Financial Market Reform In China - Essay Example

Examine the way in which market infrastructure shape bond ratings in an emerging financial market Introduction Financial market infrastructure is divided in to institutional infrastructure and regulatory infrastructure. Institutional infrastructure consists of market-centric institutional structures that have been put in place by both the government and private enterprise. For instance both the government and corporate sector make use of the Central Bank, commercial banks and a number of government agencies and institutions such as the Treasury in issuing bonds. However this paper would particularly focus on the corporate bond ratings rather than government bonds (Choudhry, 2006). On the other hand private enterprise is also responsible for creating infrastructure in financial markets as and when expediencies arise. For example such institutions as rating agencies and portfolio management and investment firms have more or less been the response of private enterprise to an ever increasing complex and diverse environment of bond markets. The regulatory environment and the connected infrastructure in financial markets equally well play a very important role in shaping bond ratings in emergent markets. In fact regulatory infrastructure is the response of governments to the ever increasing number of implications associated with the bond markets. The functional variabilities of bond markets in emergent financial markets in Asia have been researched in order to produce a comprehensive theoretical and conceptual framework of analysis with specific emphasis on bond ratings (Emery, 1998 ). Financial market infrastructure in the Asian region in general and China in particular has played a pivotal role in shaping bond ratings. Especially government bonds issued by the Central Bank in order to raise money to finance government physical infrastructure projects such as road networks are bought by both individual and institutional investors. For example institutional investors include provident funds, banks, portfolio management firms and so on. Unlike other financial instruments such as treasury bills and debentures, the demand for and the supply of bonds are determined by a completely different set of variables. As such bond rates and ratings are influenced by an equally complex and diverse set of variables. Especially in emergent markets in Asia – China and India – the trend has been closely associated with a positively skewed ogive. Literature Review The currently available literature on the subject of the influence of market infrastructure on bond ratings in emerging markets in Asia, especially China, is much less focused on issues than on the theoretical concepts. This particular characteristic is all the more influenced by the emerging market practices related to the legal and regulatory frameworks, disclosure and compliance procedures, and above all the advent of bond rating agencies into a less regulated market environment (Choudhry , 2003). While a priori causal factors in determining the outcomes related to infrastructure creation process are obviously subject to a new paradigm shift, the norm-based approach to bond rating in highly competitive emerging markets is equally indeterministic. In the first instance norm-based bond rating practice is dependent on compliance and transparency procedures that demand a degree of professional expertise. Given the uncertainties associated with emerging markets in Asia there is very little theoretical and conceptual support to underpin the process of evolution in these markets. The institutional infrastructure in China has been influenced by the economic resurgence there. The huge growth rates registered in its Gross Domestic Product (GDP) for over a decade, have helped the country to launch financial market related infrastructure initiation programs to achieve much faster and sustainable market based development (Barnhill , Shenkman & Maxwell 1999) Though in comparison to the Western and American standards the infrastructure development process has not been so impressive, the country has successfully developed institutional infrastructure comparable to a modern economy. China’s financial institutional infrastructure includes the government’s Central Bank, regulatory bodies, Communist party official apparatus, commercial banks, financial houses, portfolio investment companies, investment trusts, financial brokerages, financial advisors and consultants and a host of other institutions. The China Banking Regulatory Commission (CBRC) and the Central Bank play a pivotal role in creating the necessary background for the development of sound infrastructure (Chen, Dietrich & Feng, 1999). For example CBRC’s permission to foreign banks to trade and underwrite corporate bonds will pave the way for a more advanced bond market, thus strengthening the existing institutional framework. Economic theory presupposes that bond rates and rating practices are influenced by the quality of the available institutional infrastructure as against the quantity. Foreign banks and financial institutions operate on the principle of increasing returns to their shareholders. As a result there can be a conflict of interest between institutional interests such as banks and regulatory bodies. As such the process of developing institutional infrastructure to have a substantial impact on the nature and extent of influencing bond ratings becomes all the more important. Despite this conflict some recent research studies have pointed out that the recent infrastructure development efforts of China in particular and East Asia in general have essentially