China - The emerging Asian bond market

CIHII[ NA  The International Bank for Reconstruction and Development/THE WORLD BANK 1818H Street, N.W. Washington, D.C. 20433, U.S.A. All rights reserved Manufactured in the United States of America First printing June 1995 Design by Patricia Hord.Graphik Design The findings, interpretations, and conclusions expressed in this paper are entirely those of the author(s) and should not be attributed in any manner to the World Bank, to its affiliated organizations, or to members of its Board of Executive Directors or the countries they represent. The World Bank does not guarantee the accuracy of the data included in this publication and accepts no responsibility whatsoever for any consequence of their use. Any maps that accompany the text have been prepared solely for the convenience of readers; the designations and presenta- tion of material in them do not imply the expression of any opinion whatsoever on the part of the World Bank, its affiliates, or its Board or member countries concerning the legal status of any country, territory, city, or area or of the authorities thereof or concerning the delimitation of its boundaries or its national affiliation.  FOREWORD The World Bank Group has been engaged in financial market studies in many East Asian countries as an integral part of its ongoing operations. Most East Asian countries now have well developed banking systems and robust equity markets. However, the East Asian bond markets are relatively small but growing rapidly. Future efforts, therefore, is likely to shift to development of capital market especially bond markets. To facilitate the process, the Bank, in consultation with its member countries and market participants, has undertaken a comprehensive study of the East Asian bond markets. The study was carried out by a Bank team in collaboration with counterparts in mem- ber countries. The main report The Emerging Asian Bond Market provides a cross-country analysis and highlights the successful policies and good practices in these bond markets. The report has greatly benefited from the eight country stud- ies-China, Hong Kong, Indonesia, Korea, Malaysia, the Philippines, Singapore, and Thailand. The report con- cludes that with the right policy measures and further strengthening of the supporting institutional infrastructure, the East Asian bond markets will grow rapidly over the next decade. This will help facilitate financing of infra- structure investment, enable market participants to better manage their risks, and provide long-term investment vehicles for institutional investors in the region. This background paper has been prepared by local market practitioners. It is hoped that this report, together with The Emerging Asian Bond Market would stimulate further discussion among policy makers, regulators, and market participants in shaping an agenda for bond market development in each of these economies. &- Ishrat Husain Chief Economist East Asia and Pacific Region   ACKNOWLEDGMENTS This report on China's bond market has been prepared as one of nine background papers for the Emerging Asian Bond Market study. The Emerging Asian Bond market study team was led by Ismail Dalla (Principal Financial Specialist) and included D.C. Rao, Deena Khatkhate, Kali Kondury, Kwang Jun, and Terry Chuppe. This report was prepared by Anjali Kumar (task manager, EAZCO) and David Wilton (FSD) (authors), with contri- butions from Kwang Jun (IEC), and Susan Selwyn (consultant). The authors would like to express their apprecia- tion to the Securities Exchange Executive Council, China Securities Regulatory Commission, Government Debt and International Departments of the Ministry of Finance for their close cooperation and assistance. 'The Emerging Asian Bond market team would like to express its gratitude to Mr. Gautam Kaji, Managing Director, for invaluable guidance and continued support; Mr. Russell Cheetham, Regional Vice President, for full support; Vinod Thomas and Ishrat Husain successive Chief Economists in EAP for getting the study off the ground and for bringing it to a successful completion; Callisto Madavo, Pamela Cox, William McCleary, Vineet Nayyar, and Khalid Siraj for providing the guidance and resources to carry out this regional study from the EA1 Department. Ismail Dalla Task Manager, Emerging Asian Bond Market Study.   T A B L E O F C O N T E N T S SUMMARY AND RECOMMENDATIONS I THE ROLE OF BOND MARKETS IN CHJNA'S ECONOMY I1 THE DOMESTIC PRIMARY BOND MARKET I11 SECONDARY MARKETS IN DEBT SECURITIES IV PARTICIPATION IN INTERNATIONAL BOND MARKETS V THE REGULATORY FRAMEWORK APPENDIX ENDNOTES REFERENCES  Tables inText 2.1 Government Debt Purchases: Households and Non-Households 2.2 Treasury Bill Coupon Rate, Deposit Rates and Inflation 2.3 Comparison of Coupon and Deposit Rates, and Secondary Market Yield 2.4 Comparison of Coupon on Treasury Bills Sales by Purchaser: Households, Enterprises, and Financial Institutions 2.5 Tradability of 1994 Treasury Bill Issues 3.1 China: Spot and Futures Trading of Bonds 3.2 Ratio of Bond Trading Value to Stock Outstanding 3.3 Trading in Repurchase Agreements 4.1 Average Spread on Floating Rate Medium and Long-Term Bond Issues Figures inText 1.1 Securities Markets in China's Financial Sector 2 1.2 Central Government Budgetary Deficit and Treasury Bond Issues 3 1.3 Contribution of Bond Markets to Real Sector 4 1.4 Share of Bonds in China's Overseas Borrowing 4 2.1 Growth of Securities Issued and Outstanding (1981-1993) 6 2.2 Outstanding Debt Composition Disaggregated 8 3.1 Secondary Markets in China's Securities 17 3.2 China: Trading Value of Bonds 18 3.3 Ratios of Trading Volume of Debt to Debt Stock and to GDP 19 3.4 Ratios of Debt Stock Outstanding to GDP: China and Other Countries 2 0 3.5 Regional Bond Yield Differentials (1990) 2 2 3.6 Yield Differentials between Treasury Bills on Principal Markets: 1994 2 3 (Shanghai, Wuhan and Shenzhen) 3.7 China: Secondary Market Yield Curve 2 3 3.8 China: Bond Yield, Deposit Rate and Inflation 2 4 3.9 China: Equity Index and Average Bond Yield 2 4 4.1 China and Other Emerging Markets: Participation in 2 6 International Capital Flows 4.2 International Bond Issues by Chinese Borrowers: Currency, Type and Maturity 27 4.3 China: International Syndicated Loans 2 9 4.4 China: Maturities and Spreads on International Syndicated Loans 30 AppendixTables Al.1 China: Securities Markets and the Financial Sector A1.2 Financing of the Government Deficit: Contribution of Bond Issues A1.3 China: Contribution of Bond Issues to Investment A1.4 China: Overseas Debt and Portfolio Capital Inflows(1987-1993) A2.1 China: Debt Securities Issued and Outstanding B2.1 Bond Yield Calculations: Current Yield and Yield to Maturity A3.1 China: Trade in Securities A3.2 China: Securities Trading on the Shanghai Exchange in 1994 (January 1994 to January 1995) A3.3 China: Securities Trading by Region A3.4 Monthly Transaction Volume in the Interbank