By Hu Yuwei    Source: Global Times    Published: 2016-4-26

The past decade has seen rapid development in China`s bond market, with its trading volume having reached 48 trillion yuan ($7.4 billion) by the end of 2015, the third-largest in the world. Meanwhile, China`s trading volume for debentures, a type of bond backed only by the credit of the issuer, now ranks second globally. Debt financing as a significant financing tool for China`s companies and even for local governments, has played a big role in promoting the country`s economic growth. And China`s rapid development of corporate bonds and debentures has helped to relieve the over-dependence on indirect financing, and helped to elevate the proportion of direct financing in society.

But at the same time, unregulated behavior in bond issuance has also emerged. This could potentially corrode the fundamentals of the bond market and the financial market, and it might even bring about a ripple effect that could affect overall economic growth.

In recent years, amid downward economic pressure, an alarming wave of bond defaults, particularly in the debenture market, has emerged. In 2014, some private firms began to default on their debt and the situation in the domestic bond market further deteriorated with the first default by a State-owned enterprise (SOE) in 2015. In 2016, the number of default cases seems to be rising. Some market observers have even said China is facing the risk of a "Minsky moment," referring to a sudden major collapse in asset values after excessive credit expansion.

Following these default cases, I believe that investors first have to rid themselves of the presumption that there is an implicit guarantee of debt repayment by the Chinese government. Second, investors should accept the ups and downs of the market.

A lot of domestic investors, especially retail investors, still hold the assumption that repayment in China`s financial market is inherently guaranteed by the government. As high-grade bonds like interest rate securities and financial bonds are normally backed by the government, such bonds are at low risk of default. But investors` presumption of guaranteed repayment can also cover other kinds of bonds, such as debentures issued by companies. Further, when issuing debentures, the issuing company tends to lower costs through enhancing its credit worthiness, and if the issuing company is backed by a parent company with a SOE background, this will even strengthen investors` presumption of guaranteed repayment.

Even though the recent wave of default incidents has increased market volatility in the short run, as long as this wave of bond defaults doesn`t trigger systemic financial risks, such cases will actually help to foster the healthy development of China`s bond market in the long run, because investors will have a better understanding of it, and will be more inclined to conduct due diligence beforehand.

China`s development of its debenture market is still limited, and there are various problems. Driven by commercial interests, the main players in the debenture market form a community of interest that could ultimately damage the creditors, namely the investors. This could damage investors` confidence, which would lead to a downward spiral in the bond market.

To be more specific, issuing corporate debentures mainly involves five sides - the issuer, the parent company, investors, the principal underwriter, and the credit rating agency. In an unregulated scenario, there are abuses that can occur. For instance, a debenture-issuing company can tunnel profits to its parent company or an affiliated company by replacing high-quality assets with risky ones, and the underlying risks are thus transferred to the investors.

Various factors can lead to this situation, and one of them is asymmetric information. In other words, among all the sides involved in debentures, creditors are placed in a comparatively disadvantageous position because they do not necessarily have access to timely and accurate information on activities like bond-issuing and the whereabouts of funds, and must passively accept information that is offered to them.

Further, under extreme circumstances, if a bond-issuing company enters into bankruptcy and liquidation proceedings, compared with the principal underwriters, namely the commercial banks, the creditors are normally more vulnerable, again as a result of asymmetric information. For instance, commercial banks have access to the issuers` business transactions, so they can be the first to apply to local courts to freeze the issuer`s assets and protect their interests.

In this regard, enhancing information disclosure is pivotal. The principal underwriters, in particular, should conduct due diligence before the bonds are issued, and should publicly disclose relevant information to investors in a timely manner. Meanwhile, the issuers should provide information on their financial position on a regular basis so that the investors can be informed where the capital is being directed and how the issuers` business operations are performing. Using such methods can strengthen investors` confidence and thus maintain market stability.

As long as the Chinese government remains committed to structural reforms and strengthening the real economy, and as investors become better-educated about the market, China will be able to avoid a "Minsky moment."

The author is a research fellow at Chongyang Institute for Financial Studies, Renmin University of China.