China's bond market reforms key to growing with less debt

This is a thought leadership report issued by S&P Global. This report does not constitute a rating action, neither was it discussed by a rating committee.

The ratio of nonfinancial sector debt to GDP remained stable for much of the 2000s but has more than doubled between 2008 and 2023, based on our estimates (Chart 1). On several occasions in the past decade, authorities have taken action to reduce leverage in different parts of the financial system. However, despite these efforts, debt continues to rise even as nominal GDP growth slows down.

In principle, managing macro leverage has been a policy objective since 2018. But policymakers have often relaxed credit policies to boost economic growth, leading to an increase in overall debt and total social financing (TSF) — the People's Bank of China's (PBOC) concept of aggregate financing — as a share of GDP. 

The government's concurrent focus on containing leverage and raising efficiency reflects the recognition that these factors are interconnected. Indeed, if China's large savings pool continues to be deployed inefficiently, it may end up fueling more systemic risks than growth potential. 

A large savings pool may also raise policy risks if it were to lead to complacency and the perception that China does not need foreign capital, and therefore, outward-oriented reforms. However, foreign investments are crucial for introducing global competition and market discipline to raise efficiency in sectors that have been protected from such forces.

The larger need for credit is partly due to a shift in investment composition towards more infrastructure since the global financial crisis. Such projects tend to be largely debt-funded as they hold long-lived assets that are typically owned and regulated by local or central governments through their state-owned enterprises (SOEs). Since 2010, the share of investments in infrastructure rose, while that of corporates fell. The share of real estate investment has fallen in recent years, after rising earlier on.

In addition, due to a decline in profitability, there has been an increase in external financing. The rate of return on assets in industry fell significantly in the early 2010s (Chart 5). That was particularly so in SOEs, which are generally less profitable than privately owned enterprises (POEs), even when correcting for sectoral composition. Profitability has improved since 2016, in part because of supply side reforms, but it has not been enough to offset the earlier fall. 

Policymakers understand the need to simultaneously control leverage and sustain economic growth over the long term to keep systemic risks at bay. However, the path forward is fraught with challenges.

China may need to reduce its investment-to-GDP ratio as returns on investment fall and shift its pattern of growth towards consumption. The country's capital-output ratio has been consistently rising (Chart 6), which cannot continue indefinitely. However, cutting investments to contain macro leverage will invariably slow down the pace of growth. To minimize the impact on growth, rebalancing towards more consumption and less investment may need to take place alongside robust productivity growth. 

While China's total factor productivity (TFP) growth has fallen from the very high rates of the 2000s, it continues to compare favorably internationally (see "China's Trend Growth To Slow Even As Catchup Continues," published Nov. 9, 2022). Yet more productivity-enhancing reforms may be needed to continue to sustain TFP growth in the decade ahead.  

Meanwhile, improving the efficiency of financing would reduce debt accumulation for given levels of investment, thus helping to control leverage while sustaining growth. China's policymakers recognize this. In its May 2024 quarterly monetary policy report, the PBOC noted "a weakening correlation between credit growth and economic expansion" and cautioned about "diminishing returns for additional loan extension with already substantial credit stock." 

When credit is extended to less competitive firms over time, it incentivizes lower productivity and obstructs market forces from selecting out firms that cannot sustainably grow their cash flows faster than their debt servicing and repayment needs Such an environment may prevent more competitive firms from emerging in sufficient numbers, and may incentivize lenders to continue to lend to less competitive firms, This leads to more investment needs, more debt, and less productivity growth. 

The efficiency of financing is determined by a range of factors, including the composition of investment and policies towards the banking sector and equity financing. Yet, allowing market forces to play a larger role is essential for raising it. Credit markets will be key in this endeavor, as they are the main delivery vehicle of market forces when it comes to credit allocation. 

More importantly, the bond market's expansion has been driven by government bonds, which grew to 19% of TSF from 8%, while that of corporates remained broadly unchanged at around 8%. This suggests that the bond market's ability to allocate credit efficiently according to risk has remained weak.

This is because corporate bonds are more influenced by credit risks than bonds issued by the central government and government-owned financial institutions, as the latter are viewed by domestic investors as nearly free of default risk or highly unlikely to default. Hence, as they occupy larger shares of the bond market, less credit is allocated on the basis of efficiency or credit risk differentiation between stronger and weaker firms.

The increased sales of special-purpose bonds by local governments has exacerbated these issues. By reducing the need for local government financing vehicles (LGFVs) to issue bonds to finance infrastructure projects, the substitution of government issuers for corporate issuers has undermined credit differentiation and credit risk pricing in the market.

The diminishing significance of corporate bonds versus government bonds is an important indication of the state sector's crowding out of the private sector in terms of financing, which reduces participation by more diverse cohorts of firms. This trend remains a core challenge for the country, despite decades of reforms aimed at improving efficiency.

The size of China's bond market is no longer a problem. Rather, the key issue lies in the market's ability to allocate funds efficiently to enhance efficiency in the economy. In this regard, corporate bond reforms that ease access for issuers and that allow more market forces to function would be key to improving the quality of the market and to reversing current trends. 

The ultimate discipline exerted by bond markets are defaults. In China, that discipline continues to lag well behind other global markets. After the country's first domestic bond default in 2014 and its first domestic SOE bond default in 2015, defaults have remained remarkably low compared to elsewhere in the world (Chart 9). After a brief normalization towards global levels in 2018 and 2019, default rates diverged and fell to yet lower levels in the last four years, as concerns of triggering systemic risks led officials to guide against open defaults in the bond market. 

As a result, the low default rates in China likely reflect weaker market discipline rather than better credit quality, indicating a step back rather than a step forward in the development of the country's bond market.

Another challenge to developing more disciplined, market-driven and efficient credit allocation through China's bond market is the overwhelming weight of SOEs and the small presence of POEs. Out of a total of 6,884 issuers in the domestic bond market, state-owned corporates make up 5,225, while privately owned corporates make up only 1,037 (Chart 10). 

In terms of bond volumes, or bonds outstanding, SOEs make up 19%, and POEs only 1% of the market (Chart 11). In other words, entities that are most fully and directly subject to market-driven credit allocation make up only 1% of China's bond market. This presents a major obstacle as market forces struggle to drive efficiency improvements when their influence affects only a small share of China's total financing needs. 

Since SOEs make up 83% of China's corporate bond market, any corporate bond reform would also involve SOE reforms. The declining share of POEs in the bond market also explains why default rates could surge among POE property developers in 2021 and 2022 while overall default rates fell — that is, that the former was too small to overwhelm or reverse the latter. 

More importantly, since these defaults include most large POEs in the sector, investors, lenders and home buyers have been compelled to shift to SOE developers. This resulted in more crowding out of the private sector and more credit selection by perceived state support, exacerbating moral hazard rather than raising efficiency.

For decades, most domestic investors have relied on the government to support most SOE issuers. This has led to an overwhelming number of SOEs in the bond market, which has led to the lack of credit differentiation. Currently, almost 90% of domestic credit ratings are concentrated in the AAA (21%), AA+ (29%), and AA (39%) ratings, making it difficult for investors to differentiate and price risk, and therefore, challenging the market's ability to allocate credit to improve efficiency (Chart 12). 

A more granular and differentiated risk distribution, such as the one seen in Asia-Pacific's dollar bond market (Chart 13), can improve the market's ability to channel more credit to more competitive and efficient borrowers and less to less competitive or less viable borrowers. This would reduce deadweight loss incurred by the latter.