positively impacted on the evolving bond ratings environment to a greater extent. Ang and Patel (1975) point out that rating agencies base their classification of bonds in keeping with ex ante probabilities and the extent of financial distress. In other words the authors have referred to the agency problem and leveraging. The capital structure of the firm is basically determined by the nature of the disagreements between agents (managers) and owners (shareholders). However the institutional infrastructure in financial market tends to favor agents or managers as against owners or shareholders. For instance in emerging markets like China industry related constraints are acknowledged to exist basically due to the inability of individual banks and other market players to develop their own risk and yield assessment techniques. The common yardsticks adopted by rating agencies are much less determined by the level of institutional infrastructure. This inadequacy is further exacerbated by the lack of transparency and regulation related controls. Bonds are rated according to the yield offer of the bond and the dynamic risk level. For example the latter concept encourages rating agencies to adopt techniques that incorporate an element of compensation for institutional infrastructure related risk. Dynamic risk assessment techniques have gained acceptance over static risk assessment techniques among rating agencies though many of them do not positively think of adopting them in emerging markets. While dynamic risk assessment variables are difficult to evaluate with a degree of consistency, the outcomes related to value parameters remain more or less customary. Multinomial discriminant analysis of variables to achieve a degree of coherence in diverse institutional settings requires a more complex approach than this (Livingston, Naranjo & Zhou ,2007). However this paper would focus on China’s institutional infrastructure model and its influence on bond ratings. The environmental analysis would focus on the causal factors such as government regulatory regimes, compliance legislation and transparency norms. The market value of bonds in emerging markets such as China and India is not purely determined by market forces. Usually firms spend a considerable amount of money to have their bond issues rated. It is here that the rating agency tends to use multinomial discriminant analysis to rate the bond issue. For example in China as an emerging market a few bond issues were carried out by a number of firms during the current year. The role played by institutional infrastructure in these bond issues and ratings can be understood only with reference to the amount of money spent by each firm as consultation fees to rating agencies. China has a negative reputation when it comes to speedy approval for new manufacturing and business licenses. The corrupt political system has been blamed for delays. Thus bond issues by private firms are particularly subject to procedural delays arising from an underperforming political culture. Only a very few firms received the rating of investment grade bonds along with Aaa while many received junk bond status (Schlevogt, 2001). While it is difficult to determine the extent to which institutional infrastructure played a role in the award of these different statuses to bond issues and the ratings, it is not difficult to determine the influence of institutional infrastructure on these ratings. In the first phase China in particular and the rest of Asia in general have received much less recognition as primary bond related investment destinations. The gap between China and the West can be seen when statistics for the former destination are compared with the latter. While market capitalization for China has been rising fast enough there is still a greater degree of vulnerability in China’s efforts to enlist the support of rating agencies to identify and categorize the importance of institutional infrastructure on bond ratings. The higher the risk the lower the rating and higher the bond yield. However institutional infrastructure such as highly advanced supervisory or monitoring bodies and regulatory frameworks would do much to enhance the positive image in emerging markets. For example numerous foreign investment funds, Real Estate Investment Trusts (REITs), banks, EPFs, investment portfolio management companies and so on have sought to invest in China’s high yield corporate bonds. Yet a particular drawback that these potential investors in China are faced with is the fact that Chinese officials are more or less corrupt and therefore have a tendency to adopt often controversial decisions. These decisions have an inevitable impact on institutional infrastructure development (Sawyer, Schyslowsky, & Nickerson ,2000). For instance Chinese Communist Party officials have often been found guilty of tolerating orthodox approaches to change. Analysis: China as an emerging market and the financial market institutional infrastructure Table 1: Major Developments in China’s Bond Markets Year Development 1988 MoF for the first time issued Treasury Bonds in some major cities in China. 1990 Bonds were traded with the setting up of Shanghai Stock Exchange. 1994 Short selling of T-bonds was allowed thus T-bond futures also were allowed to trade. 1995 Regional Treasury Bond Trading Centers were closed due to speculations. 1995 Over-The-Counter (OTC) trading of T-bonds came to an end with Shanghai & Shenzhen Stock Exchanges becoming the sole lawful platforms. 1996 Shanghai & Shenzhen SEs issued book-entry bonds and re-purchases took place with the setting up of bond trading system. 