Last week's liberalization of China's notoriously restrictive corporate debt regulations is likely to set off a stampede of firms looking to swap their existing bank loans for cheaper paper. Despite the changes, transforming China's bond market will face a number of challenges.

Last year Chinese companies issued $17 billion of corporate debt. In comparison US firms issued over $3 trillion. The decision to open the traditionally moribund corporate debt market reflects the government's desire to shift credit risk to the capital markets and off of bank balance sheets. Additionally the move is seen as a way to provide an alternative to the volatile Chinese stock market for investors.

The changes also appear to solidify the emergence of the CSRC as the dominant regulator in the bond sector. Whereas in the past the CSRC had shared regulation with the National Development Regulatory Commission, it now appears to be the sole agency responsible for granting approvals.

Easier credit, greater options

Specifically the ruling by the China Securities Regulatory Commission (CSRC) makes changes to three key provisions of the existing rules:

1. Removes previous requirement for bank guarantees for any debt maturities over 12 months.

2. Relaxes many of the strings attached to how the proceeds of debt offerings can be used. No longer are firms required to use the cash only for specific state-approved projects. The new ruling allows proceeds to be deployed in accordance with shareholder's interests and macro-economic policy. In the short run, the majority of bond will likely be used to pay down high interest loans.

3. Ends old quota system which capped total corporate bond issues at RMB100 billion annually.

Stumbling blocks ahead

One of the greatest challenges to the emerging debt market is China's current lack of any type of independent credit rating agency. The existing bond regulations, which by requiring guarantees effectively made all issues risk-free, resulted in little variation in yields and little need for ratings.

Unfortunately, it is doubtful that many debt experts have forgotten the debt default debacles of the 1990’s, capped by Guangdong International Trust and Investments default on $4B of debt. Such memories make establishing a ratings agency all the more vital if foreign investors are to help grow the debt market.

In addition to a ratings body, China's bond market faces the additional hurdle of needing to establish a benchmark for long-term government debt. At present, debt issued by the Chinese government tends to be of short or medium term lengths, and is often held to maturity by its holders, who are often government owned banks. As a result there is little market depth or breadth.

“The government needs to develop a yield curve to help pricing of corporate bonds.” Wang Qing, Executive Director Morgan Stanley Asia.

China certainly has a need for adequate debt markets. Heavily capitalized industries such as power, transport, property and infrastructure will certainly benefit from great competition. Whether it can establish the mechanisms necessary to encourage this market remains uncertain.