Market A3.5 Assets of Financial Institutions Engaged in the Interbank Market A4.1 Sovereign Rating-Selected Developing Countries A4.2 Credit Ratings of Chinese Borrowers A4.3 China: Overseas Bond Issuing Institutions (1985-94) A5.1 China: Structure of Securities Regulation  CURRENCY EQUIVALENT (Y/US$) Year-end 1994 8.45 Year-end 1991 5.43 Average 1994 8.62 Average 1991 5.32 Year-end 1993 5.80 Year-end 1990 5.22 Average 1993 5.76 Average 1990 4.78 Year-end 1992 5.75 Year-end 1989 4.72 Average 1992 5.51 Average 1989 3.77 LIST OF ABBREVIATIONS ABC Agricultural Bank of China OTC Over-the-counter BOC Bank of China PBC People's Bank of China BOCOM Bank of Communications PCBC People's Construction Bank of China CD Certificate of Deposit PDB Pudong Development Bank CIB China Investment Bank SAEC State Administration for Exchange Control CITIC China International Trust and Investment SCRES State Commission for Restructuring the Corporation Economic System (abbrev. SRC) CSRC China Security Regulatory Commission SCSC State Council Securities Policy Committee CSTS China Securities Trading System Corporation Ltd SDBC State Development Bank of China FDI Foreign Direct Investment SEEC Securities Exchange Executive Council GDP Gross Domestic Product SETC State Economic and Trade Corporation GITIC Guangdong Industrial Trust and Investment SEZs Special Economic Zones Corporation SFC Securities and Futures Commission (Hongkong) GNP Gross National Product SHSE Shanghai Securities Exchange ICBC Industrial and Commercial Bank of China SITICO Shanghai International Trust and Investment IF1 International Financial Institutions Corporation IMF International Monetary Fund SOEs State-Owned Enterprises ITIC Investment and Trust Corporation s o u s State Owned Units ITS Intermarket Trading System SPC State Planning Commission MICEX Moscow Interbank Currency Exchange STAQS Securities Trading Automated Quotations System MOF Ministry of Finance SZSE Shenzhen Stock Exchange MOFTEC Ministry of Foreign Trade and Economic T BILL Treasury Bill Relations T BOND Treasury Bond MOU Memorandum of Understanding TICS Trust and Investment Corporations NETS National Electronic Trading System UCC Urban Credit Cooperative NBFI Nonbank Financial Institution YTM Yield to Maturity   S U M M A R Y A N D R E C O M M E N D A T I O N S A first broad observation is that China's bond market China has been cautious and experimental. The prob- today is a market in transition, and is confronting criti- lem with this approach is that eventually its internal cal conflicts between the requirements of efficiently contradictions will distort capital market development functioning capital markets, and features inherited from the former planning system; (i) the Credit Plan, These problems today affect the primary markets far (ii) administratively determined interest rates, and (iii) more acutely than secondary markets. The closer one the absence of market pricing of risk. Bond issuance is gets to primary markets, the more apparent are the con- still essentially regarded as an alternative revenue flicts due to controls imposed under the remnants of the mobilizing system, and an extension of the budgetary former system. And reform in primary markets will be process, in terms of financing options under the Credit difficult without parallel reforms in other basic features Plan. Coupon rates are set with regard to the adminis- of China's transitional economy. The primary process of tratively determined deposit rate and do not reflect sec- bond issue in China still retains many features which ondary market yields. Since the default risk of enter- arose from its historic origins as an obligatory tax mech- prises is still relatively low, bond pricing has not ade- anism. In particular, the continued reliance on admin- quately reflected risk differentials. Corporate bond istered or quasi-administered placement, the lack of coupon rate ceilings are determined by the government effective competition between underwriters, the large with reference to deposit rates and government coupon and infrequent nature of government bill issues, instead rates. The government is in a position to also change the of issues based on a preannounced year-round sched- relative rates of return on different securities, for exam- ule, the targeting of the retail investor base rather than ple by boosting returns to equity through announcement recognizing and differentiating between wholesale and effects, if it is felt that the equity market is in need of retail investors, the system of coupon determination, support, or by raising coupon rates on bonds, when based on deposit rates rather than market yields, the large new government securities issues are due to be lack of coupon payments and the method of determina- made. In these circumstances, the link between bond tion of redemption amounts, are issues to be addressed market activity and underlying real sector develop- to improve the efficiency of the primary issue process. ments, in terms of raising or pricing capital, is con- strained, and the bond market cannot act as an efficient In terms of the development of secondary markets, allocation mechanism for capital, or pricing mechanism China has made considerable progress since 1990. for risk. Transactions on the exchanges of Shanghai and Shenzhen, and even some of the larger regional bond Many of the market's features are contradictory: a sec- trading centers, are sophisticated, with screen-based, ondary market in bonds using relatively sophisticated satellite-linked trading systems, continuous order trading technology, futures contracts and repurchase matching and the capacity for T+O settlement. The agreements coexists with interest rate regulation in the form of the markets is advanced, compared to other primary market and the money market; a system of developing countries and even relative to the standards underwriters and primary dealers has been established, of advanced economies. Yet, the market needs to but these entities continue to use a retail distribution increase its liquidity and to achieve greater price unity. system that was originally used for forced placements of Key factors in improving market liquidity are the pri- bonds. The approach to capital market development in mary issue design features referred to above. In addi-  tion, present constraints on the operation of the money of coupon rates on government issues. Coupon rates on market need to be addressed, to ~rovidefunding for government securities have been set with reference to, bond portfolios and a reliable short-term yield bench- and at a relative premium to, deposit rates of compara- mark. Greater price unity across different regions today ble maturities, rather than with reference to secondary requires the creation of a centralized depository (or market yields. Illiquid secondary markets compound existing depositories will be required to agree on a com- the difficulty of pricing at