1. ‘The China Impact’ Workshop: The Ascent of China’s DCM The Houses of Parliament, 25 April 2007 Francesco U. Garzarelli Managing Director, Macro and Markets Research Goldman Sachs International, London francesco.garzarelli@gs.com

2. The Ascent of China’s DCM

3. 3 China’s DCM Can Become a Heavy-Weight China’s bond market has expanded twelve-fold since 1997, reaching around US$ 700bn (~30% of GDP). China’s bond market has expanded twelve-fold since 1997, reaching around US$ 700bn (~30% of GDP). It remains immature, largely due to two factors: (i) the banks’ role in advancing the government’s priorities; (ii) the ongoing reliance on quantity and price controls in the conduct of monetary policy. It remains immature, largely due to two factors: (i) the banks’ role in advancing the government’s priorities; (ii) the ongoing reliance on quantity and price controls in the conduct of monetary policy. The pace of capital market reform has accelerated. GS estimates that DCM capitalization could double, reaching about 60% of GDP in ten years’ time. The pace of capital market reform has accelerated. GS estimates that DCM capitalization could double, reaching about 60% of GDP in ten years’ time. By 2016, China’s DCM could represent 4-10% of G7 debt capitalization, in today’s prices – a similar order of magnitude as the French and German markets combined today. By 2016, China’s DCM could represent 4-10% of G7 debt capitalization, in today’s prices – a similar order of magnitude as the French and German markets combined today.

4. 4 The Evolution of G7 Domestic Debt Markets Source: Davis (1996), BIS *US, UK and Canada. **Japan, France, Germany and Italy G7 Bond Market Capitalization as % of GDP

5. 5 Cross-Section Data Points to DCM Growth Source: Goldman Sachs calculations. See: Bonding the BRICs: The Ascent of China’s Debt Capital Market, Nov. ’05. 1970-1990 Panel Regression on G-7 Countries

6. 6 Per Capita Income to Follow in G7 Footsteps Source: National central banks, GS BRIC model projections China and G7 Per Capita GDP, 1970-1995 (Actual) and 2005-2030 (GS f’cst)

7. 7 Aging Should Boost Demand for Pensions Source: UN population statistics China and G7 Dependency Ratio Projections

8. 8 By 2016, as Big as the UST Market Today Source: GS calculations in 2005 prices Estimated Growth Path for China’s DCM

9. 9 Growth and Liberalization Are the Main Drivers Source: GS calculations. *These figures reflect the contribution to the size of the DCM market in GDP terms Estimated Contributions to China’s DCM Growth

10. The Current State of Play

11. 11 China’s DCM Is Still Comparatively Small Source: BIS Asian Bonds: 2006 figures *includes PBoC sterilisation bills Asian Debt Capital Market Capitalization, in % of GDP

12. 12 And an Immature Market in Several Respects  Government bonds account for half the market, state-owned policy banks for roughly an additional 40%.  Non-financial corporate bonds are just 9% of the market.  Fastest-growing segment is the commercial paper market, which has soared to around US$40bn in just 18 months.  Turnover is light, with banks holding most securities to maturity.  Inter-bank market has a 95% share of secondary trading.

13. 13 Banks Hold the Lion’s Share of Chinese Bonds Source: ChinaBond Note: Data as of Sept 2006. Other financial institutions include credit cooperatives and other non-bank financial institutions Breakdown of Bonds Ownership by Type of Institution

14. 14 Growth Has Been Rapid, But Driven by Public Debt Source: ChinaBond, Sep 2006 data China: Composition of Outstanding Bonds

15. 15 A Comparatively Small Non-Public Debt Market….. Source: BIS calculations Note: For China government bonds include bonds issued by policy banks. Corporate bonds include commercial paper. *US, UK and Canada. **Japan, France, Germany and Italy Breakdown of Bonds Outstanding by Issuing Sector, % of GDP

16. 16 …..Whether Measured by GDP or by Market Share Source: BIS calculations Note: For China government bonds include bonds issued by policy banks. Corporate bonds include commercial paper. *US, UK and Canada. **Japan, France, Germany and Italy Breakdown of Bonds Outstanding by Issuing Sector, % of Total

17. 17 Corporate Debt Is Just a Tiny Slice of the Pie Source: ChinaBond China: Breakdown of Outstanding Bonds by Instrument

18. 18 Commercial Paper Market Takes Off Source: CEIC, Goldman Sachs China: Outstanding Amount of Commercial Paper

19. 19 Private Savings Languish in Bank Deposits Source: National central banks Corporate and Household Sector Savings, as % of GDP

20. 20 Institutional Investors: A Snapshot Insurance: US$200bn  50+% in domestic bond market, <40% with banks  Low insurance penetration rates and preference for precautionary savings suggest significant growth ahead Mutual funds: US$60bn and growing rapidly  40% in equities; <1% in corporate bonds  Strong growth in just 2 years State pension (Social Security Fund): under-funded at US$32bn  By law, 50% must be in bank deposits and Treasuries Occupational pensions: US$10bn on its way to US$125bn?  40% invested in equities; <15% in banks and Treasuries

