Will China’s latest Bond Offering Penetrate U.S. Markets, Institutional Portfolios Through A ‘Backdoor’?
(Washington, D.C.): Despite lingering investor anxieties regarding global emerging markets
and
the recent default of one of China’s largest International Trust and Investment Corporations (i.e.
Guangdong ITIC),(1) the People’s Republic of China is
expected to announce today the sale of a
general-purpose bond in the amount of $1 billion. This so-called “Yankee” bond will be issued on
the Luxembourg and Hong Kong Stock Exchanges at slightly less than three percentage points
above the 10-year U.S. Treasury Note and will be co-led by prominent Swiss and American
investment banks. The U.S. Treasury market has reportedly reacted to the “road show” designed
to market the offering with “mixed reviews,” according to one financial journalist. For those, like
the William J. Casey Institute, concerned with both the financial and national security
implications
of such a transaction, a careful look is in order.
Although it appears that the underwriters of this latest Chinese offering are deliberately
avoiding
bringing the bond to market in New York, subscribers may end up including U.S. pension and
mutual funds, insurance companies, corporations and other American entities due to a “backdoor”
provided under the regulations of the Securities and Exchange Commission (SEC). Rule 144A
allows foreign borrowers to market issues to “Qualified Institutional Buyers (QIB’s)” — i.e.,
institutions with over $100 million invested in the capital markets — without the
kind of scrutiny
that such an offering would receive if issued in the United States. It also allows
the offering to
be concluded in a relatively short time frame.
Did Wall Street and China Break The Code?
Between October 1993 and December 1997, the People’s Republic of China, borrowing under
its
own name, issued seven dollar-denominated bonds totaling about $3.2 billion in the U.S. capital
markets. During that same time period, the PRC also tapped into other
international markets
(e.g., yen- and DM-denominated bonds) on five occasions, but for only roughly $1.3 billion.
The relatively large proportion of Chinese bond issues in U.S. capital markets is not
particularly
surprising, given the global dominance of these American markets and Beijing’s need to access
them if it is to meet its large-scale money needs over time. It does raise a question as to why the
Chinese government and their U.S.-based underwriters have decided to issue the upcoming bond
in two foreign markets (and, arguably, second-tier ones at that), rather than in New
York.
The explanation may be that China and its advisors on Wall Street are doing so in
response to
the experience of a controversial foreign bond offering in the U.S. market last year. In late
October-early November 1997, a $3 billion bond offering by Gazprom, the giant state-owned
Russian natural gas monopoly, was unceremoniously withdrawn. It had become a
focus of controversy in light of congressional concerns about Gazprom’s violation of the
Iran-Libya Sanctions Act by dint of that firm’s participation in a large offshore energy project in
Iran.
In fact, in the course of tough hearings in the Senate Banking Committee, economic retaliation
against Gazprom was threatened, chilling the market’s appetite for the Russian monopoly’s
paper.(2)
In short, for the first time in memory, a foreign bond offering in the U.S. capital
markets
was derailed for primarily national security reasons. In light of this experience, and the
distinct possibility that a China engaged in political repression at home, the proliferation of
weapons of mass destruction and a threatening military build-up could inspire similar reactions to
its bond offerings, the PRC and its underwriters may have concluded that it would be safer to
enter the U.S. market through foreign markets — via the 144A “backdoor” — than to risk coming
through the higher-profile “front door” in New York.
Why Luxembourg and Hong Kong?
Pursuant to the U.S. Securities Exchange Act of 1933, the SEC requires a high degree of
disclosure and transparency regarding bonds underwritten by U.S. firms and offered in New York.
In order to circumvent some of this burdensome scrutiny, a foreign government may choose to
offer its paper to large U.S. portfolios and funds through two loopholes governing bonds offered
“off-shore”: “Regulation S” and “Rule 144A.”(3)
Ironically, these “safe harbor” mechanisms were originally designed to protect
individual
investors from less-than-transparent overseas bonds. In practice, however, these arrangements
make it possible for an unscrupulous foreign entity to register its offering overseas and then
market its bonds to Qualified Institutional Buyers through a U.S. holding company.
