Chapter

Chapter 12 Patterns of Trading in China’s Bond Market

Editor(s):
Alfred Schipke, Markus Rodlauer, and Longmei Zhang
Published Date:
March 2019
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Author(s)
Tobias Adrian, Henry Hoyle and Fabio M. Natalucci 

The authors are grateful to Li Yang for her excellent support on data issues.

Because of unusual structural features of China’s financial system, periods of tightening in monetary and funding conditions in China tend to be associated with declines in trading volumes in the bond market. This periodic deterioration in market depth represents an amplification mechanism that can potentially exacerbate adverse shocks, leading to procyclicality of trading and funding market conditions. Authorities have injected liquidity to limit this vulnerability and avoid a pernicious tightening cycle. Such liquidity injections help stabilize markets but reinforce the perception of implicit guarantees (see Chapter 13 on implicit guarantees). Improving bond market liquidity will help ease this trade-off and should be an important part of the agenda to tackle financial vulnerabilities. The increased presence of international investors in China’s bond markets is expected to improve market liquidity.

Low trading liquidity, as measured by the turnover ratio, is a well-known characteristic of the Chinese bond market.1 This chapter expands on this observation by documenting the considerable cyclicality of Chinese bond market liquidity, linking it to unique aspects of China’s financial system, in particular the prevalence of off-balance-sheet investment vehicles like bank wealth management products (IMF 2018a). The chapter also discusses associated financial stability risks (see also Chapter 10 on financial stability) and provides policy recommendations.

Liquidity and Funding Conditions in China’s Bond Market

Trading activity in China’s nearly RMB 80 trillion ($12 trillion) bond market, the world’s third largest, is quite volatile by international standards. Trading in Chinese government bonds and policy bank bonds (collectively known as “rates bonds”) and corporate bonds (“credit bonds”) fell sharply in mid-2013 and then again in late 2016.2 These episodes were associated with a sharp drop in bond prices (Figure 12.1).3 These declines in trading volumes have recently been partly offset by the rise in trading of short-term bank-issued debt instruments known as negotiable certificates of deposit (discussed later in the chapter). While many metrics of bond market liquidity indicate that conditions have improved in recent years, rapid shifts in trading volumes suggest that market liquidity is not as robust as some of these metrics may suggest.

Figure 12.1.Bond Market Trading Turnover and Bond Prices, 2011–18

(Trillions of renminbi; price index, Dec. 2011=100)

Sources: CEIC; ChinaBond; and authors’ calculations.

Note: Turnover is a 12-month moving average. Government bonds include policy bank–issued bonds.

In particular, sudden shifts in trading volumes may pose financial stability risks. Bond trading is closely linked to borrowing activity in China’s bond repurchase (repo) market, in which volumes are much higher and which is dominated by demand from investment vehicles and, to a lesser degree, smaller banks (Figure 12.2). As most borrowing in this market is at one- and seven-day maturities, this suggests that most bond transactions are financed with short-dated leverage. This means trading activity is exposed to maturity and liquidity transformation risks and may be sensitive to shifts in funding conditions. As explored later in this chapter, links between bond and repo market activity may result in a feedback loop and amplify shifts in broader financial conditions.

Figure 12.2.Interbank Bond Repo Market and Trading Turnover, 2013–18

(Trillions of renminbi)

Sources: Bloomberg L.P.; CEIC; and China Foreign Exchange Trade System.

Note: Data shown are from June 2013 through July 2018.

Shifts in Trading Volumes in an International Context

A comparison with other bond markets suggests that trading conditions in China are unusual in several respects. In particular, turnover is highly volatile and bond prices and trading volumes show a clear positive relationship.

Trading volumes in China shift much more rapidly and persistently than in other bond markets. The interquartile range of China’s monthly government bond trading volumes over the last five years is 80 percent of the average monthly volume during the same period. This is almost double the range of the next-closest emerging market bond market peer, and eight times the range of variation of trading volumes of the US Treasury market (Figure 12.3).

