‘‘The China Impact’ Workshop:The China Impact’ Workshop:The Ascent of China’s DCMThe Ascent of China’s DCM

The Houses of Parliament, The Houses of Parliament, 25 April 200725 April 2007

Francesco U. GarzarelliManaging Director, Macro and Markets ResearchGoldman Sachs International, Londonfrancesco.garzarelli@gs.com

The Ascent of China’s DCMThe Ascent of China’s DCM

3

China’s DCM Can Become a Heavy-WeightChina’s DCM Can Become a Heavy-Weight

China’s bond market has expanded twelve-fold since 1997, reaching China’s bond market has expanded twelve-fold since 1997, reaching around US$ 700bn (~30% of GDP). around US$ 700bn (~30% of GDP).

It remains immature, largely due to two factors: (i) the banks’ role in It remains immature, largely due to two factors: (i) the banks’ role in advancing the government’s priorities; (ii) the ongoing reliance on advancing the government’s priorities; (ii) the ongoing reliance on quantity and price controls in the conduct of monetary policy.quantity and price controls in the conduct of monetary policy.

The pace of capital market reform has accelerated. GS estimates The pace of capital market reform has accelerated. GS estimates that DCM capitalization could double, reaching about 60% of GDP that DCM capitalization could double, reaching about 60% of GDP in ten years’ time.in ten years’ time.

By 2016, China’s DCM could represent 4-10% of G7 debt By 2016, China’s DCM could represent 4-10% of G7 debt capitalization, in today’s prices – a similar order of magnitude as the capitalization, in today’s prices – a similar order of magnitude as the French and German markets combined today. French and German markets combined today.

4

The Evolution of G7 Domestic Debt MarketsThe Evolution of G7 Domestic Debt Markets

Source: Davis (1996), BISSource: Davis (1996), BIS*US, UK and Canada. **Japan, France, Germany and Italy*US, UK and Canada. **Japan, France, Germany and Italy

0

20

40

60

80

100

120

140

160

70 75 80 85 90 95 00 05

Debt outstanding, % of GDP

G7

Bank-based economies**

Non-Bank based economies*

G7 Bond Market Capitalization as % of GDPG7 Bond Market Capitalization as % of GDP

5

Cross-Section Data Points to DCM GrowthCross-Section Data Points to DCM Growth

Source: Goldman Sachs Source: Goldman Sachs calculations. See: calculations. See: Bonding the BRICs: The Ascent of China’s Debt Capital MarketBonding the BRICs: The Ascent of China’s Debt Capital Market, Nov. ’05., Nov. ’05.

1970-1990 Panel Regression on G-7 Countries1970-1990 Panel Regression on G-7 Countries

Impact on Debt-to-GDP Ratio of Different Factors

Factor% of GDP Change*

A 10% increase in per-capita GDP 2.5 (8.6) A full financial liberalization 12.2 (1.7)A 1 point increase in the 'dependency ratio' 1.8 (4.7)

R-Square 0.41

Durbin-Watson 2.03Source: GS calculations

* t-statistics are reported in brackets.

6

Per Capita Income to Follow in G7 FootstepsPer Capita Income to Follow in G7 Footsteps

Source: National central banks, GS BRIC model projectionsSource: National central banks, GS BRIC model projections

China and G7 Per Capita GDP, 1970-1995 (Actual) and 2005-2030 (GS f’cst)China and G7 Per Capita GDP, 1970-1995 (Actual) and 2005-2030 (GS f’cst)

0

5

10

15

20

25GDP per capita

China (2005-2030)

G7 (1970-1995)

19702005

19802015

19852020

19902025

19752010

19952030

7

Aging Should Boost Demand for PensionsAging Should Boost Demand for Pensions

Source: UN population statisticsSource: UN population statistics

China and G7 Dependency Ratio ProjectionsChina and G7 Dependency Ratio Projections

0

10

20

30

40

50

60

1950 1960 1970 1980 1990 2000 2010 2020 2030 2040 2050

China G7

Number of people aged 65+ for each 100 aged 15-64

8

By 2016, as Big as the UST Market TodayBy 2016, as Big as the UST Market Today

Source: GS calculations in 2005 pricesSource: GS calculations in 2005 prices

Estimated Growth Path for China’s DCMEstimated Growth Path for China’s DCM

0

500

1000

1500

2000

2500

3000

3500

4000

4500

5000

2006 2008 2010 2012 2014 2016

USD, bn

Trajectory based on DCMremaining at 27% of GDP

Model-based trajectory

9

Growth and Liberalization Are the Main DriversGrowth and Liberalization Are the Main Drivers

Source: GS calculations. Source: GS calculations. *These figures reflect the contribution to the size of the DCM market in GDP terms*These figures reflect the contribution to the size of the DCM market in GDP terms

