Seize Opportunities in China's Bond Market

Global political polarization will gradually become more apparent and is expected to persist for a considerable period in the future. In the context of the US-China rivalry, the United States is attempting to sever the close ties between China's financial market and the rest of the world. Faced with these challenges, China's bond market needs to shoulder a greater responsibility and develop its own market characteristics and advantages.

Over the past five years, the global geopolitical landscape has undergone revolutionary changes. From the US-China trade war to the Russia-Ukraine conflict, the Israel-Palestine conflict, and the uncontrollable spillover effects, these conflicts have not only led to the fragmentation of political and military blocs but also to the differentiation of economic blocs. Naturally, this has had a significant impact on the interconnectivity of global financial markets.

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In the US-China rivalry, the rise of trade protectionism is evident, posing a significant barrier to industry and technological competition and cooperation. The negative effects of the United States' direct and indirect measures to curb Chinese enterprises' integration into the global financial system are even more prominent.

The development of any country's capital market is inseparable from its interconnection with the global capital market. As a direct financing instrument, the stock market has been significantly impacted in the US-China rivalry:

On one hand, after the United States introduced the Holding Foreign Companies Accountable Act, it adopted a stricter regulatory stance towards foreign companies listed in the US, targeting more than 200 large Chinese enterprises. This targeted and discriminatory regulation has created a high level of regulatory risk, not only increasing the risk of delisting for Chinese concept stocks but also affecting the enthusiasm of Chinese enterprises to list in the US for fundraising in the future.

On the other hand, the Hong Kong capital market, which connects China with the global financial market, has also experienced a continuous downturn for several years. The effectiveness and willingness of Chinese enterprises to raise equity funds through the Hong Kong market have significantly diminished. Affected by the industry's prosperity and the low investor sentiment, China's stock market has also shown weakness in corporate financing, even experiencing several rounds of small-scale "repurchase waves." Against this backdrop of impacts on stock market financing, China's bond market needs to seize opportunities for targeted high-quality development.

China's bond market is the second-largest in the world, after the United States. As of the first quarter of 2024, the outstanding scale of China's bond market exceeded 158 trillion yuan, accounting for more than 125% of the GDP (Gross Domestic Product) at the end of 2023. However, this proportion still has a certain gap compared to the scale of the US bond market (the total outstanding amount of all bond types divided by the GDP ratio exceeds 200%). The scale of China's bond market has surpassed that of the stock market since 2016 and reached 2.04 times the size of the stock market in the first quarter of 2024.

As an important medium for direct financing by the government and enterprises, China's bond market needs to take up the banner of stabilizing economic operations in the broader context of US-China rivalry. To achieve this goal, it is necessary to "go with the flow" in multiple aspects.On the one hand, China needs to continue to improve the construction and regulatory bodies of the bond market infrastructure. Due to some historical reasons, the products of China's bond market are mainly traded in two large and distinct markets, namely the interbank bond trading market and the exchange market. China's interbank bond trading market is very similar to the interbank trading market in the United States, and the exchange market is part of the Shenzhen and Shanghai stock exchanges. More specifically, the interbank market competes in bond issuance and trading between the Central Treasury Registration and Settlement Co., Ltd. (CCDC) and the Shanghai Clearing House (SHCH) based on different product types. As of the first quarter of 2024, CCDC issued a total value of various bonds exceeding 5.3 trillion yuan within the year, while SHCH issued a total of more than 10.6 trillion yuan, and the exchange market issued bonds worth nearly 5.4 trillion yuan in the first quarter.

Considering that different products are issued and traded in the two major markets, the People's Bank of China (PBOC) regulates the interbank market, while the China Securities Regulatory Commission (CSRC) regulates the exchange market. The Interbank Market Dealers Association (IMDA), established in 2007, acts as an industry self-regulatory organization and also exercises self-regulation over institutional participants. Although there is a certain division of regulatory responsibilities among various departments, the issue of "cross-border areas" in "two markets and multi-head regulation" is still inevitable, leading to vague regulatory authority and low law enforcement efficiency.

For example, Chinese government bonds are jointly regulated by the PBOC, the Ministry of Finance, and the CSRC. Commercial bank bonds are jointly regulated by the China Banking and Insurance Regulatory Commission (CBIRC) and the PBOC. Short-term financing, medium-term bills, and targeted tools are regulated by the IMDA, while international institutional bonds are even regulated by the PBOC, the Ministry of Finance, the National Development and Reform Commission, and the CSRC.

Based on this, against the backdrop of the rapid expansion of China's bond issuance and trading scale, first, on the one hand, different bond varieties should be encouraged to fully compete in different trading venues, leverage comparative advantages, enhance market liquidity, and improve bond value discovery.