Figure 12.3.Government Bond Trading Volume: Five-Year Interquartile Range

(Percent)

Sources: Bloomberg L.P.; Brazil's Tesouro Nacional; CEIC; and Haver Analytics.

Note: Data shown are the five-year interquartile ranges of monthly government bond trading volumes (through June 2018, or latest), expressed as a percentage of the period average trading volumes.

Large shifts in trading activity in China’s bond market are also evident in turnover ratio terms. The turnover ratio in the Chinese government bond market is much lower than in the United States, and much more volatile (Figure 12.4).4 For example, the turnover ratio fell by over half around mid-2013 and the end of 2016 (Figure 12.4, panel 1). In the Chinese corporate bond market, the turnover ratio was notably elevated before the 2013 interbank liquidity shortage episode, but it has fallen sharply, reflecting both lower volumes and continued rapid growth in corporate debt outstanding (Figure 12.4, panel 2).5

Figure 12.4.Turnover Ratio, by Bond Type, China and the United States, 2012–18

( Percent)

Sources: CEIC; and Haver Analytics.

Note: The data show the monthly trading volume divided by the total stock outstanding.

Another unusual aspect is the positive (negative) relationship between trading volumes and bond prices (yields) overall. In China, bond trading volumes generally rise in sync with bond prices (as measured by bond price indices), particularly for corporate bonds, where the regression slope is steeper (Figures 12.5 and 12.6). By contrast, this price-volume relationship does not appear to be meaningful in the United States.

Figure 12.5.Government Bond Trading Volumes and Index Price, China and the United States

(Price index; trading volume in 100 millions of renminbi and billions of US dollars)

Sources: Bank of America Merrill Lynch; Bloomberg L.P.; CEIC; and ChinaBond.

Note: For China, price index and trading volume data include policy bank bonds, and trading volumes are 5-day averages. For the United States, government bond trading volumes are weekly averages of daily trading from July 14, 2010, through July 11, 2018.

Figure 12.6.Corporate Bond Trading Volumes and Index Price, China and the United States

(Price index; trading volume in 100 millions of renminbi and billions of US dollars)

Sources: Bloomberg L.P.; CEIC; ChinaBond; and Financial Industry Regulatory Authority.

Note: For China, data cover January 6, 2014, through July 25, 2018. For the United States, data cover December 28, 2011, through July 11, 2018.

One possible interpretation of this finding for China is that when bond yields rise, most market participants are unable or unwilling to purchase the higher-yielding bonds, perhaps because of funding or liquidity constraints. Another interpretation is that few market participants are willing to sell bonds at that level, perhaps to avoid recognizing a loss. Structural and institutional features of China’s bond market discussed in the next section suggest that both of these factors may play a role.

Market Structure Features

Several market structure features probably contribute to the documented large swings in trading. One is the prevalence of carry-trade-type activity, in which leverage is commonly used for long positions but is difficult to use for short posi-tions.6 Another is the lack of hedging by market participants, reflecting the scarcity of appropriate hedging instruments. A third and more general factor is related to the reliability of market pricing, reflecting the lack of centralized market making. As a result of all these factors, the Chinese bond market typically experiences one-way positioning during stable or declining interbank interest rates. However, when interbank interest rates tighten, or bond prices are more volatile, trading volumes tend to fall sharply (Figure 12.7).

Figure 12.7.Bond Turnover and Interbank Yields, 2011–18

(Percent; 60-day turnover)

Sources: WIND Economic Database (www.wind.com.cn); and authors’ calculations.

Note: The interbank yield is the 1-month Shanghai interbank offered rate (Shibor). Bond turnover is the 60-day sum of the daily bond turnover rate. Bond turnover and yield data are based on government and policy bank bonds.