Estimated Contributions to China’s DCM GrowthEstimated Contributions to China’s DCM Growth

Economic development16%

Demographics6% Financial liberalization

12%

The Current State of PlayThe Current State of Play

11

China’s DCM Is Still Comparatively Small China’s DCM Is Still Comparatively Small

Source: BIS Asian Bonds: 2006 figuresSource: BIS Asian Bonds: 2006 figures*includes PBoC sterilisation bills*includes PBoC sterilisation bills

Indo

nesi

aP

hilip

pine

sC

hina

*H

ong

Kon

gTh

aila

ndS

inga

pore

Kor

ea

Mal

aysi

a

Japa

n

0

50

100

150

200

250% of GDP

Asian Debt Capital Market Capitalization, in % of GDPAsian Debt Capital Market Capitalization, in % of GDP

12

And an Immature Market in Several RespectsAnd an Immature Market in Several Respects

Government bonds account for half the market, state-owned Government bonds account for half the market, state-owned policy banks for roughly an additional 40%.policy banks for roughly an additional 40%.

Non-financial corporate bonds are just 9% of the market.Non-financial corporate bonds are just 9% of the market.

Fastest-growing segment is the commercial paper market, Fastest-growing segment is the commercial paper market, which has soared to around US$40bn in just 18 months. which has soared to around US$40bn in just 18 months.

Turnover is light, with banks holding most securities to maturity.Turnover is light, with banks holding most securities to maturity.

Inter-bank market has a 95% share of secondary trading.Inter-bank market has a 95% share of secondary trading.

13

Banks Hold the Lion’s Share of Chinese BondsBanks Hold the Lion’s Share of Chinese Bonds

Source: ChinaBondSource: ChinaBondNote: Data as of Sept 2006. Other financial institutions include credit cooperatives and other non-bank financial institutionsNote: Data as of Sept 2006. Other financial institutions include credit cooperatives and other non-bank financial institutions

0

10

20

30

40

50

60

70

80

90

100

Commercialbanks

Institutionalinvestors

Otherfinancial

institutions

Other

% of ownership of total debt outstanding

Breakdown of Bonds Ownership by Type of InstitutionBreakdown of Bonds Ownership by Type of Institution

14

Growth Has Been Rapid, But Driven by Public DebtGrowth Has Been Rapid, But Driven by Public Debt

Source: ChinaBond, Sep 2006 dataSource: ChinaBond, Sep 2006 data

0

5

10

15

20

25

30

97 98 99 00 01 02 03 04 05 06

% of GDP

Commercial bank bonds

Corporate bonds and commercial paper

Policy bank bonds

Government bonds

China: Composition of Outstanding BondsChina: Composition of Outstanding Bonds

15

A Comparatively Small Non-Public Debt Market…..A Comparatively Small Non-Public Debt Market…..

Source: BIS calculationsSource: BIS calculationsNote: For China government bonds include bonds issued by policy banks. Corporate bonds include commercial paper.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*US, UK and Canada. **Japan, France, Germany and Italy

0

20

40

60

80

100

120

140

160

China Asia exJapan&China

Bank-BasedG7**

Non-Bank-Based G7*

% GDP

Corporates

Financial institutions

Government

Breakdown of Bonds Outstanding by Issuing Sector, % of GDPBreakdown of Bonds Outstanding by Issuing Sector, % of GDP

16

……..Whether Measured by GDP or by Market Share..Whether Measured by GDP or by Market Share

Source: BIS calculationsSource: BIS calculationsNote: For China government bonds include bonds issued by policy banks. Corporate bonds include commercial paper.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*US, UK and Canada. **Japan, France, Germany and Italy

0%

20%

40%

60%

80%

100%

China Asia exJapan&China

Bank-BasedG7**

Non-Bank-Based G7*

share of market Government Financial institutions Corporates

Breakdown of Bonds Outstanding by Issuing Sector, % of TotalBreakdown of Bonds Outstanding by Issuing Sector, % of Total

17

Corporate Debt Is Just a Tiny Slice of the Pie Corporate Debt Is Just a Tiny Slice of the Pie

Source: ChinaBondSource: ChinaBond

As of end September 2006 RMB bn USD bn % of total

Government bonds 2,771 349 49.6

Policy bank bonds 2,093 264 37.5

Commercial paper 263 33 4.7

Corporate bonds 239 30 4.3

Commercial bank bonds 207 26 3.7

ABS 13 1.6 0.2

'Panda' bonds 2 0.3 0.04

Total 5,588 705 100

pro memoria: PBoC Bills 3,260 411

China: Breakdown of Outstanding Bonds by InstrumentChina: Breakdown of Outstanding Bonds by Instrument