market rates. mon set of operating standards). The difficulty with this strategy is that it could prove Today the role of the bond market in China's economy very expensive in the long run, as the stock of out- is relatively small, despite recent rapid growth. The slanding debt cumulates. For example, secondary mar- share of outstanding fixed income securities in 1993 ket yields are shown to have been low in the latter half was less than 10 percent of GDP; assets and liabilities of 1994 (around 8 percent), but the government had of securities traders are estimated to be at most 6 per- issued its new debt for the year in the first half of 1994, cent of the financial sector's total assets / liabilities, at rates varying between 10 and 14 percent. The impli- and contributions to real investment have been at most cation is that the government may be adopting an undu- 20 percent (and more likely closer to 10 percent) of ly expensive financing strategy. With increased reliance investment financing. Controls on the growth of China's on government debt issues to finance the deficit due to securities markets under the Credit Plan imply that the restrictions imposed since 1994 on treasury borrowing extent to which they are able to support the investment from the central bank, the problem will become more requirements of the real sector is also predicated upon important over time. A fortiori, should the invisible the limits imposed under the Credit Plan. As such, (quasi-fiscal) deficit currently covered through PBC whether China's capital markets will lend support to the lending to the financial system be transferred to the vis- financing of infrastructure investment, or to the raising ible budget, costs of government borrowing will be an of equity capital for enterprises, depends today on increasingly serious issue. whether these investments are approved under the credit plan, and whether capital markets are the chosen The limited participation of wholesale and institutional vehicle for the financing of these investments. In the purchasers of securities refers not only to the limited case of bonds, the problems of illiquidity of the bond development of contractual savings institutions, but market additionally make investors reluctant to hold also, to the limited (voluntary) participation by large instruments of long maturity, and this effect is rom- financial institutions such as banks in the wholesale pounded by the relatively high levels of inflation China market for government securities. The causes lie deep has experienced in recent years. in the evolution of the financial system. Insurance was banned at the outset of reform in 1979, and until the The contribution of the bond market to the financing of present, remains limited, although its accumulations the government's deficit, and its potential aid to macro- are growing faster today than pension funds or social economic management is not being realized to the security systems, which have suffered primarily from extent desirable. Yet, this role is growing rapidly, espe- largely unfunded pension schemes. The growth of sig- cially with the decision to cease to finance the govern- nificant funds here for investments in securities could ment deficit through recourse to central bank borrow- take time. Meanwhile, participation in wholesale secu- ing. Treasury bond new issues alone increased threefold rities markets by financial institutions has only recent- in a single year from 1993 to 1994. As a result, the ly begun to develop because of their limited active liq- importance of a well-functioning bond market in China uidity management; itself partly the outcome of restric- has grown sharply. The government's strategy of target- tive regulations, branch-level liquidity management ing of retail investors for bond issues and use of admin- and difficulties in intra-bank transactions. Neither has istrative placement techniques when voluntary pur- the design of securities issues by the government, with chase is not forthcoming, has its limitations, which are typically limited transferability and administrative growing increasingly obvious. The government realized placement, facilitated the participation by financial these limitations after the mid 1980s, when it was institutions. obliged to shorten maturities and permit the develop- ment of secondary markets, to prevent the illicit sales of To reduce speculative tendencies, the volume and qual- bonds at heavy discounts. Another solution, sought ity of information in the market needs to be increased. more recently by the government, has been the raising This applies particularly to enterprise and financial  bonds. This entails the improvement of disclosure strategy for the Chinese authorities to pursue. requirements and the standardization of listing require- Finally, bond markets need an appropriate environment ments. Another element of this concerns improved in terms of a regulatory framework. The proposed new standards for credit rating agencies, and the develop- government Bond Law, to be issued in 1995, and the ment of a class of informed institutional investors. recently issued regulations on futures trading in bonds are welcome steps in this direction. Two major issues The regional participation of China's provinces in the concerning the regulation of China's bond markets are emerging securities market is still limited. The region- raised here. The first concerns the extensive role of the al primary market for bonds, like equities, is driven by government in the operation of the markets. First of all, a combination of quotas (for corporate bond issues) and access to the bond market in China is restricted in sev- administrative placement (for government securities). eral ways. (i) The State Council, through the SPC, reg- In terms of secondary markets, integration in the bond ulates the volume of securities issued and their terms, markets has been facilitated by the growth of the auto- by setting annual limits on the amount of bond (and mated electronic quotation systems; STAQSand NETS, share) issues, and the maximum interest that can be which have greatly helped reduce regional price differ- paid on corporate bonds. (ii) Access to overseas issues entials. However the national integration of the debt or listings of bonds by individual enterprises is also market is impeded by the multiple independent depos- defacto restricted, to one of the approved banks or itories, and the lack of mutual recognition of bond cer- major TICS. (iii) The local government of the province tificates issued by different centers. Market segmenta- in which a company is located must approve companies tion by investor type, which is a major problem in equi- for public offering of bonds (or equities), and addition- ties markets, has been greatly reduced in debt securi- ally, local SPC approval is also required for bond ties (where formerly the coupons payable to individual issues. and enterprise investors