Evidence of Speculative, Carry-Trade-Type Activity

Shifts in volume occur in part because much trading activity appears to reflect cycles of carry trades, where the most common form of leverage can be used to finance purchases of bonds. As noted, interbank trading volumes are tightly correlated with repo market volumes (Figure 12.2). This is unlikely to reflect market-making activity, as repo volumes are several times larger than spot transactions and most repo collateral is “pledged” and therefore cannot be reused for sale.7 In addition, given the “pledged” nature of most repo borrowing, only bond buyers can cheaply borrow cash to purchase more bonds. By contrast, sellers cannot easily borrow bonds to short.

Because most purchase transactions are financed with short-term borrowing, activity is sensitive to shifts in interest rates. Trading volumes tend to be lower when interbank interest rates are higher, and vice versa (Figure 12.8).8

Figure 12.8.Daily Average Trading Volume and Interbank Repo Rates, 2013–18

(Trillions of renminbi; percent)

Sources: Bloomberg L.P.; CEIC; and China Foreign Exchange Trade System.

Note: Data are monthly. Trading data exclude bonds with maturities of one year or less. Shibor = Shanghai interbank offered rate.

Recently, one factor contributing to weaker market trading for government and corporate bonds has been the increased trading of negotiable certificates of deposit. This is evident in the rapid shift in the maturity composition of trading activity away from bonds with maturities above one year (Figure 12.9). This development may reflect increased trading by money market funds, which have grown rapidly since 2015. It may also reflect the possibility that during periods of higher interest rates, leveraged bond buyers prefer the shorter duration and higher turnover of negotiable certificates of deposit, which expose their carry trade to less maturity and liquidity mismatch risk. As trading in negotiable certificates of deposit has grown to many multiples larger than trading in equivalent-maturity government instruments, this phenomenon may also be weakening price discovery at the short end of the risk-free yield curve.

Figure 12.9.Share of Interbank Trading of Bonds with Maturity above 1 Year, 2011–18

(Percent)

Source: CEIC.

Lack of Hedging by Market Participants

While the Chinese authorities have successfully established several liquid hedging markets, there are several important limitations to their effectiveness for market participants. The Chinese government bond futures market, discussed in detail in Chapter 8, lacked a short-tenor instrument until August 2018. It also does not allow participation by banks, which are the dominant players in the cash market, accounting for around 80 percent of Chinese government bond holdings and net purchases. The Chinese government bond futures market comprises primarily investment vehicles and other nonbanks, which mostly hold shorter-duration credit bonds.

The interest rate swap market also provides limited hedging benefits to bond investors. Most swap volume is at the 1-year tenor, while the bond market average maturity is around 2–3 years for credit bonds and 6 years for government bonds. Significant trading volumes in the interest rate swap market may be driven by flows hedging or speculating on the floating rate leg (either the 7-day repo rate or the Shanghai interbank offered rate [Shibor]), which are more volatile than in other major markets because of the ongoing quantity orientation of aspects of the People’s Bank of China’s monetary policy framework (see Chapter 14). In addition, because few financial assets or liabilities are explicitly tied to either the 7-day repo rate or Shibor, the interest rate swap market also lacks liquidity provided by firms or banks with nonspeculative hedging needs.

Bond repo agreements, credit default swaps (CDS), and other tools regularly used to hedge or short interest rate risk in other developed bond markets are available, but little used, in part because of regulatory uncertainty.9 As noted, the repo market, a key hedging tool for market makers in other markets, is mostly conducted on a “pledged” basis. As a result, cash lenders are precluded from selling the received bond collateral, a step necessary to create an effective short position. The size of the outright repo market, where such rehypothecation of collateral is possible, is comparatively small. Forward contracts, securities lending, and CDS contracts have all been launched but take-up has been low. One reason commonly cited by market participants is the lack of legal certainty around “close-out netting” in the bankruptcy regime and for bank regulatory purposes. This means that exposures between two counterparties cannot be recognized on a net basis but instead need to be accounted for on a gross basis, a restriction that limits a financial institution’s ability to use collateral to offset credit exposure and to reduce counterparty credit-related capital requirements.