18

Commercial Paper Market Takes OffCommercial Paper Market Takes Off

Source: CEIC, Goldman SachsSource: CEIC, Goldman Sachs

0

5

10

15

20

25

30

35

40

Jan-05 May-05 Sep-05 Jan-06 May-06 Sep-06

USD bn

China: Outstanding Amount of Commercial PaperChina: Outstanding Amount of Commercial Paper

19

Private Savings Languish in Bank DepositsPrivate Savings Languish in Bank Deposits

Source: National central banksSource: National central banks

60

80

100

120

140

160

180

200

99 00 01 02 03 04 05

Total bank deposits, % of GDP

ChinaG10

Asia-ex Japan&China

Corporate and Household Sector Savings, as % of GDPCorporate and Household Sector Savings, as % of GDP

20

Institutional Investors: A SnapshotInstitutional Investors: A Snapshot

InsuranceInsurance: US$200bn: US$200bn

50+% in domestic bond market, <40% with banks50+% in domestic bond market, <40% with banks

Low insurance penetration rates and preference for Low insurance penetration rates and preference for precautionary savings suggest significant growth aheadprecautionary savings suggest significant growth ahead

Mutual fundsMutual funds: US$60bn and growing rapidly: US$60bn and growing rapidly

40% in equities; <1% in corporate bonds40% in equities; <1% in corporate bonds

Strong growth in just 2 yearsStrong growth in just 2 years

State pension (Social Security Fund)State pension (Social Security Fund): under-funded at : under-funded at US$32bnUS$32bn

By law, 50% must be in bank deposits and TreasuriesBy law, 50% must be in bank deposits and Treasuries

Occupational pensionsOccupational pensions: US$10bn on its way to US$125bn?: US$10bn on its way to US$125bn?

40% invested in equities; <15% in banks and Treasuries40% invested in equities; <15% in banks and Treasuries

21

Half of State Pension Funds Are in Bank DepositsHalf of State Pension Funds Are in Bank Deposits

Source: National Social Security Fund (SSF) 2005 Annual Report, GS calculationsSource: National Social Security Fund (SSF) 2005 Annual Report, GS calculations

Others, 5%

Equity, 6%Long-term bonds, 6%

Short-term bonds, <1

Bank deposits,

48%

Mandated Investment,

34%

China’s State Pension Funds: Asset AllocationChina’s State Pension Funds: Asset Allocation

22

Insurance Funds Are Moving Towards BondsInsurance Funds Are Moving Towards Bonds

Source: China Economic Information Network, 2005 dataSource: China Economic Information Network, 2005 data

Equities, 1%Gov Bonds,

25%

Bank deposits,

37%

Others, 10%

Secondary Bonds, 6%

Corporate bonds, 9%

Financial Bonds,

13%

China’s Insurance Funds: Asset AllocationChina’s Insurance Funds: Asset Allocation

23

Mutual Funds Are Largely Invested in EquitiesMutual Funds Are Largely Invested in Equities

Source: China Fund, 2005 dataSource: China Fund, 2005 data

Convertible bonds, 3%

Financial bonds, 16%

Corp Bonds

<1%

Equities, 41%

Central bank bills,

17%

Others, 11%

Gov bonds, 8%

Bank deposits,

5%

China’s Mutual Funds: Asset AllocationChina’s Mutual Funds: Asset Allocation

24

The Goal: Channeling Savings into InvestmentsThe Goal: Channeling Savings into Investments

National household savings rate is 24%, more than three times the National household savings rate is 24%, more than three times the OECD average.OECD average.

Most savings are ‘precautionary,’ due to weak social security Most savings are ‘precautionary,’ due to weak social security programs and low penetration of pensions and insurance.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 Institutional investor community is nascent, but holds high potential for growth.for growth.

Moving from Quantities to PricesMoving from Quantities to Prices

26

Three Overarching GuidelinesThree Overarching Guidelines

Market size should not be the main priority. The focus should be on Market size should not be the main priority. The focus should be on price disclosure and transfer of risk.price disclosure and transfer of risk.

Extensive and deep changes to both policy and the regulatory Extensive and deep changes to both policy and the regulatory framework are required.framework are required.

Incremental approach has its benefits, but reforms should be Incremental approach has its benefits, but reforms should be pursued simultaneously, to avoid creating further distortions. pursued simultaneously, to avoid creating further distortions.

27

Macro Policy Suggestions (I)Macro Policy Suggestions (I)

Allow greater FX flexibility and progressively remove interest rate Allow greater FX flexibility and progressively remove interest rate controls:controls:

Current FX regime constrains the use of market-oriented Current FX regime constrains the use of market-oriented instruments in monetary policyinstruments in monetary policy

PBoC is racing to sterilize FX inflowsPBoC is racing to sterilize FX inflows

Sterilization hasn’t been expensive . . . yetSterilization hasn’t been expensive . . . yet

Broader benefits of an autonomous monetary policy are increasingly Broader benefits of an autonomous monetary policy are increasingly evident as China integrates further with the world economy.evident as China integrates further with the world economy.

