One of the most immediate dangers facing the Chinese economy right now is money leaving the country — what’s called capital flight.
It has hit record highs over the last year, and even long term China-bulls realise that’s a big problem.
They understand that China needs cash to deal with huge systemic problems, like an ailing real-estate market and massive zombie state-owned enterprises weighed down by debt.
So this outflow has to be stopped as soon as possible. The Institute of International Finance estimates that $676 billion left the country in 2015.
The government has continued to introduce strict measures to stop outflows, and has continued to defend the yuan to make it less likely that people will exchange it for other currencies, but those measures won’t work completely. Companies know how to get around them if they want to.
So the question has become, “can you create a product that keeps money onshore,” said Brett McGonegal CEO of Hong Kong investment bank, Reorient Group.
In other words, can you create something that yield-hungry investors will want to park their money in? We are, after all, living in a world where central banks are considered daring if they raise rates by 0.25%.
“If you take local government debt and make it trade with an interest rate of 3% to 4%, they won’t leave,” McGonegal said.
And, he points out, the Chinese people have the savings to get in the mix here too. Creating this market definitely isn’t a cure-all, but it could help the government keep things together while they fix systemic problems.
How bond markets are born
China’s local government financing vehicles (LGFVs) have been key drivers of the economy for years, mostly spending their resources building infrastructure projects. Now, their debt has come to equal almost 40% of China’s GDP, according to Moody’s.
In a country fighting debt and overcapacity, the LGFV debt has become a significant part of the problem. What’s more, that debt is being traded around in China’s opaque shadow banking sector.
That is why the government has been swapping local government debt for lower interest bonds — creating the transparent market McGonagal is talking about. In 2015 the country converted $486 billion worth of that debt into low interest bonds.
This, ladies and gentlemen, is how a sleepy, low interest municipal bond market is (ideally) made.
The best laid plans
Now you may be saying to yourself — this plan sounds familiar. It sounds like the Chinese stock market.
You’re right. This plan does sounds like the stock market. Create a market for investors and draw out the savings of Chinese citizens, maybe attract some foreigners, and keep money flowing through the system.
The Chinese government has been trying different ways to do that through monetary easing measures for over a year now. Dealing with issues like debt and overcapacity suck money out of the system. This is a counter to that.
All that said, creating the stock market didn’t exactly pan out like the government thought it would given its two major crashes last summer and major volatility into 2016. It’s become something that investors point to as an example of how the best laid plans don’t always work out, and according to research firm Autonomous, they’re losing faith in the Chinese government’s management skills.
In fact, Credit Suisse said this summer that the stock market bubble and pop was actually part of a triple bubble caused by the government driving investors there, as well as into credit and property markets.
So a venture into China’s new municipal bond market may not be for the faint of heart.
“Do I think it’s going to go off without a hitch? Absolutely not,” McGonegal said.
But — if you’re looking for 3%-4% returns in a low yield world, you may be willing to stop playing it safe. That’s what China and its bulls is hoping for.