Other Factors Contributing to Fluctuations in Trading

Banks and investment vehicles, the largest investors in the bond market, lack incentives to actively hedge because they often hold bonds to maturity and do not mark their holdings to market. Chinese commercial banks classify about 60 percent of bond investments as held-to-maturity (Figure 12.10), compared to less than 10 percent for most developed-economy banks. Bank wealth management products and other investment vehicles, the dominant investors in credit bonds and the second-largest investors in government bonds, do not publish net asset values.10 Evidence suggests that these vehicles meet redemption pressures largely via short-term collateralized borrowing, rather than asset sales in the open market. Investment vehicles appear to be among the least active traders of rates bonds as measured by total trading volumes relative to holdings in the interbank market (Figure 12.11; note that investment vehicles are represented under “Funds,” where they account for the majority of assets held).11

Figure 12.10.Bank Bond Holdings by Accounting Classification, 2011–17

(Percent of sample bank assets)

Sources: S&P Global Market Intelligence; and authors’ calculations.

Note: Based on annual report data for a sample of 61 Chinese commercial banks with RMB 165 trillion in assets as of the end of 2017 (84 percent of total commercial bank assets).

Figure 12.11.Monthly Turnover Ratio by Market Participant Type: 2016 and 12 Months through August 2018

(Multiple)

Sources: CEIC; and China Central Depository and Clearing Co., Ltd.

Note: Data shown are averages of each market participant type’s monthly trading volume divided by month-end bond assets. Data are based on China Central Depository and Clearing Co.–registered bond holdings and trading activity. “Funds” includes investment vehicles. Trailing 12-month average is from September 2017 through August 2018.

Reflecting drawbacks in available hedging markets, China’s bond market also lacks the centralized market-making structure common in other advanced markets, where broker-dealers linked by an interdealer market dominate trading activity. Securities companies account for only 24 percent of bond trading, compared to broker-dealers’ 62 percent share of trading in the United States (Figure 12.12). The robust interdealer market provides important benefits to secondary-market liquidity and continuous pricing by providing incentives for dealers to give quotes that accurately reflect broader market pricing (Viswanathan and WANG 2004).

Figure 12.12.Bond Trading by Firm Type, United States and China, 2017

(Percent)

Sources: CEIC; China Central Depository and Clearing Co., Ltd; and Haver Analytics.

Note: Data shown are the 2017 average and are calculated counting both counterparties to every trade. For China, the data are based on trades registered with the China Central Depository and Clearing Co. For the United States, the data are based on the Federal Reserve’s FR2004 primary dealer data series.

Price discovery is also weakened by the lack of a deep, liquid benchmark yield curve. In part reflecting the dominant position of banks in the Chinese government bond market, other de facto alternative risk-free yield curves are more widely used. Policy bank bond trading volumes are three times higher than those of Chinese government bonds, have tighter bid-ask spreads, and are traded by a wider array of market participants. At shorter tenors, bank-issued negotiable certificates of deposit are traded three to four times more than all other short-tenor instruments combined, and those issued by large national banks are seen as effectively risk-free because of perceived implicit guarantees.12 This lack of a single, strong benchmark yield curve makes it difficult for market participants to accurately value bonds or hedge their portfolio risks using existing hedging instruments. It also impedes the transmission of monetary policy, because risk-free yields are often heavily influenced by issuance of negotiable certificates of deposit or other factors that affect interbank liquidity conditions.

Financial Stability Implications

Episodes of deteriorating bond trading volumes and market liquidity may pose financial stability risks. In particular, the tendency for both trading and funding conditions to weaken at the same time implies that, in times of stress, market participants facing funding pressures could experience difficulties accessing liquidity when they need it most. This poses the risk of a procyclical deterioration of both trading and funding liquidity that could lead to defaults.

This link between market and funding liquidity is unique in China’s case. Investment vehicles and other market participants tend to rely on interbank borrowing to meet liquidity shortfalls, which is often made possible by implicit guarantees from sponsoring financial groups. This prevents the need to sell bonds as markets become increasingly illiquid, but can result in rising debt and upward pressure on borrowing rates. This creates a negative feedback loop by further reducing rate-sensitive trading. This practice is reflected in the large imbalance between short-term borrowing and trading. At around RMB 9 trillion, the stock of short-term borrowing was about 20 times larger than average daily trading volume in 2017 (Figure 12.13). That is nearly triple the peak ratio of 7 times reached in the US repo market in September 2008.

