Opinion: China’s Baffling Bond Market

Some aspects of China’s bond market are deeply puzzling to observers.

The Chinese government has over the past few years called for the country to develop a multilevel capital market, especially the bond market and stock market, driven by worries about increasing leverage. However, this push has not resulted in the expansion of direct investment in the capital market, but rather in the dramatic growth of “shadow banking.” Some estimates put the scale of shadow banking in China at 90 trillion yuan ($14.1 trillion) — a huge amount. In comparison, the size of the bond market is currently around 75 trillion yuan. This is the first puzzle — why have the funds flowing out of China’s banking system not entered its bond market?

Here’s another puzzle: Since 2009, the government has continuously encouraged the internationalization of the yuan. It has focused on opening the bond market, and allowing foreign investors to hold yuan assets, primarily bonds. But, in reality, foreign capital accounts for less than 2% of the Chinese bond market. At the end of 2017, this figure was around 1.6%. Why is this figure so low?

Seven problems

What exactly are the problems faced by the Chinese bond market? After conducting some research on market participants inside and outside China, we have uncovered seven major problems.

The first problem is uncertainty over policy. Chinese authorities sometimes launch policies without much of a lead-up. One of the biggest policy changes for international investors has been China’s strengthened controls on cross-border capital flows in the past couple of years.

The second problem is inconsistent regulatory standards. Because the Chinese bond market is severely fragmented, each market is governed by different rules, with incompatible standards and infrastructure, creating an unfriendly environment for investors.

The third problem is the existence of a nonmarket pricing mechanism, especially among state-owned enterprises, local platforms and local debt. China’s credit spread is far narrower than most other countries’ spreads, according to data from the International Monetary Fund, suggesting either lower risk, or a problem with the rating system.

The fourth problem is a lack of market discipline. The default rate for bonds in China is far below international levels, showing that market mechanisms are not fully in place in the country.

The fifth problem is low liquidity, primarily due to the low turnover rate. There are many reasons for this. Commercial banks hold large volumes of bonds, which basically remain in the same hands until they reach maturity. As a consequence, investors with fewer liquid assets do not dare to invest for fear that they will be unable to sell them off in the future. It is also difficult to accurately determine the market value of a financial product if there are few transactions taking place.

The sixth problem is China’s unreliable rating system. If you compare bond ratings in China and the U.S., you will notice a significant discrepancy in the distribution of ratings. The ratings of Chinese bonds mostly tend toward the higher end of the scale, and are clearly inflated, undermining the credibility of the Chinese rating system.

Last, but not least, is the lack of alignment with the international market. Foreign capital can now, in theory, enter China through multiple channels. However, due to differences between domestic and international regulations, including in accounting and settlements, foreign investors are effectively still unable to enter.

Root causes and solutions

Among the many reasons for the current state of China’s bond market is a lack of long-term planning in its early days. In the past, the Chinese government saw the bond market primarily as a means for government financing. In the 1980s, it was practically mandatory for public officials to purchase bonds whenever the government issued them, and the fees were deducted directly from their paychecks. The policymakers developing the bond market were less concerned about constructing a functional system than they were about raising funds.

Additionally, China’s bond market developed in an environment where capital projects were tightly controlled. The policies that created the market did not take into account the factor of foreign investment, much less the issue of how to integrate with the global market. Now that the bond market has been opened to foreign investors, the lack of planning in this area has become increasingly pronounced.

Furthermore, China’s bond market is deeply fragmented. Within the country, there are exchanges, inter-bank markets, corporate bonds overseen by the National Development and Reform Commission, corporate bonds regulated by the China Securities Regulatory Commission, and financing instruments managed by the central bank. China’s overall bond market is large with a baffling structure. With different development aims and different drivers, many of the country’s bond markets function according to their own rules.

If we take a step back, these causes can be further distilled into two main issues.

The first issue is the existence of multiple supervisory bodies, each responsible for only a fragment of the market. As a result, the standards existing today are varied and disconnected from each other. Many rules have been formulated in response to short-term problems, without consideration of long-term, overarching issues.

The second issue, as previously mentioned, is the large volume of bonds held by commercial banks, usually to maturity, which affects the depth of the market. The low volume of transactions, which results in inaccurate pricing and poor liquidity, scares off many investors.

So, what should China do to fix these problems?

There are three principles the country should follow. First, it must adhere to the principle of marketization, whether it is in relation to the issues of pricing, ratings or rigid repayment. The second principle is the acceptance of international standards, especially through the rebuilding of infrastructure. The third principle is to ensure independent, unified and consistent supervision.

China could achieve a breakthrough if it builds a bond market supervision system that is both coordinated and relatively independent. The country should establish a coordination committee comprising officials from the central bank, the CSRC, the NDRC and the Ministry of Finance tasked with clarifying and unifying regulatory standards. Afterward, the country should safeguard the professionalism, independence and authority of regulatory departments by separating market and industry development departments from regulators.

Challenges ahead

China’s bond market can expect to face a number of challenges in the near future, due to changes in policy and the macroeconomic environment.

The first challenge is increased risk stemming from many sources, including local platforms that need to postpone repayment after their bonds reach maturity, recently issued regulations on asset management, and vows to move away from rigid repayment.

Another challenge is deleveraging, a main aim of the central government. Developing the bond market while deleveraging will require a delicate balancing act because bonds are a form of leverage. On the bright side, the bond market can help identify and improve the quality of leverage.

A third challenge is China’s serious level of financial repression. This is reflected in the bond market, through the huge difference between the nominal gross domestic product (GDP) growth rate and the market’s rate of return, meaning the cost of capital is very low. This situation is unlikely to last long, with China’s current situation mirroring that of Japan in the 1960s and 1970s. Eventually, the difference between GDP growth and rate of return must shrink, either through a decline in growth or a rise in rates. Which of these fates will China face?

The last challenge is coordinating opening up with reform. China has, in the past, always insisted on using openness to promote reforms, but it is equally important for reforms to help make the country more open.

The opening of the bond market is a necessary step for China’s further capital market reforms and for its plans to internationalize the yuan. However, capital poured into the bond market is highly mobile, and many emerging countries experience financial crises when they begin to open up. After capital enters these countries, the exchange rate rises, causing the growth of an asset bubble. When the influx of capital reaches its peak, it flows out, triggering a financial crisis. In the process of opening up, China must prepare to make the necessary domestic reforms, rather than relying only on opening-up. In addition, the country must establish macroprudential supervision policies, to avoid serious financial risk.

Huang Yiping is a professor of economics at the National School of Development, Peking University. This piece was adapted from a speech that Huang gave at a recent forum organized by the BiMBA Business School of the National School of Development at Peking University.

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