China issued one third of the world’s green bonds in 2017 and has quickly become a world leader in green finance, a relatively new area that focuses on money products related to sustainable business.
But of the US$38.6 billion in green bonds issued by Chinese institutions in 2017, the majority was in the domestic market, with just US$6.6 billion issued abroad. To help the green bond market grow further, China is looking to improve access to international investors.
Why green bonds?
Increasingly, businesses are turning to green bonds to finance efforts to become sustainable. For a business to do this it needs investment. This requires taking on debt, which can be done by issuing a bond. What makes green bonds different from conventional bonds is that companies can only use the borrowed money for sustainable purposes.
Since 2015, money raised with green bonds has been an important component in greening the Chinese economy. Businesses are using them to update production facilities and reduce their ecological footprint, cities to electrify infrastructure, and finance institutions to raise funds to lend to small and medium sized enterprises that have prospects for bringing innovative green technologies to market.
China is now looking beyond its domestic market to continue the expansion of green bonds. It’s doing this because the country will need an estimated 3-4 trillion yuan in green investments annually in the coming years – meanwhile, international investors have shown a keen interest in green assets: 38% of European investment officers polled in June 2017 said they were in the market for green bonds, 50% said they were interested in renewables.
In other words, the supply for Chinese green bonds falls short of the demand, particularly from abroad, by a long way.
But Chinese finance markets are notoriously closed to outsiders because the authorities wish to control monetary policy and the currency exchange rate of the RMB.
But as our analysis shows, there is some progress in this area, meaning China’s green bonds will become more accessible to international investors.
Green is the new black
Despite the limited size and short history of China’s green bond market, research by the Bank of International Settlements, HSBC, and Natixis suggests that investors can find greater security and earnings in a green market than a conventional one.
For companies in certain areas of China, a green profile allows access to cheaper financing from banks, resulting in less volatility and greater long-term thinking within companies.
For banks, issuing green bonds allows them to bundle existing green loans together into a new bond with a longer running time, lower risk and lower interest rate. This frees up space on the bank’s balance sheet to extend new loans. And because green bonds take longer to mature and are more diversified than direct loans, they present a lower risk to the issuer. This process is encouraged by the China Banking Regulatory Commission.
Lastly, evidence suggests that we have underestimated the size – and the popularity – of the existing green market. Not all bonds that meet the criteria of green bonds have been labelled and issued as green. It is estimated that before the green bond label was officially introduced, about 30% of corporate bond issuance would have qualified as green. As issuers become increasingly aware of the advantages of green bonds, more and more of those bonds will be labelled and issued as green, providing another source of increasing issuance.
For information-hungry investors there are added advantages to green bonds with regards to risk and the environment. Compared to conventional bonds, they have a higher degree of transparency and information disclosure because a third-party auditor has to make sure that the green credit is being used for green purposes.
Existing green bonds have shown to be less volatile than conventional bonds while also trading slightly higher in secondary markets. While the market for green bonds is still smaller than the conventional bond market, the size remains adequate for most investors looking to buy or sell green bonds. Investing in green bonds also provides a positive reputational and market signal.
Today there are three ways that international investors can tap into China’s green bond market. The first is the Bond Connect Program, which allows international investors, including smaller ones, to buy bonds through a Hong Kong based trustee.
The second is the Direct China Interbank Bond Market, which was launched by the People’s Bank of China in 2016. This opened up access to a wider range of investors by relaxing rules for banks, securities companies, fund management companies, and long-term investors in insurance and pensions, etc.
These two initiatives have increased access for foreign investors and given an indication about future possibilities in the market for green bonds. In November a Ministry of Finance spokesperson outlined new legislation that will allow foreign companies to own Chinese banks and hold majority stakes in Chinese investment houses. This will further allow small investors to trade in Chinese markets through their foreign banks.
But there is also a third way, wherein Chinese issuers list their bonds offshore, providing wide access for investors of any origin. Recent examples include Bank of China’s issuance on the Euronext Exchange, Industrial and Commercial Bank of China on the Luxembourg Exchange, and the China Three Gorges Corporation on the Irish Stock Exchange. These issuances were in yuan, euro and the US dollar. Chinese companies and banks issue abroad because they can receive lower interest rates and get easy access to foreign currency for investments outside of China.
More access may sound like a good thing, but foreign investors still don’t understand enough about the Chinese green bond market when it comes to different bond categories, proceeds regulations, pre-issue verification and audits. They also don’t know how to find information in these areas.
The good news is that the Green Finance Committee of China is working with the European Investment Bank to harmonise green bond standards between Europe and China. This will give investors the chance to apply their existing knowledge to a foreign market. The first step was completed in November, providing a framework for compatibility between the standards, and allowing investors to make a direct comparison.
The process for an international green bond issuance is different than for a domestic one so the practice is yet to be institutionalised in the financial industry. For example, foreign issuance has to undergo a different approval procedure by the National Development and Reform Commission (NDRC).
Ultimately, the rapid expansion of green bonds in China shows the pace at which capital markets there can develop. And as the domestic market expands, the next step will be to internationalise, helping China to realise the US$3-4 trillion green investment gap in the coming years, while showing the world that it is serious about its commitment to widen access to its markets.
Serious efforts are underway to remove obstacles between foreign investors and Chinese regulations and issuers. Whether the internationalisation of Chinese green bonds can expand substantially in 2018 depends on the pace of these efforts.