Figure 12.13.Daily Average Trading Turnover and Total Repurchase Market Borrowing, 2010–18

(Trillions of renminbi)

Sources: CEIC; WIND Economic Database (www.wind.com.cn); and authors’ calculations.

Reduced trading liquidity appears to exacerbate funding market conditions because it is associated with rising demand for longer-dated repo debt (Figure 12.14). When trading declines, the weighted average maturity of daily repo borrowing tends to increase from around two days to three to four days. This may be because borrowers expect it will take longer to sell or source stable funding for their existing positions funded with repos. As a result, the stock of total short-term debt tends to rise as trading declines (Figure 12.15).

Figure 12.14.Bond Market Turnover and Repo Borrowing Maturities, December 2014 through July 2018

(Days; percentage points)

Sources: CEIC; WIND Economic Database (www.wind.com.cn); and authors’ calculations.

Note: Data are 5-day averages. WAM = weighted average maturity.

Figure 12.15.Bond Market Turnover and Repo Debt Growth, December 2014 through July 2018

(Percent; percentage points)

Sources: Bloomberg L.P.; and China Foreign Exchange Trade System.

Note: Data are 5-day averages.

The link between trading and funding may also reflect the imbalance between the stock of borrowing and daily trading, which may limit the market’s flexibility to absorb further increases in demand for liquidity. This imbalance means the majority of repo borrowing maturing each day must either be rolled over or financed through other instruments like deposits. When trading volumes decline, a larger share of maturing borrowing must be rolled over or repaid with deposits, increasing the strain on available liquidity. As shown in Figure 12.16, money market rates tend to reflect the ratio of repos outstanding to average daily trading values.

Figure 12.16.Interbank Interest Rate and Ratio of Repo Borrowing to Daily Spot Average Trading, June 2013 through June 2018

(Percent; times)

Sources: CEIC; WIND Economic Database (www.wind.com.cn); and authors’ calculations.

The procyclical link between trading and funding presents two interrelated risks. The first is that deteriorating funding conditions could trigger interbank defaults, causing instability as market participants simultaneously attempt to reduce counterparty exposure. The second is that an investment vehicle facing financing pressures attempts to sell largely illiquid corporate bonds into a thinning market. This could create a different but similarly destabilizing feedback loop between declining bond (collateral) values, weakening balance sheets, and interbank funding conditions.13

This procyclical link between bond trading and financial conditions rep-resents a significant vulnerability in China’s financial markets and highlights the continuing importance of implicit guarantees. In practice, authorities have injected liquidity to stabilize interbank liquidity costs, in part reflecting efforts to transition monetary policy toward an interest-rate-targeting framework. This arrangement has prevented instability related to procyclical deteriorations in funding conditions. But it has come at the cost of reinforcing moral hazard and increasing borrowing, exacerbating the original imbalance between debt and trading liquidity.

Policy Recommendations

To address financial vulnerabilities, including implicit guarantees, and enhance the transmission channel of monetary policy, Chinese policymakers should make improving bond market liquidity a priority. Policy measures should be aimed at increasing the availability of competitively priced market-making services as well as at diversifying the investor base in order to foster demand for such services. Key supply-side priorities include strengthening market making and market structure, including by deepening derivative and securities financing markets. Demand-side efforts should revolve around measures to broaden the set of market price–sensitive investors, including foreign investors.14

Policies to Strengthen Trading Liquidity Supply: Market Making and Market Structure