differed for the same security), although segmentation by wholesale and retail investors A second key area of concern in the regulatory structure (in favor of the latter) persists. for bond markets in China today is the fragmentation of oversight, both functionally, for different segments of China today is not vulnerable to a destabilizing domes- the securities markets, (and for different parts of the tic backlash, if flows of portfolio investment to China market for each security, ie, primary and secondary were to be sustained. Indeed, China needs to achieve a markets), and regionally, between central and regional better balance of its foreign resource inflows between authorities. The CSRC and SCSC are the principal cen- direct and portfolio investment. China's domestic fixed tral authorities. The PBC's role in securities regulation income securities market is today closed to foreign par- is largely effected through its branch offices. ticipation. For the time being, strengthening the domes- Additionally, the MOF has begun to assume a role in tic market should be the first priority. China, like other this area, and regional governments have powerful bod- countries, has greatly increased its presence in the ies of securities legislation. international bond market, and to date enjoys favorable terms, relative to most other emerging market Thus, (i) in primary markets, the fragmentation of economies. While the high international ratings enjoyed authority is the outcome of the historical variety of bond by China until end 1994 are commendable, China is issues by different government departments. Although likely to face deteriorating terms in the future, on two there is now some move towards a consolidation of counts: any general reduction in international enthusi- these issues, the oversight still remains fragmented. (ii) asm for emerging markets which could followthe Mexico In secondary markets, the PBC remains responsible for crisis and the rise in developed country and especially overseeing trading activities of bonds (except bond US interest rates, and second, persistent symptoms of futures, which are now under the CSRC). In practice, macroeconomic imbalance, particularly concerning the CSRC and local governments also remain involved, inflation, in China. Chinese overseas bond issues have as regulators of the exchanges on which the securities begun to trade at a discount in secondary markets. are traded. (iii) With regard to regulations concerning China could try to further expand the maturity of its bond market dealers and their activities, the split in bond issues, in view of domestic needs. Streamlined responsibilities is the most evident. Although the PBC domestic procedures for issuing international bonds no longer has a major role in the supervision of equity would benefit from greater flexibility. In overall terms, markets, it has retained responsibility for the licensing broadening of overseas funding options should be the of all financial institutions, including securities  exchanges, 'stock trading centers,' and securities deal- cise monetary control through debt sales, it needs to ers, under Document No. 68, although it is required to be certain, in a deregulated environment, that the report to the SCSC. One recently introduced exception volume of debt sold will not cause interest rates to is the licensing of bonds futures dealers, which is now rise to levels which damage both the real economy under the MOF and the CSRC. However, this require- and the developing capital market. So far, this has ment does not apply to securities firms which exclu- not been a problem, but as the volume of treasury sively trade treasury bonds since they are supervised by debt outstanding escalates, it will be an increasing- the MOF who has apparently said that the PBC's ly important concern. In parallel, the government approval is not necessary. This means that the role of must establish better knowledge of its cash flow licensing intermediaries and the on-going supervision requirements, so that debt issues can be better coor- of dealers is split between the PBC and the dinated with its spending requirements. SCSCICSRC. The PBC remains responsible for all bond trading activities, including financial futures on T Bills, In terms of the banking sector, the speedy imple- and the supervision of mutual funds. Unlike the CSRC, mentation of the separation of 'policy' and commer- the PBC has a regional presence, through its branch cial lending is required, so that banks grow more offices. In the future, efficient supervision of China's aware of the need for risk management. In parallel, bond markets will require a clarification and consolida- banks must begin to acquire the capacity to manage tion of these functions. interest rate risk, and also attend to the current mis- match between their assets and liabilities. RECOMMENDATIONS Turning to interest rates, deregulation could begin in First of all, the goveinment would have to determine the areas which most affect primary markets; short whether it is prepared to launch upon reforms on a term rates and money market rates. Liberalizing broad front, in terms of those features of the economic interest rates in these areas would help establish a system that impede capital markets from performing better defined short term yield curve and thus help efficiently: financial sector reforms which allow a the pricing of new short and medium term govern- greater role for the interest rate as a pricing mecha- ment securities issues. nism; a reduced role to credit and investment plans for capital allocation, the transformation of banks into enti- Second, turning to securities markets themselves, the ties which lend on the basis of risk evaluations and most important area for attention, where the greatest creditworthiness of clients rather than their credit plan problems lie, is the primary market. In the bond mar- quotas, and reforms of state enterprise which permit ket, the government could consider the following: them to face a real environment of risks and returns; ie, a 'binding budget constraint'. Such major decisions can clearly distinguish between wholesale and retail perhaps not be taken solely on the basis of the future investors, and increase the relative emphasis on the development of capital markets alone. former category. Focus on a wholesale investor base will permit the offer period to be reduced, and will The question which clearly follows is, how, in the con- permit the eventual adoption of an auction system. text of capital market development, are such changes to The present distribution system, parcel sizes and be implemented? It is recognized at the outset that title transfer systems are poorly suited to a whole- abandoning the credit plan in the absence of indirect sale market, or to the development of a liquid sec- instruments of monetary control, or the simultaneous ondary market. decontrol of all interest rates, will lead