1998 PBC started Open Market Operations (OMOs). China Development Bank issued financial bonds in the interbank market. Pacific Basin Development Council approved insurance companies were permitted to be members in the interbank bond market. 1999 Some securities firms became members in the interbank bond market. 2000 PBC permitted financial firms to be members of the interbank bond market. 2002 PBC permitted non-financials to become members of the interbank bond market. 2005 Corporate notes of short term duration issued in the interbank bond market. 2007 Issue of Yuan denominated bonds was permitted by financial institutions in Hong Kong. Pension funds were permitted to trading in the interbank bond market. This study depends exclusively on the secondary data already published by other researchers. Secondary data was collected through an extensive research effort conducted both online and in libraries. The researcher extensively used the books written on the topic and also study research journals, reports, graphs, articles, newspaper articles and so on. References were taken from most of the research material available in the field. This study depends mainly on the secondary material, because theoretical analysis is much well facilitated by it than primary material which is basically limited to responses in the questionnaire and the survey. The available literature would be analyzed with specific focus on the Chinese bond market structures and their impact on bond ratings. This researcher would make a singular effort to show the most important aspectual overview of the research in the Literature Review. Also there is considerable reflection on the state and relevance of current research. Future research possibilities in the field are discussed in depth to show how theoretical underpinnings evolve with time and space with specific reference to retail industry and international multicultural workforce management at retail stores. There is little or no critical literature to support the methodology of metrically determining the extent to which bond ratings have been influenced by institutional infrastructure in China. (Mauro ,Sussman & Yafeh, 2008). This particular handicap has affected the researcher to a greater extent. However the research methodology segment of this paper places emphasis on the qualitative aspect of it rather than the quantitative aspect. As such the available empirical evidence has been greatly utilized by the researcher to delineate the current line of arguments as expounded in the Literature Review of this paper. Secondary analysis of some selected firms in China Market players such as public and private pension funds, insurance companies, investment funds and numerous savings accounts funds in China have particularly played a significant role in changing the traditional approach to investment. Their impact on the bond ratings in China can be categorized in to three structural phases. (a). The corporate investor base is totally affected by government taxation policy and therefore corporate investors have sought to minimize and in some instances to shift the impact of government’s taxation policy away from distributable profits to leveraged funds so that they become entitled to tax exemptions. Assuming that such structural institutional changes have impacted on the bond rating exercise of bond rating agencies, the investment related outcomes could have compelled corporate investors to think twice before undertaking a new investment. For example even government corporations and departments in China were compelled to evade tax payments due to the progressive nature of the Chinese government’s taxation policy. However private enterprise, especially with foreign collaboration, was partially or wholly exempt from these tax commitments. The corporate sector in China is highly characterized by labor intensive production techniques and as a result is subject to an extra level of risk in bond rating exercises by rating agencies. For example the country specific risk parameter has influenced rating agencies to a greater extent (Kurz & Scannell, 2006). Chinese firms listed in Hong Kong are well known for issuing debt domestically in order to raise enough capital. Chinese regulators have realized as of late that funding sources options must be diversified in order to achieve a degree of independence from bank lending. Along with foreign firms, domestic Chinese firms are greatly involved in financing bond issues to such an extent that the Chinese bond market is becoming more and more complex. (b). China Securities and Regulatory Commission (CSRC), is actively encouraging foreign firms to sell renminbi-denominated debt in the domestic market. Despite this encouragement there is still a fair quantity of bureaucracy in government departments and corporations which are responsible for the approval of debt issues (Levich , Majnoni & Reinhart , 2002). The Chinese bond market is highly characterized by system related features such as an obvious lack of well defined regulatory frameworks, a nonchalant attitude towards foreign investors and a slower pace of financial reforms. The banking sector in China is geared to meeting small and medium scale bond issues while larger scale bond issues require a much more complex approach and methodology than what can be seen at the institutional level in China. Even the Hong Kong based firms are faced with numerous problems when it comes to getting approval for their deals. Authorities in China have an unfavorable attitude towards foreign firms. Only domestic firms with domicile in China are favored because Chinese authorities tend to suspect the motives of foreign firms. The net result of