The first set of policies to boost the resilience of liquidity should be focused on strengthening hedging tools and market structure to improve the supply of continuous, competitively priced trading liquidity. Robust fixed income derivative and securities financing markets have well known and important benefits for bond market trading liquidity.15 Securities financing markets, primarily outright repo markets,16 help facilitate more efficient market making by helping finance bond inventories and source specific bonds more cheaply. Derivatives markets, such as bond futures and interest rate swaps markets, help market makers offset interest rate and credit risk, and help encourage more balanced, two-way market positioning. Conversely, market making in derivatives creates hedging needs in the underlying bond that require more trading in secondary markets. The use of derivatives and securities financing also facilitates arbitrage and spread-trading strategies that improve market price discovery and reduce price irregularities. Greater use of these instruments will, however, increase the need for more sophisticated risk and liquidity management.17

Key policy priorities in this area would include giving banks access to Chinese government bond futures, encouraging the development of the outright repo market, and reducing market fragmentation.

  • Widen investor access to the Chinese government bond futures market: The Chinese government bond market would benefit from providing commercial banks—which are the asset’s dominant investor and cash market trader—access to the Chinese government bond futures market. Small and medium-sized banks in particular are already highly active in trading (see Figure 12.11), despite classifying most bonds as held-to-maturity, and have growing incentives to manage bond risk because of updated International Financial Reporting Standards. Foreign banks and investors should also be granted access to serve as an incentive for their participation in the market and diversify sources of liquidity provision.

  • Develop the outright repo market: To facilitate the development of an outright repo and CDS market, authorities need to further strengthen creditor rights and clear up areas of regulatory uncertainty. Key steps include explicitly protecting the right to liquidate collateral in the event of counterparty default and removing remaining legal and regulatory hurdles to the use of close-out netting. These measures are needed to allow financial institutions to use their securities collateral or purchased credit protection (for example, in the CDS market) to offset counterparty credit and liquidity risk exposures, which are critical to making these trades sufficiently economical.18

  • Centralize market making to boost price discovery: To improve price discovery and market efficiency, authorities should seek to facilitate more trading between market makers. This could be accomplished by encouraging greater market infrastructure dedicated to an active interdealer market, strengthening market-making obligations at official primary dealers, and reducing impediments to trading across market venues. These measures should be an important component of efforts to unify bond market regulation and reduce the fragmentation of liquidity, issuance, and investor access between different trading venues.

  • Strengthen benchmark rates and the yield curve. Authorities should also seek to minimize and stabilize the discrepancies across various de facto risk-free yield curves. This effort would entail equalizing investor access and regulatory incentives for participation in all bond types and venues, for instance, by harmonizing the tax rates that commercial banks pay on Chinese government bond and policy bank bond coupon income, which currently favor their holdings of Chinese government bonds. A more unified and deeply traded risk-free yield curve will also help strengthen authorities’ influence over borrowing and saving decisions in the real economy, boosting monetary policy transmission.

Other important liquidity supply-side policy priorities should include further development of the interest rate swap and CDS markets.

  • Strengthen the interest rate swap market: Authorities should encourage market participants to concentrate trading in a handful of key benchmark tenors along the Chinese government bond yield curve and in a small set of floating-rate products that are acceptable to banks and corporations for use in pricing loans and other financial products (eliminating superfluous swaps linked to the loan prime rate, benchmark policy lending, deposit rates, and so on). Further progress in transitioning toward an interest-rate-targeting monetary policy framework will also be important to minimize volatility in the floating rate leg of the swap.

  • Develop a CDS market: Bring CDS closer into alignment with international practice by reducing remaining regulatory uncertainty about documentation and creditor rights, so that purchased credit protection can factor into risk management (see above). Developing a deeper CDS market will improve the management of credit risk in repo and support credit bond market making.

