analysts have been closely monitoring the People’s Bank of China deleveraging strategy and liquidity reduction plans. Concerns have also been raised about the need for regulators and policy-makers to increase the overall transparency of the system and resilience of the bond market.
While up until 2014 the Chinese government and major banks were expected to bail out financially troubled companies, in the last three years the number of corporate defaulters has been increasing steadily indicating that this practice may be on the way out.
Financial commentaries and experts have turned to using hyperbolic and panic-loaded statements to characterize the current market situation, spurring sentiments of caution or worry in investors and observers alike.
But what else is panic if not the consequence of ill-defined risk?
How should financial institutions investing in the Chinese bond market reduce uncertainty?
Among the most established and proactive measures employed is third-party due diligence. Properly outlined due diligence checks help understand who you are dealing with, define the boundaries of a problem, and identify hidden risks.
There are three essential areas that should not be overlooked when conducting a due diligence assessment.
The Chinese bond market, notoriously, has been considered a regulatory wild west, fraught with conflicts of interest, loose regulations and inadequate enforcement. This has contributed to reckless behavior bordering on illegality by some operators. For example, in 2013 authorities cracked down on trading practices known as “passageway business,” “substitute holding,” and “shadow banking,” used by funds, brokerages, and banks to disguise losses, undercut clients profits and to elude regulatory requirements. More recently in 2016, following a bond default, a dispute between Evergreen Industries Holding Group’s investors and underwriters highlighted gaps in disclosure requirements and lack of accountability by the latter, that left investors bear the cost of the default.
Due diligence can ensure a clear and up-to-date understanding of the market rules as well as identify potential conflicts of interest or undisclosed problems.
It is not unusual in China for businesses to either be owned by government officials or to have ties to them. Specifically, the Chinese government retains a strong presence in the bond market, as the majority of issuers are government-linked entities. The intricacies of Chinese corporate social networks go beyond the simple identification of politically exposed person or entities. In fact, companies that have connections to local or national public officials can benefit from financial backing and protection from market downturns. But this is highly dependent on the level of influence and power exerted by the official or state-linked entity in state affairs at the time. To complicate matters further, there is also a strong correlation between government ties and incidences of corruption.
Thus, navigating the universe of political connections and the balance of power is a complex exercise that requires a thorough knowledge of Chinese politics and culture. This is needed to assess the likelihood an entity or a bond issuer will be bailed-out or receive government support and, at the same time, protect from undue violation of anti-bribery regulations.
Financial accountability and corporate transparency
In numerous recent due diligence investigations Thomson Reuters has conducted in the Chinese market, a common thread has emerged. Accounting irregularities tend to go hand-in-hand with convoluted corporate structures, reliance on government subsidies, and opacity of the key stakeholders’ source of wealth. Such occurrences are normally followed by the discovery of fraudulent behaviors (e.g. false financial statements), multiple legal disputes and, worse, official investigations. While none of these issues, on its own, will necessarily predict the presence of all the other problems combined, they should nevertheless be treated as symptoms of potential misconducts.
To find out more access our webinar recording of Emerging Market Challenges and Opportunities – How are you mitigating KYC Risk? and listen to what our experts have to say about navigating complex emerging markets with a special focus on investing in the China Bond Market.