21. 21 Half of State Pension Funds Are in Bank Deposits Source: National Social Security Fund (SSF) 2005 Annual Report, GS calculations China’s State Pension Funds: Asset Allocation

22. 22 Insurance Funds Are Moving Towards Bonds Source: China Economic Information Network, 2005 data China’s Insurance Funds: Asset Allocation

23. 23 Mutual Funds Are Largely Invested in Equities Source: China Fund, 2005 data China’s Mutual Funds: Asset Allocation

24. 24 The Goal: Channeling Savings into Investments National household savings rate is 24%, more than three times the OECD average. National household savings rate is 24%, more than three times the OECD average. Most savings are ‘precautionary,’ due to weak social security programs and low penetration of pensions and insurance. Most savings are ‘precautionary,’ due to weak social security programs and low penetration of pensions and insurance. Bank deposits are 141% of GDP, despite low returns. Bank deposits are 141% of GDP, despite low returns. Institutional investor community is nascent, but holds high potential for growth. Institutional investor community is nascent, but holds high potential for growth.

25. Moving from Quantities to Prices

26. 26 Three Overarching Guidelines Market size should not be the main priority. The focus should be on price disclosure and transfer of risk. Market size should not be the main priority. The focus should be on price disclosure and transfer of risk. Extensive and deep changes to both policy and the regulatory framework are required. Extensive and deep changes to both policy and the regulatory framework are required. Incremental approach has its benefits, but reforms should be pursued simultaneously, to avoid creating further distortions. Incremental approach has its benefits, but reforms should be pursued simultaneously, to avoid creating further distortions.

27. 27 Macro Policy Suggestions (I) Allow greater FX flexibility and progressively remove interest rate controls: Allow greater FX flexibility and progressively remove interest rate controls:  Current FX regime constrains the use of market-oriented instruments in monetary policy  PBoC is racing to sterilize FX inflows  Sterilization hasn’t been expensive... yet Broader benefits of an autonomous monetary policy are increasingly evident as China integrates further with the world economy. Broader benefits of an autonomous monetary policy are increasingly evident as China integrates further with the world economy.

28. 28 PBoC Still Controls Borrowing and Lending Rates Source: CEIC GS Research estimates

29. 29 PBoC Racing to Sterilize FX Inflows Source: CEIC GS Research estimates *Over the sample period, average maturity has been close to 1 year.

30. 30 Macro Policy Suggestions (II) Clearly separate fiscal policy from the banking sector: Clearly separate fiscal policy from the banking sector:  Likely to be a difficult divorce  Lending supports uncompetitive industries in order to maintain social stability  This has culminated in $300bn in NPL carve-outs from the ‘Big Four’ banks A better solution: transfer ‘quasi-sovereign’ obligations to the central government’s balance sheet A better solution: transfer ‘quasi-sovereign’ obligations to the central government’s balance sheet  Expensive but affordable: $250bn (10% of GDP) for transitional pensions?

31. 31 Promote non-bank institutional investors: Promote non-bank institutional investors:  Need incentives and safeguards for savers and a more flexible regulatory structure for investors  Fiscal policy can steer funds in line with government preferences  Growth need not come at the expense of banks Macro Policy Suggestions (III)

32. 32 Strengthening the Regulatory Landscape (I) Build a ‘credit culture’: Build a ‘credit culture’:  Bankruptcy: new law (effective mid-2007) looks better, but implementation will be key  Corporate governance, disclosure, international accounting standards  Rating agencies  Regulators need authority Need to eliminate expectations of ‘bailouts’ Need to eliminate expectations of ‘bailouts’

33. 33 Strengthening the Regulatory Landscape (II) Relax administrative controls on corporate borrowing: Relax administrative controls on corporate borrowing:  Opaque regulatory regime involves 4 agencies  ‘Merit-based’ rather than ‘disclosure-based’ approvals  Quotas  Credit guarantees  PBoC sets the coupon rate

34. 34 Strengthening the Regulatory Landscape (III) Strengthen the market infrastructure: Strengthen the market infrastructure:  Separate wholesale market and market for end-users in order to increase liquidity  Improve the repo and securities lending markets  Clarify tax and accounting issues around short-selling  Settlement and clearing systems

35. 35 Pace of Reform Is Accelerating Important steps over the past 18 months Important steps over the past 18 months  Bankruptcy law, commercial paper market, non-guaranteed debt, talk of abolishing quotas And more in just the past two months: And more in just the past two months:  PBoC announces intention to liberalize interest rates  Asset-backed securities based on NPLs to be issued  Overseas managers hired to invest part of state pension fund  Foreign banks can now operate across the domestic banking market

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