at least initial- An effort can be made to gauge wholesale investors' ly to chaotic conditions, and the more germane question demands for bonds, and their preferences in maturi- therefore is, what are the next incremental steps that ties. can be taken towards realizing these objectives? Three Bonds could then be targeted for sale to this group, broad suggestions are proposed here, before interest and retail investors should be treated separately. rate deregulation, and reduced reliance on the credit To achieve this, the government would need to have plan, are embarked upon. a preannounced issue calendar for the year for its debt issues, for its longer term financing require- The government must better coordinate its monetary ments, spread over the year, to improve liquidity and fiscal policy. If the government intends to exer- management at the level of the wholesale buyers,  and assist the development of benchmark issues. this). (ii) The greatest challenge in this area lies in aug- The government, or the central bank, can also issue menting the sources of funds, through pension and short term bills for liquidity management purposes. social security reform, where the mobilization of funds Electronic registration and transfer of title can be is limited, due to the prevalence of pay-as-you-go pen- adopted as the standard for wholesale issues. sion systems. The yield at issue could be related to current sec- ondary market yields, rather than to deposit rates. Fifth, regarding the participation of foreign investors in All bond issues for wholesale investors could be China's securities markets, (i) China can afford to tradable. encourage foreign portfolio equity investment today, Any remaining administrative placement of bonds vis-k-vis foreign direct investment; and should reduce would need to be eliminated. the fiscal incentive bias in favor of FDI. (ii) But present restrictions against foreign participation in the domes- For retail investors, an on-demand savings bond type tic debt securities market need to be maintained, until issue should be designed, which would have the effect the domestic bond market is considerably strength- of spreading retail sales over the year. The interest rate ened. (iii) In terms of China's participation in overseas offered could be altered to stimulate or dampen retail bond markets there is still scope for expansion. A demand. Since such issues will be difficult to trade greater variety of domestic firms could be permitted to because of the variety of maturity dates, it should be access this market. possible to redeem them early at a penalty. For corpo- rate bonds, the determination of capacity to issue is Sixth, there is clearly a problem of the fragmentation of based more on evaluations from credit rating agencies functional oversight in the bond market. While the than quota-driven decisions by local authorities. CSRC (and defacto the regional regulatory authorities) have oversight on trading activities at authorized The third area for action is secondary market develop- exchanges, the PBC has the authority to supervize bond ment. Many of the problems here stem from underlying trading at these exchanges. Yet the CSRC supervises primary market problems. In the bond market, the the trading activities of securities dealers, but again, problem of poor liquidity impedes price discovery and only the PBC can grant them licenses, or revoke these is reflected in the ill-defined present yield curve. China 1~censes. ' has still to develop a benchmark issue to enable more efficient security pricing. These problems will be Finally, another key legal issue to be addressed is the assuaged by the measures recommended above, for the clarification of the separation of bank and non-bank primary market, especially: issues more evenly spaced activities. So far this appears to have been handled by out over the year, on a preannounced schedule, target- administrative regulations under the PBC, but in view ed primarily towards wholesale investors. Additionally of the close institutional ties between deposit taking (although detailed recommendations are beyond the institutions and securities dealers, as well as the rapid scope of this study), constraints on the operation of the growth of the latter, a clarification and strengthening of money market must be addressed. these laws is required. This could be addressed through the proposed (commercial) banking law. Regional market segmentation in the bond market, and regional price differentials, have greatly improved, but will not be eliminated unless the government either (i) sets up a centralized depository for all government bond issues, or (ii) requires the adoption of mutual recogni- tion of share certificates from different trading centers. The former is the route adopted by most mature economies, including large economies such as the US. Fourth, all parts of the market would benefit from the development of an institutional investor base, and here the government should (i) further encourage flexibility in the uses of funds for contractual savings institutions (the new insurance law already goes some way towards   T H E R O L E O F B O N D M A R K E T S I N C H I N A ' S E C O N O M Y ROLE OF BOND MARKETS IN CHINA'S been assigned the dual roles of carrying out monetary FINANCIAL SECTOR policy to control aggregate demand, as well as the quasi-fiscal function of channelling credit in accor- ecurities markets in China have evolved in tan- dance with national priorities, or so called 'policy-lend- dem with the gradual but impressive deepening ing'. While theoretically endowed with the ability to and diversification of the financial system. undertake monetary policy through the use of indirect Reform of the financial system began with the breakup instruments such as the interest rate, reserve require- of the monobank system in 1979, and the restoration of ments and a discounting facility, its use of such instru- the Peoples's Bank of China to the role of a central ments has been restricted as its capacity to make inde- bank. Four large specialized banks' were carved out of pendent decisions has been limited. Approval from the the former monobank system, and around ten smaller State Council has been required for most decisions, universal banks have since been establi~hed.