In the case
of the current Chinese offering, the designated holding company is the Depository Trust Company
of New York.
In contrast with SEC procedures, Luxembourg — where the latest Chinese bond was first
registered — requires, according to one Wall Street insider, “form over substance.” As a result,
China has not been obliged to provide as much information about its activities and
creditworthiness as well as the intended use of the funds. Once the bond offering is successfully
sold to QIB’s through the holding and clearing companies in New York and Europe, the bond will
be officially listed on a foreign stock exchange (in this case, the Hang Seng).
Should China succeed in implementing such a strategy, the PRC and its underwriters will have
achieved the best of both worlds: They will secure funds from many of the same American
investors who would have purchased the Chinese bonds had they been offered in the U.S., while
avoiding full disclosure with respect to the specific offering, the foreign government borrower and
the end-use of the funds. In particular, through this “backdoor” Beijing can: 1) avoid having to
comply with arduous SEC rules regarding listing requirements; 2) bypass a possibly extended
“due diligence” process; and 3) minimize exposure to the sort of controversy and potential
Congressional action that sank the Gazprom offering in 1997.
maneuver will likely become the favored path of Wall Street firms advising hard currency-seeking
foreign governments and the entities they control.
What’s Wrong With General Purpose Chinese Bonds?
Although not all Chinese bonds should be considered risks due to financial, national
security-related or other concerns when listed off-shore (i.e., outside the purview of the SEC), as
a general
rule these instruments require close scrutiny for a number of reasons. These include the
following:
- Sovereign Chinese bonds of the type coming to market are general purpose in nature,
meaning
that Americans have little, if any, specific information concerning where the cash proceeds
raised from bond offerings are going and how they will be used. While the relative
efficiency
and cost-effectiveness of this means of borrowing makes it attractive for a foreign
government like China, the lack of discipline and transparency makes it problematic for
the West. - Foreign government bonds cannot be “rescheduled” with nearly the same ease as, for
example,
traditional commercial bank loans. If China were to experience a liquidity crisis (or
worse)
in the future, it would be nearly impossible to locate all of the holders of Chinese bonds
for the purposes of rescheduling or restructuring the country’s debt,
secondary market for such bonds exists. These end up being purchased by institutions and
individuals worldwide.(6) - Also, unlike loans from Western governments and commercial banks, by borrowing via bond
offerings, Beijing is able to recruit a wide spectrum of American financial entities as
lenders to China (e.g. pension and mutual funds, insurance companies, corporations,
leasing
firms and even individuals). Beijing is, no doubt, mindful of the fact that this form of
borrowing in the U.S. and elsewhere in the West creates a vested financial interest on
the part of lenders and investors, for example, to oppose future economic sanctions or
other penalties associated with proliferation activities, human rights abuses, environmental
degradation and other misdeeds. By expanding substantially the American holders of Chinese
paper, such transactions could facilitate even greater PRC influence in the halls of Congress
and the Executive Branch.
Indeed, general purpose (also known as “balance of payments”) loans by Western
governments and other lenders to sovereign borrowers have contributed to
creditworthiness problems down the road (e.g. Russia and other emerging market
economies). This has been true, in part, due to the fact that lenders did not ensure that
loan proceeds were used for productive purposes (such as fostering export-oriented or
import-substituting projects and industries which might have generated the hard
currency cash flow — or savings — required to repay the loans). Worse yet, from a
national security perspective, such bond proceeds could be more easily diverted to
purposes inimical to U.S. security interests, a problem compounded by the inherent
fungibility of money.
