High Noon for Regulators in China’s Wild West Bond Market

By Nathaniel Taplin and Samuel Shen

SHANGHAI – A conflict between investors and the underwriter of a bond issued by Evergreen Industries is revealing regulatory shortcomings that must be addressed if China hopes to maintain strong foreign capital inflows into its bond market.

As China’s economic growth slows and its currency faces downward pressure from domestic capital flight, regulators have opened the country’s corporate bond markets to foreign investors to ensure continued credit availability.

In June, foreign ownership of onshore Chinese bonds surged by a remarkable 40.9 billion yuan, exceeding previous inflows from commercial bank wealth management products for the first time since May 2015.

Although foreign investors still hold less than 2 percent of China’s bond market, further increases in these flows may be jeopardized by concerns over yuan depreciation and the potential for uncontrollable defaults.

Traditionally, struggling companies were frequently rescued, often with local government support, allowing bondholders to recover their investments. However, 2016 has seen over 20 defaults, creating a much riskier market environment. Insiders indicate that China’s regulatory framework has not kept pace with these developments.

Bondholders of the Evergreen Industries Holding Group Ltd bond, which is currently in default, allege that the Industrial and Commercial Bank of China (ICBC), the bond’s underwriter, failed to perform due diligence and disclose important information. They have raised concerns about the conflict of interest due to ICBC’s separate loan to Evergreen.

These bondholders have taken their grievances directly to regulators, who have facilitated discussions between the investors and ICBC, potentially setting the stage for a significant test of China’s underwriting regulations.

ICBC has not provided comments, but an official involved stated that current guidelines—which mandate that underwriters encourage issuers to disclose issues and safeguard bondholders’ interests—lack clarity. The official remarked, "Determining whether we have met our responsibilities requires a judicial resolution."

China’s bond markets are overseen by three distinct regulators, each with its own set of rules, many of which remain untested in court. Additionally, penalties for wrongdoing within the interbank markets, where most bonds are traded, are relatively minor.

In this environment, rapid growth—total bond debt in China has risen over 50 percent in just 18 months to reach 57 trillion yuan, approximately 80 percent of GDP—has fostered a "Wild West" mentality. This has resulted in underwriters and rating agencies operating with minimal accountability, while issuers select markets with regulations that favor them.

Reports in January indicated that relaxed issuance rules had led to an influx of high-yield private placement bonds on the Shanghai exchange, complicating government attempts to control risks associated with other financial sectors, such as shadow banking.

An Evergreen bondholder expressed concerns about the vague regulations that allow underwriters to interpret rules to their advantage, which may deter prospective investors: "If this continues, who will be willing to invest? How can the bond market thrive?"

Evergreen bondholders are pursuing their case with the National Association of Financial Markets Institutional Investors (NAFMII), which oversees commercial paper like that of Evergreen. Despite recent discussions with ICBC, a resolution has yet to be achieved.

Market insiders report that conflicts of interest, where underwriting banks have information that may benefit their loans at the expense of bondholder interests, are commonplace. Evergreen bondholders claim that ICBC has not disclosed whether its loan to Evergreen has been repaid.

A Hong Kong-based employee at an international ratings agency noted, "When the regulators designed the system, they didn’t foresee potential conflicts between banks’ loan portfolios and their underwriting roles."

In response to the increasing number of defaults, regulators are becoming more proactive. For example, NAFMII recently suspended the auditing firm Ruihua for one year due to irregularities related to the default of a logistics firm earlier in the year. Additionally, the central bank has indicated support for investor attempts to hold financial intermediaries accountable for regulatory lapses.

Investors are expressing a desire for a stronger, clearer regulatory framework that is tested in court before expanding their exposure to Chinese corporates. Jie Peng from Western Asset Management in Singapore, which invests in Chinese debt, stated that she is currently limiting investments to AAA-rated credits and established state-owned enterprises, noting concerns regarding the legal framework if investments were to venture into lower-rated securities.