~ including interest rate adjustment. The role of the inter- Diversification in the last five years has taken the form est rate mechanism is rnarginal as adjustments are of accelerated growth of hundreds of new non-bank infrequent and relatively small. The ability of the PBC financial institutions; rural and urban credit coopera- to control money creation has been hampered by the tives, trust and investment corporations, leasing com- rapid growth of the relatively unregulated interbank panies, securities firms and insurance companies, market, and transfers of funds out of the banking sector many of whom are major participants in securities mar- to nonbank financial institutions (often for the purpose kets. Despite difficulties in its operation and regula- of participation in securities markets) via the illicit par- tion, the rapid growth of an interbank market has also ticipation of the latter in the interbank market. With the contributed to the development of an integrated nation- recent passage of a Central Bank law (March 1995), the al financial market. Financial deepening accompanied role of the central bank is expected to be strengthened. institutional change and the ratio of financial assets to GDP grew from 127 percent in 1987 to 170 percent in Specialized banks continue to dominate China's finan- 1993. cial system, and have undertaken the implementation of policy lending. PBC refinancing of these credits has China today is making efforts to accord a greater role to expanded the specialized banks' lending ability. In financial markets for resource allocation, and move 1994 however PBC has shown remarkable control in away from the central allocation of credit. Yet at present limiting relending to commercial and specialized the credit plan remains the primary vehicle for resource banks. Policy lending has also implied that a large part allocation. Rapid financial innovation has eroded the of specialized banks' total lending is directed towards effectiveness of older instruments, but new instruments loss-making state owned enterprises (SOEs), with and institutions are as yet not sufficiently developed to adverse implications for portfolio quality and commer- ensure the stability of the macroeconomy. This has led cial orientation. Bad debts are estimated at around 15 to periodic cycles of liberalizing reform followed by to 20 percent and provisioning levels are insignificant. partial reversions to old instruments and market con- In 1994, the government announced major changes to traction. It has also led to the imposition of conflicting support the 'commercialization' of banks by separating government objectives on financial institutions. Thus policy lending and comrnercial lending; transferring the central bank (People's Bank of China, or PBC) has the former to three newly-created development banks;  the State Development Bank of China (SDBC), the icy agents. TICs and securities companies can under- Export-Import Bank and the Agricultural Development take a range of capital markpt L l L ; i ~ n s ;brokerage, Bank of China. dealing on their own account, and underwriting securi- ties issues. Banks have also participated directly in The role of capital markets in China's financial sector certain capital market activities, acting as 'underwrit- is small relative to the banking system, but has been ers', since 1992, for the issue of government bonds by growing. Total assets of non-monetary financial institu- certificate. Bank branches have been used as the vehi- tions grew from 6 percent in 1989 to a high of 8 percent cles for distribution to retail investors. in 1992, of the financial sector's assets, declining once again to 5 percent by 1994. The pattern reflects the Figure I.I Securities Markets in China's growth of enthusiasm for securities with the legalization Financial Sector (Y billion) of exchanges and high returns to equities from end 1990 to mid-1993. With the introduction of a major program for controlling the 'overheating' of the Chinese economy in July 1993 (the '16-point program'), and the squeeze of credit to the non-bank financial institutions, their levels of activity declined. By early 1994, the decline was exacerbated by the increase in deposit rates offered in the banking sector. Data on the annual issue of securities, compared to the liabilities of the financial sector, indicate a similar pattern and similar relative size: (a 4 percent share in 1989, rising to 6 per- cent by 1992, and declining to 2 percent in 1993).Both sets of estimates clearly reinforce the officially expressed position, that the Chinese government's approach to the growth of capital markets has been 'experimental' and is still an experiment on a small scale. The banking sector without doubt dominates resource flows to the real sectors (see Figure 1.1 and Scurtbs oulrtandhg Appendix Table Al.l). ~curtbr(annulbeus) There are nevertheless strong institutional links between the real sector, the banking system, and capi- Note: Securi1ie.i oulslanding d n ~for 1994 are estimales. a Source: World Bank and IMF &la. tal markets, provided by members of the large group of 'non-bank financial institutions' (or non-monetary financial institutions, according to the new PBC defini- At present, administrative regulations of the PBC effec- tion). NBFIs include a variety of Trust and Investment tively prevent easy transfers of funds (apart from the Corporations (TICs) finance companies, leasing compa- initial equity) from parent to subsidiary, borrowing from nies, as well as insurance companies and securities the parent company, or maintaining close manageria1 dealers. Not all these institutions participate in the cap- ties. While the 'firewalls' appear to be fairly effective so ital market, but a number of large securities dealers far, it is disquieting that they take the form of adminis- come from the ranks of the TICs. Moreover, many of the trative regulations rather than law. A draft law on com- TICs, and most of the largest securities dealers, were mercial banking was prepared by the authorities in set up as wholly or partially owned subsidiaries of 1994, but it made little reference to the issue of banks China's specialized or cornmercial banks. Several were and their subsidiaries operating in securities markets. bank departments and were spun off as independent Supervision is clearly an issue. companies as their operations grew. China's urban credit cooperatives are also participants in securities The principal vehicle for the transfer of funds between markets. Of the 80 UCCs in Shanghai at the end of banks and NBFls3 appears to have been the interbank 1993, 2 6 were registered brokers of the Shanghai market. China's interbank market has permitted the Securities exchange, 58 were dealers in state bonds, participation of banks as well as NBFIs.