Analysis: How a Scrapped Tax Exemption Will Change China’s Bond Market

A recent tax change in China targets institutional investors in the Chinese bond market, introducing value-added tax (VAT) on interest earned from newly issued sovereign, local government, and financial bonds. Analysts suggest that this reform will drive increased trading, reduce price distortions caused by previous tax policies, and encourage diversification away from an over-concentration of funds in these bonds [para. 1]. The new VAT requirement, announced in July and effective from August 8, 2023, is part of a broader shift as China’s bond market has grown into the second largest globally [para. 2][para. 3].

Historically, China exempted interest income on these government-related bonds from VAT to attract investors as the market developed. However, with the total value of outstanding sovereign, local government, and financial bonds reaching 131.6 trillion yuan ($18.4 trillion) by June—almost 70% of the market—the authorities deemed the exemptions no longer necessary [para. 4]. The new tax applies only to institutional investors, while individual investors remain exempt. Importantly, the reform does not retroactively cover existing bonds issued before August 8, and its applicability to foreign institutions remains unclear [para. 5][para. 6].

The VAT rate introduced is set at 6% for institutions investing their own funds, including banks, insurers, and securities firms. Institutions investing on behalf of clients, such as mutual funds and asset managers, face a 3% VAT rate [para. 7]. The end of the tax exemption corrects the previous situation where government bond yields were artificially low. Exemption from VAT previously led to increased demand for government bonds, raising their prices and suppressing yields, thereby distorting the benchmark “risk-free” rate, with effects permeating the entire bond yield curve [para. 8][para. 9][para. 10]. Market participants, such as those from China Chengxin International Credit Rating, argued that the discrepancy rendered comparisons between government and corporate bond yields difficult, undermining the benchmark status of government bonds [para. 11].

Another expected consequence of the VAT imposition is the stimulation of trading activity. Commercial banks, holding over 55% of interbank bonds as of last year, often preferred holding government bonds to maturity due to the previous VAT exemption [para. 12][para. 13]. Now, with the tax in place, analysts like those from Guosheng Securities believe capital will be less concentrated in government and policy bank bonds, potentially enhancing liquidity [para. 14]. Regulators have also been encouraging banks to direct more investments toward corporate bonds instead of concentrating on government and policy bank bonds [para. 15].

The new policy also influences the competitive landscape among different fixed-income instruments. For instance, bank-issued negotiable certificates of deposit (NCDs), which remain exempt from VAT, may become more attractive, and there could be a boost to corporate and other non-sovereign bonds as estimated by China Minsheng Banking Corp analysts [para. 16][para. 17].

Nevertheless, most insiders anticipate only a modest overall effect on the market, particularly in the short term. Many institutions had completed their main bond investments for the year before the policy’s introduction, mitigating immediate disruptions. According to one senior banker, industry-wide net profit may fall by tens of billions of yuan due to the VAT, but the impact should be manageable this year [para. 18][para. 19].