The National Security Dimensions
Over the past two years, Chinese — and Russian — bond offerings have increasingly become a
source of concern to some in the U.S. security community as well as to key members and
Committees on Capitol Hill. The following are among the grounds for such concern:
- Some $800 million in dollar-denominated bonds have thus far been issued
(primarily in
the U.S.) by China International Trust and Investment Corporation (CITIC), headed by
China’s most notorious arms dealer, Wang Jun. Wang can no longer obtain a visa to
enter
the United States due to allegations that he was involved in efforts to smuggle (via a subsidiary
of the PLA- and CITIC-affiliated company, Poly Technologies) roughly 2000 AK-47’s to West
Coast street gangs. There are reports that CITIC, which is a $23 billion Beijing
government-controlled entity, does not report — as advertized in past bond prospectuses — to
China’s State
Council, but rather to that nation’s Military Commission. - Another potentially problematic issuer of international bonds is the Bank of China,
which has sold $2.3 billion of its dollar-denominated paper since 1985, primarily to U.S.
investors. The bank has been implicated in the U.S. campaign finance scandal for
executing
electronic money transfers to both Johnny Chun and Charlie Trie. According to Insight
Magazine, the Bank of China is suspected of involvement in “information-gathering” (read
intelligence collection) that has reportedly contributed to long delays in its efforts to open a
branch office in the San Francisco area. - The People’s Republic of China is the largest Chinese borrower of dollars in the
United
States, with some $3.2 billion in sovereign bond offerings. As Roger Robinson, former
Senior Director of International Economics at the Reagan National Security Council and Casey
Chair, put it in testimony before the Senate Banking Subcommittee on Financial Institutions on
5 November 1997: “Hopefully, a portion of these funds did not find their way to help fund the
new DF-31 mobile ICBM, the new JL-2 submarine launched ICBM or other sophisticated,
world-class military systems which will be targeted at the United States and our assets
overseas.”(8)
Geopolitical Backdrop of the Newest PRC Bond
Despite assertions by the Clinton Administration and Beijing’s supporters in the U.S. private
sector to the effect that China is successfully cooperating on a number of fronts to ease bilateral
tensions, the past few weeks have amply demonstrated the need for continued U.S. vigilance and
monitoring of undisciplined Western borrowings. Consider the
following:
- China is currently in the midst of a renewed period of
political repression. A fledgling
opposition group, the China Democracy Party, has been forcibly suppressed by the wholesale
arrests of its members. The government has announced plans to try one of the Democracy
Party’s leaders for “subversion” next week, virtually ensuring that he will soon be sentenced to
a lengthy prison term. - According to the Washington Times’ National Security Correspondent Bill
Gertz’s front-page
report of 9 December, China has defaulted on its promised crack-down on dangerous
proliferation activities. The article states, “China last month delivered a new shipment of
missile technology to Iran…The transfer included telemetry equipment that could be
used in the testing of medium-range missiles, such as Iran’s new Shahab-3.” This
shipment follows a transfer last year of an entire “telemetry infrastructure,” which gave Iran the
capability to test the Shahab-3 last March. Both shipments violate a pledge China made to
abide by the Missile Technology Control Regime. - A front page article in the New York Times today indicate that a
classified Pentagon report
completed on 7 December found that Hughes Space and Communications “gave China
technological insights that are crucial to the successful launching s of satellites and
ballistic missiles.” This scandal would be further exacerbated if, as reported by the
Washington Post and New York Times on 5 December, CIA
officials tipped off Hughes
Electronics Corporation to the fact that company officials were going to be called before the
Senate Intelligence Committee which was investigating the transfer of sensitive, militarily-relevant
technology to China.(9)
Bottom Line
The Casey Institute has long argued for greater disclosure and surveillance with respect to
foreign
government bond offerings marketed to U.S. investors (institutional or otherwise) — particularly
by Russia and China. This is not an argument for capital controls or other such
disruptive
measures. In the case of China, as Mr. Robinson stated in testimony before a Senate
Banking
Subcommittee on 5 November 1997,
- “The purpose here is not to cast aspersions on all Chinese borrowers or fund-raisers in
our markets, or to propose the suspension of any borrowers or equity issuers on the
basis of what we know today. It is rather to affirm…that greater security-related
disclosure and screening is urgently required if we are to build a more
cooperative and sustainable bilateral relationship with China.”