On the other hand, the "interconnection" mechanism between the interbank and exchange bond markets, led by the PBOC and the CSRC since 2020, is a good policy adjustment that promotes information sharing in the fragmented market.

For regulators, in the short term, various regulatory agencies need to further strengthen cross-departmental communication and establish more convenient coordination mechanisms. Although multi-departmental regulation has certain historical issues, in the long run, the market should gradually move towards unified regulation and law enforcement entities, reducing market information asymmetry and enhancing investor protection.

Secondly, like other developed bond markets, China's risk-free interest rates and corresponding term structures are inferred from bonds of different maturities issued by the government—they also anchor the pricing of all financial assets.

The interest rates of Chinese government bonds are determined by financial institutions in the primary market (mainly commercial banks and securities firms) through bidding, and these financial institutions can trade government bonds they hold with each other in the secondary market.

Compared with the highly liquid U.S. market, the liquidity in the issuance and trading process of Chinese government bonds is still at a lower level, and the market lacks effective price discovery. Efficient price discovery of government bonds is key to the PBOC's effective monetary policy, which can better stabilize China's economy.Despite the objective assertion that China's government bond auction market has exemplified market-oriented mechanisms over the past two decades, there remains a high barrier to entry in the primary market, limited to qualified financial institutions, which constrains the discovery of bond value. Concurrently, the majority of market makers serving the interbank secondary market are commercial banks, exhibiting a high degree of homogeneity in trading strategies and financing channels, thereby impeding the effectiveness of price discovery.

On one hand, it is necessary to appropriately relax the entry of institutions in both the primary and secondary markets. On the other hand, specialized "lubricants" of the bond market, such as money brokers, have played a significant role in transaction matching and price discovery mechanisms and should be developed to a higher level, akin to developed markets.

Furthermore, given that China's real estate industry is entering a period of adjustment, and the significant audit responsibility omissions and risk warnings in PricewaterhouseCoopers' audit of China Evergrande Group this quarter have garnered widespread market attention, including some state-owned real estate companies among many that have defaulted on their debts, this has sounded an alarm for the bond industry to maintain objectivity towards external audits and rating agencies. Although China's bond rating system follows international mainstream standards, the majority of corporate bond ratings in China are somewhat "inflated". Over 95% of non-financial bonds in the market are confined to AAA, AA+, and AA ratings, with more than 50% of issued bonds rated AAA, which is a stark contrast to the approximately 1% proportion in the United States with equivalent ratings.

For domestic bond investors, the lack of more granular ratings and speculative bonds with low ratings and high yields reduces the attractiveness of the bond market. For international investors, the skewness of the current rating levels, leading to low investment guidance, also explains their low participation in China's bond market.

Therefore, both domestic Chinese rating companies, joint ventures, and recently approved foreign wholly-owned rating companies should fully engage in competition to provide more accurate and differentiated rating services for China's bond market, better guiding investors with information. In terms of regulation, it is also appropriate to relax the rigid requirements for the minimum rating of bonds at issuance and allow more issuers to have the authority to repurchase transactions, reducing the motivation for issuers to purchase ratings and subsequent "rating shopping."

Lastly, creating an active bond market in the context of Sino-American competition is inseparable from the innovation and enrichment of bond varieties, which is crucial for meeting the needs of different investors. Introducing new types of bonds that meet international standards, such as green bonds and social responsibility bonds (to support social welfare causes like education, healthcare, and poverty alleviation), or developing unique new bonds closely related to China's national conditions (e.g., "unicorn" company bonds, semiconductor innovation bonds, new energy R&D bonds, infrastructure bonds, bond ETFs, etc.), or upgrading the retail business of the bond market to facilitate individual investors to more intuitively and conveniently purchase and trade bond products through channels such as internet finance platforms and mobile applications are all good options.

At the same time, innovation in bond products cannot be separated from encouraging more issuers, such as local governments, state-owned enterprises, and private enterprises, to enter the bond market, developing more competitive bond products based on different issuer characteristics and financing needs, and it is very necessary to improve the yield curve.

Finally, innovation in bond varieties needs to be accompanied by an increased awareness of market risk management and broader avenues for risk mitigation. Actively introducing credit derivatives such as credit default swaps (CDS) can help investors hedge credit risks. Central banks also need to provide timely liquidity support to prevent market liquidity crises and ensure the sense of security for long-term investors in the bond market.

Global political polarization will gradually become more apparent and will continue for a considerable period in the future. In the Sino-American competition, the United States is attempting to sever the close connection between China's financial market and the outside world. The U.S. government may restrict or prohibit U.S. investors from investing in China's bond market, which could have a negative impact on market liquidity.

Faced with challenges, China's bond market bears a heavy responsibility and needs to strengthen itself, forming its own market characteristics and advantages to ensure China's important position in the international financial market.