Policies to Strengthen Demand for Liquidity

Policy priorities to strengthen investor demand for trading liquidity should focus on diversifying the investor base and increasing incentives to mark securities to market, where appropriate. Key measures include encouraging greater participation by foreign and long-term investors, such as insurers and pension funds, and amending asset management rules to more strictly limit exceptions to the use of net asset value accounting for investment products.19

  • Increase foreign investor and foreign broker-dealer activity: Several technical hurdles continue to impede foreign participation in China’s bond market, as detailed in Chapter 11 on clearing roadblocks to foreign participation. Foreign investors will add diversity to the investment strategies and time horizons of the investor base, and will increase demand for hedging products. Foreign broker-dealers will bring greater sophistication to market making and trading that can help improve the competitiveness of market-making services.20

  • Increase the diversity of local market buy-side participants: Pension funds, insurance companies, mutual funds, hedge funds, and other investors similarly add to the diversity of investment strategies and risk mandates operating in the market, which may lessen the risks of one-way positioning in the market during periods of speculation-driven flows. One way to support greater bond market participation by these entities is to make investment products less appealing by reducing their perceived implicit guarantees and other advantages over directly holding bonds. Currently, these products offer institutional investors more favorable yields, less credit risk, and less accounting volatility than a typical bond portfolio (see below).

  • Require greater use of mark-to-market accounting for investment products: The new regulatory regime for asset management products should gradually eliminate use of amortized cost valuation for asset management products, such as wealth management products and money market funds, except in very limited circumstances. This is important in increasing competition among fund managers to actively manage bond portfolios and maximize returns given risk, which should increase secondary-market trading. The lack of accurate, transparent valuations is an important factor allowing investment products to offer low-risk, high-yielding products with shorter maturities, which crowds out demand for direct exposure to the bond market.

  • Further increase the price orientation of the financial system: Phasing out the use of growth targets for banks and local governments and increasing the price orientation of monetary policy will stabilize short-term market interest rates. This will help avoid fluctuations in trading activity caused by uncertainty around valuations and term premiums. Removing commercial banks’ de facto restrictions on deposit pricing will also help them price their bids for government bond holdings more competitively.

Conclusions

Trading in China’s bond market tends to fluctuate in sync with market repo rates and bond market cycles. This likely reflects several institutional and structural features of the Chinese bond market, including the prevalence of carry-trade-type activity among the investor base, comparatively low hedging activity, and challenges around price discovery and valuation.

These fluctuations in liquidity could pose financial stability risks because they tend to lead to simultaneous deterioration in funding market conditions. Moreover, they require authorities and market participants to inject liquidity to avert a pernicious deleveraging cycle, which undermines market discipline. Improving bond market liquidity should thus be an important part of broader efforts to reduce financial vulnerabilities in China.

Reducing barriers to widespread use of derivatives and rehypothecation may bring increased risks and complexity, as demonstrated by their misuse in bond markets in developed countries in the lead-up to the global financial crisis. Yet these risks can be managed by regulation, as they were in many countries during the crisis, and as they are now in countries where such risks played a key role in the crash.

References

    BrunnermeierM. K. andL. H.Pedersen. 2007. “Market Liquidity and Funding Liquidity.” Review of Financial Studies22 (6): 220138.

    Committee on the Global Financial System (CGFS). 1999. “Recommendations for the Design of Liquid Markets.” CGFS Paper No. 13Basel.

    Committee on the Global Financial System (CGFS). 2014. “Market-Making and Proprietary Trading: Industry Trends, Drivers, and Policy Implications.” CGFS Paper No. 52Basel.

    FontaineJ.C.Garriott andK.Gray. 2016. “Securities Financing and Bond Market Liquidity.” Bank of Canada. Financial System Review (June): 3945.

    International Monetary Fund (IMF). 2013. “Local Currency Bond Markets: A New Diagnostic Framework.” IMF Policy PaperWashington, DC.

    International Monetary Fund (IMF). 2018a. Global Financial Stability Report: A Bumpy Road Ahead. Washington, DCApril.

    International Monetary Fund (IMF). 2018b. “Recent Developments on Local Currency Bond Markets in Emerging Economies.” Staff Note for the G20 International Financial Architecture Working Group (IFAWG)Washington, DC.

    ViswanathanS. andJ. J.D.WANG. 2004. “Inter-Dealer Trading in Financial Markets.” Journal of Business77 (4): 9871040.

Turnover ratio is defined as the ratio of trading volume to total bonds outstanding.