Such “security-related disclosure” would be advanced by the following steps:
- The reintroduction and adoption of S.1315, “The U.S. Markets Security Act of
1997″ —
a measure that would, for the first time, create an Office of National Security at the SEC
mandated to help strengthen reporting requirements with respect to foreign
government-controlled entities.(10) - Modification of SEC Rule 144A to better protect U.S. institutional and other
investors
from less-than-transparent foreign government bond offerings in overseas markets. - Encouraging specific-purpose bond offerings and other foreign-government
borrowings
so that U.S. investors/lenders know precisely where their money is going and how it is being
used (not to mention the obvious merits of disciplined lending practices and reduced prospects
for serious losses). - Calling for more complete prospectuses — particularly with regard to
foreign governments
engaged in activities harmful to U.S. security interests.
These sensible measures, consistent with the free flow of global capital, would help avoid
unwanted surprises for underwriters and provide clearer “rules of the road” for foreign
government borrowers. The ultimate beneficiaries of these achievable modifications would be the
U.S. investor community and the Nation’s security interests.
– 30 –
1. See the Casey Institute’s Perspectives entitled
Hedging Financial Bets In China: Will
‘ITIC’s’ And Other Entities With P.L.A. Connections Be Bailed Out By Beijing?
(No. 98-C
182, 12 November 1998) and Market Confidence in ‘China Inc.’ Appropriately
Shaken —
G.I.T.I.C. Bond Default: A Taste Of What Is To Come? (
2. See Russian Bonds Rocked By Second Senate
Hearing In A Week Focusing On
Undesirable Foreign Penetration Of U.S. Markets (
3. Regulation S allows non-U.S. investors to purchase the bonds
underwritten by U.S. investment
houses. Rule 144A allows QIB’s to purchase bonds listed on overseas exchanges.
4. Ironically, these “safe harbors” have loopholes of their own.
Specifically, after roughly 40
days, QIB’s are allowed to trade their bonds for seasoned “global notes.” These global notes may
then be sold to individual consumers. Put simply, in less than two months after the initial offering,
the individuals and entities 144A and Regulation S were designed to protect can and do purchase
paper which has not fulfilled all SEC disclosure requirements.
5. This problem was brought home by the Russian government’s
recent default on its GKO
financial instruments.
6. A principal bottleneck in Russia’s debt rescheduling efforts today is
the result of Moscow
having shifted its borrowing patterns over the past several years — both domestically and
internationally — in favor of often-lower-priced bond offerings.
7. See the Center’s William J. Casey Institute
Perspective entitled, Dangerous Upshot of
Clinton-Gore’s China ‘Bonding’: Strategic Penetration of U.S. Investment
Portfolios (No.
97-C 47, 1 April 1997), the Casey Institute’s Press Releases entitled
Insight Magazine Breaks
the Code: Chinese Penetration of U.S., Global Financial Markets Has Strategic
Implications
(No. 97-R 60, 3 May 1997), USA Today
Illuminates Case For Urgent Action To Halt Chinese
‘Bondage’ (No. 97-R 68, 16 May 1997) and
The Dog That Didn’t Bark: Moody’s, Et.Al. Fail
Investors In Asian Markets, Miss Warning Signs In China And Russia (
December 1997).
8. Please see Roger W. Robinson, Jr.’s 5 November 1997 testimony before
the Senate Banking Subcommittee on Financial Institutions.
9. Although this controversy involves alleged security-related abuses
by U.S. space and
communications companies, it, nonetheless, highlights the fact that China is continuing to pursue a
robust strategic modernization effort.
10. See Sen. D’Amato’s Committee Serves Notice On
Those Who Aid And Abet U.S.
Adversaries: No Fund-Raising On American Markets (
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