CHINA: An Introduction to Capital Markets: Debt (International Firms)
A General Overview of Debt Capital Markets in China
Issuance of offshore debt by Chinese issuers has been significantly affected by the macroeconomic policies in China and changes in the interest rates on USD and CNY-denominated assets since 2022. Impacted by US interest rate hikes, the cost for Chinese issuers to raise offshore USD funding surged, which resulted in a significant decrease in the number and size of USD bond issues by Chinese issuers. This was accompanied by weak market sentiment in the high-yield market attributable to regulatory restrictions on debt financing to property developers, increasing defaults in high-yield bonds since late 2021, and rising concern over the large amount of debt of the real estate sector to be re-financed. As a result, the total offshore debt issuances by Chinese issuers dropped by 62.1% to approximately USD111.4 billion in 2022 from USD294 billion in 2021. For the first half of 2023, the total offshore debt issuances by Chinese issuers amounted to USD88.2 billion, a 7.4% drop compared to the same period in 2022. In the meantime, CNY-denominated debt issuances in the Shanghai Free Trade Zone (FTZ) thrived in 2022 as a result of the rising USD interest rates, but reduced significantly after the second quarter of 2023 due to tightened regulatory scrutiny.
Under the current regulatory regime, developed on the basis of the Administrative Measures for the Review and Registration of Mid- to Long-Term Foreign Debts of Enterprises (the “2023 NDRC Measures”) issued by the National Development and Reform Commission (NDRC), which became effective on 10 February 2023, Chinese issuers (including offshore vehicles controlled by Chinese corporates or financial institutions and “red chip” companies with their primary business operations in China) are required to go through a “review and registration” process with the NDRC for their foreign debt issuances with an original maturity of one year or more. The 2023 NDRC Measures set out the substantive requirements on the eligibility of issuers and use of proceeds from foreign debt issuances (listing certain prohibited areas for use of proceeds). Compared to the previous NDRC rule on foreign debt issuance, the 2023 NDRC Measures removed the eligibility requirement for foreign debt registration that an issuer must not have defaulted on any outstanding debt. This relaxation could potentially allow issuers that have defaulted on debts to borrow new foreign debt. The 2023 NDRC Measures also expressly empower the NDRC to manage the total size and mix of foreign debt issued by Chinese enterprises. In addition to the pre-issuance NDRC review and registration, issuers are also required to register their foreign debt with the State Administration of Foreign Exchange (SAFE) and submit certain foreign-debt related information to the NDRC after the issuance (where applicable).
Investment Grade Bonds
Issuers of investment grade bonds primarily include financial institutions, major state-owned enterprises and public companies. Approximately 15% of USD bonds issued by Chinese issuers in 2022 and 39% of the outstanding USD bonds of Chinese issuers as of the end of 2022 were investment grade bonds. As USD interest rates rise, the offshore financing costs for Chinese investment grade issuers have spiked to a historic high since the second half of 2022, dampening their desire to issue USD debt securities.
High-Yield Bonds
The real estate sector has traditionally dominated the high-yield market for Chinese issuers. Since 2020, regulators (including the Ministry of Housing and Urban-Rural Development and the People’s Bank of China) have tightened up the restrictions on debt financing for the real estate sector, including setting “three red lines” for property developers, namely total liabilities (net of prepayments received) to total assets (net of prepayments received) at no more than 70%, net debt to equity ratio at no more than 100%, and cash to current debt ratio of no less than 100%. Property developers that breach all three of these red lines are not allowed to raise new debt.
In addition, defaults by property developers on high-yield bonds have become more frequent than ever since 2022, given the increasing difficulties in their re-financing due to the above-mentioned regulatory restrictions, as well as the decline in sales of real properties during the economic slowdown. In 2022, 63 bonds issued by property developers defaulted, with an aggregate principal amount of USD22.6 billion, a significant increase from USD4.2 billion in 2021. This has further chilled market sentiment for high-yield bonds. Only a few issuers completed high-yield debt issuances with credit enhancement through standby letters of credit in 2022, and the high-yield market for Chinese issuers remained in a slump in 2023 as defaults in the real property sector continued.
Government Bonds
Central and local Chinese governments have been active in the offshore debt markets in recent years. The Ministry of Finance of the People’s Republic of China and the People’s Bank of China have been actively issuing USD, EUR and CNY-denominated debt securities in Hong Kong and Macau since 2020. In addition, certain local governments, such as the Guangdong Provincial Government, the Hainan Provincial Government and the Shenzhen Municipal Government have also issued a number of CNY-denominated offshore debt securities in Hong Kong and Macau since 2021, further diversifying the market for Chinese government bonds.
Local Government Financing Vehicles (LGFVs)
Financing vehicles owned by Chinese local governments have contributed a lion’s share of offshore debt issuances by Chinese issuers. Offshore debt issuances by LGFVs have increased significantly since 2019, as regulatory restrictions over onshore debt financing for these vehicles tightened. In 2022, LGFVs were one of the very few sectors in the offshore debt market that saw an increase in total issue size.
As LGFVs typically do not have inherently profitable business models and rely on local government spending to repay their debt, their creditworthiness is usually assessed by investors to a certain extent based on, but not necessarily correlated to, the fiscal strength of the local government and local economic development. This remains the case, although the Chinese government has repeatedly emphasised that local governments may not provide any kind of guarantee or assurance as to the repayment of debt by these financing vehicles. Therefore, in light of the uncertainties in the Chinese economy, most offshore debt issuances by LGFVs in 2022 and 2023 were conducted by issuers in the regions with strong economies. In addition, standby letters of credit issued by commercial banks became a popular credit enhancement for this type of issuer, helping them to secure investors and manage financing costs. However, commercial banks have also faced regulatory scrutiny since the second half of 2022 with respect to standby letters of credit issued for the benefit of LGFVs. As such, certain commercial banks have cut back these types of standby letters of credit, which may result in refinancing difficulties for certain LGFVs.
On the other hand, China has continued its efforts to manage the “hidden debt” of local governments. It was reported during the first half of 2022 that offshore debt issuances by LGFVs became subject to additional scrutiny by the NDRC, including certain eligibility requirements based on the issuer’s income, profit and the use of proceeds. As such, LGFV issuances saw a significant decline in the first half of 2023, with only 175 new issuances and a total issuance size of USD15.4 billion (41% down from the first half of 2022), among which, 63% were FTZ issuances.
Shanghai FTZ Offshore Bonds
The Shanghai FTZ has been a newly developed offshore debt-financing market for Chinese issuers since 2019, and saw significant growth from the first FTZ offshore bond offering by an LGFV in December 2019. In particular, as the interest rates on CNY-denominated debt reached a level lower than that for USD-denominated debt, CNY-denominated offshore FTZ bond issuances became a popular option for Chinese issuers. The total size of offshore FTZ debt issued in 2022 amounted to USD5.5 billion, of which approximately 96.3% was CNY-denominated and 89.3% was issued by LGFVs. SAFE registration is usually not required for certain issuances of such offshore FTZ bonds, removing hurdles for the relevant issuers to issue offshore debt.
However, the FTZ offshore bond market shrank quickly towards the end of the second quarter of 2023, as Chinese issuers outside the FTZ were restricted from raising FTZ offshore bonds. This restriction almost brought this newly developed market to a halt, as a significant number of FTZ issuers were Chinese LGFVs. As a result, FTZ issuances have become scarce since mid-2023.