Chinese Banks to Reference the RMB Yield Curve: It's About Time

The yield curve adjustment in the US market was the biggest event last week, and the effect has rippled through to other parts of the world. While China is a red hot subject nowadays, nobody talks about the Chinese RMB yield curve. Do they have any idea how simple the shape of the curve is?

You probably are not interested because RMB is not a freely traded currency, and you are not allowed to buy RMB bonds.

But are you investing in Chinese H-share or A-share based ETF such as Morgan Stanley A-Share Fund (CAF), iShares FTSE/Xinhua China 25 Index (FXI) or iShares FTSE/Xinhua A50 China Tracker (2823.HK) ?

Did you know that all those funds are having a significant proportion of their assets invested in Chinese banks and insurance companies?

For example, the following list shows the 25 constituents of FXI; almost 40% of its assets are in Chinese banks and insurance companies.

So how does this relate to the RMB yield curve?

If you are indirectly owning so many Chinese banks assets, you may be interested to know how these Chinese financial institutions manage credit risk, how they perform mark-to-market financial assets valuations and how they report VaR (Value-at-Risk) or CAR (Capital Adequacy Ratio), which are all critical measurements of banks’ health.

In other words, the yield curve is the most fundamental element to derive discount rates for cash flow projection, which itself is the basis for any financial assets valuation.

However, you may be very surprised to learn that this, which seems obvious, is a brand new policy that was just imposed last week! On June 15, CBRC made an announcement that banks should reference RMB yield curves in financial assets valuation and reports starting from October 2007. As of now, Chinese banks do not reference the RMB yield curve and they derive their own discount rates based on arbitrary and subjective measures. So there is, in fact, no common point of reference in reports from different Chinese banks. Is the credit management of one bank better than the other, as indicated from its annual report? I am not too sure.

It is still a very long road to a mature capital market in China. What we have seen in the A-share market is just a beginning of the overall Chinese capital market reform. Without a solid equity market foundation, it would be difficult to move forward to develop a corporate debt market. RMB yield curves are in fact incomplete because the secondary market for corporate bonds is inactive. Without a well developed debt market, the Chinese government would find it difficult to solve banks’ non performing loan problems as there is not a vehicle for a more balanced distribution of risks to different classes of investors. Bank loans are currently the major source of funding for all Chinese firms. Based on PBOC statistics, in 2006 Chinese firms raised a total of RMB 4000b, of which RMB 3300b (82%) were bank loans and only 5.6% (RMB 230b) was from equity market.

My View

1. China is speeding up in debt market development, which is crucial to the overall health of Chinese economy
2. A healthy stock market is the fundamental requirement for debt market development. I cannot believe the Chinese government will do anything stupid to destroy what they have painfully developed over the past few years. Tackling the astronomical sum of non performing bank loans and ultimately listing all banks were huge achievements. Though the system is far from perfect, it is a one way road, the Chinese market can only be healthier.

Finally, here is the RMB yield curve, in case you are interested.