28

PBoC Still Controls Borrowing and Lending RatesPBoC Still Controls Borrowing and Lending Rates

Source: CEIC GS Research estimatesSource: CEIC GS Research estimates

1

2

3

4

5

6

7

8

Apr-04 Oct-04 Apr-05 Oct-05 Apr-06 Oct-06 Apr-07

% 1-yr PBoC sterilization bill rate

1 year deposit reference rate

1 year lending reference rate

29

PBoC Racing to Sterilize FX InflowsPBoC Racing to Sterilize FX Inflows

Source: CEIC GS Research estimatesSource: CEIC GS Research estimates*Over the sample period, average maturity has been close to 1 year.*Over the sample period, average maturity has been close to 1 year.

0

50

100

150

200

250

300

350

400

450

99 00 01 02 03 04 05 06

USD bn

0

200

400

600

800

1000

1200USD bn

PBoC sterilization bills* (lhs)

FX reserves (rhs)

30

Macro Policy Suggestions (II)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 divorceLikely to be a difficult divorce

Lending supports uncompetitive industries in order to maintain Lending supports uncompetitive industries in order to maintain social stabilitysocial stability

This has culminated in $300bn in NPL carve-outs from the ‘Big This has culminated in $300bn in NPL carve-outs from the ‘Big Four’ banksFour’ banks

A better solution: transfer ‘quasi-sovereign’ obligations to the central A better solution: transfer ‘quasi-sovereign’ obligations to the central government’s balance sheetgovernment’s balance sheet

Expensive but affordable: $250bn (10% of GDP) for transitional Expensive but affordable: $250bn (10% of GDP) for transitional pensions?pensions?

31

Promote non-bank institutional investors:Promote non-bank institutional investors:

Need incentives and safeguards for savers and a more flexible Need incentives and safeguards for savers and a more flexible regulatory structure for investorsregulatory structure for investors

Fiscal policy can steer funds in line with government Fiscal policy can steer funds in line with government preferencespreferences

Growth need not come at the expense of banksGrowth need not come at the expense of banks

Macro Policy Suggestions (III)Macro Policy Suggestions (III)

32

Strengthening the Regulatory Landscape (I)Strengthening the Regulatory Landscape (I)

Build a ‘credit culture’:Build a ‘credit culture’:

Bankruptcy: new law (effective mid-2007) looks better, but Bankruptcy: new law (effective mid-2007) looks better, but implementation will be keyimplementation will be key

Corporate governance, disclosure, international accounting Corporate governance, disclosure, international accounting standardsstandards

Rating agenciesRating agencies

Regulators need authority Regulators need authority

Need to eliminate expectations of ‘bailouts’Need to eliminate expectations of ‘bailouts’

33

Strengthening the Regulatory Landscape (II)Strengthening the Regulatory Landscape (II)

Relax administrative controls on corporate borrowing:Relax administrative controls on corporate borrowing:

Opaque regulatory regime involves 4 agenciesOpaque regulatory regime involves 4 agencies

‘‘Merit-based’ rather than ‘disclosure-based’ approvalsMerit-based’ rather than ‘disclosure-based’ approvals

QuotasQuotas

Credit guarantees Credit guarantees

PBoC sets the coupon ratePBoC sets the coupon rate

34

Strengthening the Regulatory Landscape (III)Strengthening the Regulatory Landscape (III)

Strengthen the market infrastructure:Strengthen the market infrastructure:

Separate wholesale market and market for end-users in order Separate wholesale market and market for end-users in order to increase liquidityto increase liquidity

Improve the repo and securities lending marketsImprove the repo and securities lending markets

Clarify tax and accounting issues around short-sellingClarify tax and accounting issues around short-selling

Settlement and clearing systemsSettlement and clearing systems

35

Pace of Reform Is AcceleratingPace of Reform Is Accelerating

Important steps over the past 18 monthsImportant steps over the past 18 months

Bankruptcy law, commercial paper market, non-guaranteed Bankruptcy law, commercial paper market, non-guaranteed debt, talk of abolishing quotasdebt, 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 ratesPBoC announces intention to liberalize interest rates

Asset-backed securities based on NPLs to be issuedAsset-backed securities based on NPLs to be issued

Overseas managers hired to invest part of state pension fundOverseas managers hired to invest part of state pension fund

Foreign banks can now operate across the domestic banking Foreign banks can now operate across the domestic banking marketmarket

36

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