~The principal and 2 3 were involved in the insurance business as pol- instruments on the interbank market are short term  loans, although since 1992, a growing repurchase not been very large. Measurement difficulties preclude agreement (repo) market is emerging. Although loans a precise measure of the proportion of treasury bond on the interbank market are intended to be strictly short issues used for this purpose, especially as in earlier tenn, for liquidity management purposes, short term years, bonds were frequently eannarked by purpose, loans have tended repeatedly to become long term, and linked to construction projects or 'key investment' through 'roll-over' agreements, which the PBC periodi- projects. A broad comparison of orders of magnitude is cally attempts to curtail. NBFI participation on the presented here (details of definitions and data used are interbank market was virtually unrestrained prior to the in Appendix Table A1.2). Looking first at the visible 16-point program of 1993 but has since been sharply budget deficit, net issues of treasury bonds (gross new curtailed. issues less annual redemptions) have had a highly vari- able volume, relative to the size of the overall deficit; FISCAL MANAGEMENT AND THE BOND over 50 percent as early as 1988 and 1989, when net MARKET annual issues were Y 17 and 21 billion respectively. In 1990 and 1992, the relative size of bond issues fell to When China first resumed the issue of domestic debt in around a third. But in 1994, the estimated end-of-year 1981, the primary purpose was to finance the budget visible deficit was Y 8 5 billion, and (gross) new issues deficit of the central government. In 1994, the objec- of treasury bonds amounted to Y 113.2 billion; or tive of issuing government debt to finance the budget around 133percent of the current year's deficit. deficit took on new significance, due to the decisions to (i) cease to resort to deficit financing through loans Taking account of quasi-fiscal operations of transfers to from the central bank; and (ii) gradually transfer subsi- state enterprises, which should in a conventional dies to state enterprises, hitherto funneled largely accounting framework be financed through the budget, through commercial bank lending, to the budget. The but which have instead been financed through PBC threefold increase of new issues of treasury bonds in lending to the banking system, we can estimate the con- 1994 over the previous year, to Y 113.2 billion, is par- solidated central governnient budget deficit. If, at a ticularly large in view of the fact that the total stock of lower bound, 60 percent of PBC lending to the banking outstanding treasury bonds at the end of 1993amount- sector is estimated to cover the financing of 'policy ed to only Y 167 billion. New issues planned for 1995 loans', the (consolidated) deficit increases, and the size are estimated to be Y 150 billion. of annual treasury bond issues compared to the (con- solidated) deficit consequently falls. The annual vol- Figure I.2 Central Government Budgetary ume of net treasury bonds issued over 1989to 1993has Deficit andTreasury Bond Issues varied between 11 and 23 percent of the consolidated deficit, while the annual volume of treasury bills alone has varied between 5 and 23 percent of the consolidat- ed deficit. If quasi-fiscal operations are 'fiscalized', an increase in the scale of bond issues is likely to be required. The government has recently augmented the contribu- tion of securities markets to its financing, by enhancing its external bond issues. Following a long hiatus in overseas sovereign bond issues after 1987, the govern- ment made a comeback in overseas bond markets in 1993, with issues of around US8600 million (Y 3.4 bil- lion), and a huge increase in 1994, with issues of o VisbleDeficii 0 Nettreasurybandi s m USg1.6 billion (Y 13.6 billion). If these are added to D Netissuesoftreasurybills 0 OverseasBondIssues the measures of the relative size of government bond Source: World Bunk and IMF daa. issues and the budget deficit, the role of securities mar- kets increases; to around 38 percent in 1993 (33 per- Historically, as Figure 1.2 suggests, the contribution of cent from domestic bond issues, and another 5 percent bond issues to the financing of the budget deficit has from overseas issues).  BOND FINANCING O F REAL SECTOR Chinese enterprises have also approached the interna- INVESTMENT tional bond markets for resources. Although direct access of individual firms to these markets has been The contribution of bond markets, and securities mar- allegedly relaxed, in practice, the bulk of foreign bond kets in general, to the investment needs of the real sec- issues takes place through the 'windows'; large TICS, tors of the economy, so far has clearly been small and certain banks, which have been allowed access to (Appendix Table A1.3 and summarized in Figure 1.3).4 the overseas bond markets by the SAEC.5 Looking at treasury bond issues alone, the volume of issues, relative to the volume of investments, was 5per- Figure 1.4 Share of Bonds in China's Overseas cent in 1987, increasing to 9 percent in 1989, and fluc- Borrowing tuating between 7 percent and 9 percent between 1990 and 1992. Adding 'investment bonds' (issued both by the treasury and by the erstwhile state investment cor- porations), the upper limit for both categories rises to 10percent over the period 1987 to 1992. Committment Bonds Debt securities were also issued by state enterprises after 1986, and the outstanding stock of enterprise bonds amounted to about Y 195 billion by the end of 1992. The contribution of enterprise bonds to real sec- tor investment shows a discernible upward trend between 1987 Gust after they were first permitted), when their contribution was only 1 percent, rising steadily to 11percent of total SOU investment by 1992. Adding all categories, the maximum possible contribu- tion of debt securities to investment finance grew from 8 percent in 1987 to 21 percent in 1992. After 1993,there was a clampdown on the issue of new corporate debt, which would have led to a reduction in this percentage. Figure 1.3 Contribution of Capital Markets to Real Sector lnvestment 800r Source: World Bank d n ~ a In terms of aggregate contributions to foreign resource inflows into China, international securities issues still account for a small share of China's total external debt @ (Figure 1.4). The bulk of foreign capital inflows into Equity issues Treasury bonds lssues China have taken the form of foreign direct investment. Enterprise bond issues Total lnvestmentin a Portfolio equity only constituted 5.5 percent of aggre- State Owned Units lnvestment bond issues gate net resource flows to China in 1993, and bonds accounted for only 2.7 percent of new borrowing corn- Source: Stat? PLanning Commission and Slale Council Securities Commit~re. mitments in 1993.  