this bureaucratic bungling is that the bond market in China is developing some anti progressive elements. For instance the institutional infrastructure is highly biased in favor of domestic firms. So it is not strange that foreign firms gradually relocate elsewhere in Asia. As for bond rating agencies operating in China, they have rarely been involved in competitive third ratings because Chinese firms have rarely wanted to go for a third rating. As recent research has shown a third rating of a bond issue is not only expensive but also highly uncertain. However even two successive junk bond statuses can be reversed and replaced with an investment grade in the third rating attempt. But nevertheless this is a rather theoretical probability and therefore many domestic Chinese firms don’t go for a third rating, especially public corporations (Schlichting, 2008). Junk bond ratings have a negative impact on bond issues while investment grade ratings enable the issuing firm to obtain a favorable assessment of its future revenue and profit picture. (c). Institutional infrastructure plays a very important role here. For instance the CSRC has been acting as a monolithic or autocratic government department without paying much attention to the evolving diversity and complexity of the institutional apparatus. The recent decision by People’s Bank of China to allow Chinese brokerages to engage in bond issuance business has further added to the institutional complexity related to the Chinese bond ratings by rating agencies. In fact such institutional infrastructure tends to develop along the lines of a more vigorous strategic market oriented trend. Conclusion Globalization has been associated with the current developmental pressures in emergent markets in Asia and elsewhere. For example, China in particular and other East Asian countries in general have been influenced by globalization trends to such an extent so that their financial markets have been highly exposed to these trends. In the subsequent phase of development bond issues and ratings have been subject to a degree of extraordinary pressure part of which is basically due to the nature and constitution of the market infrastructure. However, very little attention, if any, has been paid to these developments. Therefore this study focuses attention on the learning outcomes related to the influence of market infrastructure on the determination process of bond ratings in the emergent financial market in China. Finally the institutional infrastructure developments in China have affected bond ratings by rating agencies to a greater extent due to three main reasons. They are institutional infrastructure in China is determined by basically the government related regulatory framework; institutional infrastructure is developed on the line of evolving financial market structures that one way or the other inhibit the full development of independent bond ratings; and the official bureaucracy in China has had a far reaching impact on both the development of institutional infrastructure and the way in which bond rating agencies and bond issuers function. REFERENCES 01 . Barnhill, T. , Shenkman, B. , & Maxwell, W. , 1999 , High Yield Bonds: Market Structure, Valuation, and Portfolio Strategies , McGraw-Hill , New York . 02 . Chen, B. , Dietrich, J. K. , & Feng, Y. , 1999 , Financial Market Reform In China: Progress, Problems, And Prospects (Political Economy of Global Interdependence), illustrated edition, Westview Press , Colorado . 03 . Choudhry, M. , 2003 , Bond and Money Markets: Strategy, Trading, Analysis , Butterworth-Heinemann , Oxford 04 . Choudhry, M. , 2006 , An Introduction to Bond Markets (Securities Institute) , 3rd edition , Wiley & Sons inc. ,West Sussex . 05 . Emery, R. F. , 1998 , The Bond Markets Of Developing East Asia ,Robert F Emery (Author) › Visit Amazons Robert F Emery PageFind all the books, read about the author, and moreSee search results for this author Are you an author? Learn about Author Central Westview Press , Colorado . 06. Livingston, M. , Naranjo, A. , & Zhou, L. ,2007 ,Asset opaqueness and split bond ratings , Journal from Financial Management , Vol. 36 , No. 3 Pp. 49(14) 07 . Levich, R. M. , Majnoni, G. , & Reinhart, C. , 2002 , Ratings, Rating Agencies and the Global Financial System (The New York University Salomon Center Series on Financial Markets and Institutions) ,Springer , Massachusetts . 08 . Mauro, P. ,Sussman, N. , & Yafeh, Y. , 2008 , Emerging Markets and Financial Globalization: Sovereign Bond Spreads in 1870-1913 and Today , Paolo Mauro (Author) › Visit Amazons Paolo Mauro Page Find all the books, read about the author, and more. See search results for this author Are you an author? Learn about Author Central Oxford University Press, New York. 09. Schlichting, S. , 2008 , Internationalizing Chinas Financial Markets , Svenja Schlichting (Author) › Visit Amazons Svenja Schlichting Page Find all the books, read about the author, and more. See search results for this author Are you an author? Learn about Author Central Palgrave Macmillan , New York . 10 . Schlevogt, K. A. 2001, Inside Chinese Organizations: An Empirical Study of Business Practices in China , dissertation.com , 11 . Sawyer, L. , Schyslowsky, D. , & Nickerson, D.(edi.) , 2000 , Emerging Financial Markets in the Global Economy , World Scientific Publishing Company , Singapore . 12 . Kurz,K. , & Scannell, J. , 2006 , Bond rating: beyond the balance: an institutions financial stability is determined by many factors. Understanding the process is key to earning a better rating (Money Matters) , Journal from University Business , Vol. 9 , No.1, Pp. 29(2) . Read More