China’s banks are lending again. The more they extend in credit, the more they’ll feel the pressure to boost their capital buffers.
One method banks are already using is convertible bond issuance. The good news for the issuers is that this market is currently booming. The amount of convertible bonds listed on the Shanghai Stock Exchange has more than doubled in the past year, according to FactSet data. But investors should keep an eye on the market, which is still nascent: the evolution of the assets and their accounting is still uncertain.
It’s easy to see why banks like these bonds—the cost of raising equity is higher than the cost of raising new debt across most of the world, but the gap is particularly large in China. The after-tax cost of debt capital runs to around 3.6% for Chinese listed companies, as opposed to the 14.2% cost of equity capital, according to Aswath Damodaran, a professor at the Stern School of Business at New York University.
At the same time, Chinese banks can immediately account for some of the funds raised as core Tier 1 capital, the most crucial segment for lenders which are in the process of ramping up their credit growth.
Right now, buyers love them too. The market has been so popular that China’s financial regulators recently imposed rules to prevent brokerages from bidding for an allocation through dozens or hundreds of securities accounts.
Convertible bonds behave more like equity than traditional debt, so many investors whose mandates restrict them to bonds flood in during strong market conditions. With the Shanghai Composite Index up nearly 30% this year, it’s great timing—but demand for the instruments might not weather a stock market downturn, which could leave an increasingly common method for raising capital suddenly unviable.
It’s also worth keeping a close eye on just how much of that fundraising Chinese banks are immediately counting in that highly valuable sliver of capital.
In the case of Ping An Bank, 3.7 billion yuan ($551.6 million) of the 26 billion yuan it raised this year was immediately accounted for as core Tier 1 capital, just shy of 2% of the bank’s total. Though the calculation of how much of the bond should be booked as equity is a movable feast, Chinese banks have in the past booked a large portion of the instruments as equity relative to international norms.
These conditions—rapacious demand for convertible bonds, more attractive funding conditions and demands from Beijing that banks boost lending to smaller private firms—make convertible bonds a happy option for Chinese banks. But as a relatively small and rapid-growing market, it’s worth keeping a skeptical eye on the dramatic expansion.
Source: The Wall Street Journal
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