Rates bonds account for roughly one-third of Chinese bond market debt outstanding, and largely trade in the over-the-counter interbank market—which, despite its name, is open to most nonbank financial institutions. Credit bonds account for another third of bond market debt outstanding and include mainly medium-term notes, corporate bonds, and enterprise bonds, and trade in both the interbank and exchange-listed markets. The other third of the bond market in stock terms comprises local government bonds, which are traded in negligible amounts, and issuance by financial institutions, including short-term bank instruments, such as negotiable certificates of deposit.

These time periods were two notable periods of bond market stress: the widely reported interbank repo market crunch of June 2013 and the Sealand Securities fraud in December 2016.

The falling turnover ratio in US government bonds mostly reflects rising stock; trading volumes reported by primary dealers have remained relatively stable through this period on a trend basis, although market observers note this probably does not capture rising trading conducted by high-frequency market makers.

The low turnover ratio in the Chinese government bond market is less unusual compared to many other smaller emerging market local currency government bond markets; however, it is among the lowest when considering bonds issued only by the central government.

A carry trade is a strategy in which an investor borrows money at a low interest rate (typically at a short maturity) to finance a purchase of an asset that is expected to provide a higher return. A long position means an investor owns an asset (or the right or obligation to purchase an asset at a certain price), and gains from an increase in its value. A short position means an investor owes an asset to a third party (or has the right or obligation to sell an asset at a certain price), and gains from a decrease in its value.

The correlation holds when excluding bond purchases and repo borrowing volumes by securities firms, which also suggests the relationship is not due to market-making activity.

Notably, this relationship is stronger for bonds with a maturity of less than one year (R2 equals 0.71, shown) than for all bond trading (R2 equals 0.45, not shown). Trading in bank-issued negotiable certificates of deposit, which make up the bulk of trading for bonds with maturities less than one year, is positively correlated with interbank rates (R2 equals 0.28).

CDS were introduced in October 2016 by the National Association of Financial Market Institutional Investors (NAFMII), an industry group affiliated with the People’s Bank of China, along with another tool called credit-linked notes. Together with the credit risk mitigation agreement and credit risk mitigation warrant (both introduced in 2010), they form the credit risk hedging tools in the Chinese bond market. Bond repos were introduced in the early 1990s. Government bond futures were suspended in 1995 and reintroduced in 2013.

For more on investment vehicles and their bond market holdings, see IMF (2018a).

This assessment is based on the portion of the interbank market registered with the China Central Clearing and Depository Corporation, which includes all trading of government and policy bank bonds.

Adding to the problem, there are alternative Chinese government bond and policy bank curves on the exchanges.

This second risk resembles the “liquidity spiral” dynamic identified by Brunnermeier and Pedersen (2007). In that case, fre sales of bonds would lead to large price declines, which weaken funding liquidity by affecting balance sheets (via a “loss spiral”) and increasing collateral margins (a “margin spiral”). The first risk would be consistent with continued falls in trading activity and minimal declines in bond prices, which is what occurred initially in the June 2013 interbank liquidity crunch episode.

For further details on IMF and other international financial institutions’ recommendations on local currency bond market development, please see IMF (2013). For a summary of international financial institutions’ recent technical assistance programs on local currency bond market development, please see IMF (2018b).

Outright repo refers to a transaction where the exchange of collateral is an outright sale, rather than a pledge, which enables sale or relending of the collateral security.

These activities may increase financial market complexity but overall risks are manageable within the postcrisis capital and liquidity regulatory framework.

The recently announced triparty repo scheme may be helpful for development of an outright repo market if it increases securities borrowers’ reuse of collateral.

Net asset value accounting is a method for determining the value of an investment fund attributable to equity holders (that is, holders of fund shares). It is calculated by the total value of the fund’s asset portfolio less its accrued liabilities.

Given low foreign participation and the large absolute size of China’s bond market, at this time the marginal benefits to market deepening would likely outweigh any (small) risk of increased volatility or external spillovers.

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