The key factor to bear in mind, regarding the contribu- in fact subordinated to the effective channeling of large tion of capital markets to resource inflows to the real volumes of resources, which can be mobilized by a vari- sectors of the economy is that at least at present, this ety of means, to specific ends, and in short periods of contribution is controlled by the government, and time. The central question to be examined in the pre- embedded within the mechanisms of the investment sent study is, to what extent do China's bond markets and credit plans. Thus quotas are determined for the contribute to these manifold functions of efficient issue of domestic debt and equity securities, as well as resource allocation, efficient risk and return pricing, for overseas bond issues, by a combination of the SPC, and risk management, and how can their efficiency be PBC, and in the case of overseas issues, the SAEC. enhanced? How can bond markets help allocate Thus the extent to which the capital markets contribute resources efficiently to the real sector, and how can it is largely determined by the extent to which the gov- help establish the efficient pricing of risks and returns ernment permits them to contribute, and the issuers of across different investment alternatives? securities are determined by the distribution of quotas for each of these heads by the central and regional Of great concern to the authorities today is the question offices of the authorities cited. of the extent to which the government can successfully implement its proposed major reforms of eliminating ISSUES TO BE EXAMINED reliance on PBC borrowing for the financing of its deficit, and at the same time, reducing quasi-fiscal China first resumed the issue of domestic securities in operations and transferring 'policy lending' to the bud- 1981,shortly after the launching of its economic reform get. If these aims are to be realized, it is critical that program, after a twenty year hiatus. The motivation at the government secures stable and additional sources the time was the emergence of a budget deficit, and the of financing, and in this context, the report explores the need to raise financing for the deficit. Accordingly, extent to which the bond market can be developed to treasury bond issues were introduced, essentially as a provide financing for the government. The extent to vehicle for purpose of government resource mobiliza- which securities markets can provide support for the tion. Early bond issues bore a strong resemblance to adoption of indirect instruments of monetary control, taxes; subscription to bonds was obligatory, and quotas although highly relevant, is however omitted from the for bond placement had to be fulfilled by enterprise and scope of the present study, apart from an investigation by administrative district, in parallel to tax contracts of the extent to which the bond market can presently under the fiscal contracting system. Bonds were non- provide support to this process through the establish- negotiable and non-transferable. ment of a benchmark issues which would assist the process of pricing of government securities issues. The Today, fifteen years later, the capital market in China is issues investigated are, to what extent do current diffi- still viewed essentially as a vehicle for resource mobi- culties in the development of China's bond market stem lization. The bulk of bond issues are still administra- from factors related to the primary issue process (issue tively placed, and are non-tradable. But while the size, pricing, placement methods, timing) and to what mobilization of resources is one of the functions of a extent are problems observed in the operation of sec- capital market in a market economy, capital markets ondary markets. Markets for debt securities (although also have other functions: aiding the efficient allocation currently dominated by government issues in China) of resources, by increasing the transparency of pricing, are also important for providing appropriate leverage of risks and returns, and assisting investors with risk- for enterprise financing, and the constraints on the management. The function of resource mobilization is overall development of debt securities are investigated.  I I T H E D O M E S T I C P R I M A R Y B O N D M A R K E T SIZE AND GROWTH OF THE DOMESTIC Early government bond issues were essentially a rev- PRIMARY BOND MARKET enue mobilization effort, for the financing of the newly emerging deficit, and bond issues bore a strong struc- rom 1981, when China resumed the issue of tural resemblance to taxes. In some cases, payments domestic debt, shortly after it launched on its for government bonds were deducted through payroll program of economic liberalization, to 1986, deductions or compulsory withdrawals from bank the stock of outstanding debt securities increased accounts. Bonds were distributed through administra- eightfold, from Y 5 billion to Y 40 billion. Debt on issue tive placement mechanisms, and their acquisition was then accelerated to nearly Y 300 billion, by the end of involuntary. A bewildering variety of bonds thus 1993.The rate of growth of debt on issue over 1987 to emerged (Appendix Table A2.1). 1993,at 31 percent per year, far outstripped the rate of growth of GDF: of 17 percent per year, at current prices. Apart from all the above treasury bonds, bond issues by As a ratio to GDF: the share of debt on issue increased other public authorities were also authorized from from 1percent in 1981 to 9 percent in 1993.The pace 1987, initially by the state investment corporations of growth continued to escalate, and between 1993and ('key enterprise bonds' and 'capital construction 1994annual debt securities issues nearly trebled, from bonds'), banks ('financial bonds'), some non-bank Y 38 billion to Y 113billion of new treasury bills. New financial institutions ('trust income securities' and issues of Y 150billion are planned for 1995.The issue 'investment fund bonds'), and national and local state and trade of equities in China developed later than debt enterprises' bonds. securities, and although their growth has been rapid, the stock of outstanding equities is small, relative to bonds. Until 1992, the two major categories of debt in addition Between 1989 and 1993, the value of equities issued to treasury bills were certificates of deposit and corpo- increased from Y 3 billion to Y 30 billion (at issue rate debt. The growth in corporate debt (comprising price); a tenfold increase in four years (Figure 2.1). local enterprise bonds and short term enterprise bills) Figure 2.1 Growth of Securities Issued and Outstanding (1 981 1993) - Debt Securities Equities YlOOm Y 100m p z q IRedemption Ashares imi iana ianc +an7 inan*MI iom 1W7 1- 1989 1990 1991 1992 1993 Source: Slate Council Securities Committee and PDC.  China's Domestic Bond Market Development:A Chronology Phase 1: Bond Issues Resume, as a part of the State Credit Plan 1981-84 After over twenty years, China resumed the issue of domestic bonds. The issue was placed by forced allocation, via quotas assigned to state enterprises, collectives and local governments, who subsequently placed the bonds with individuals. The bonds were non-negotiable and had a ten year maturity. A fifth of the issue was redeemed by lottery each year, after the 6th year. In 1984, the Ministry of Finance (MOF) extended the ability to issue debt securities to the People's Bank (PBC) and the State Planning Committee (SPC). Over the next few years a range of debt issues developed, much of which was placed involuntarily via administrative methods. 1985: The Ministry of Finance reduced treasury bill maturity to five years and abandoned the lottery system for redemption. The use of treasury bills as collateral was permitted. 1986: The People's Bank extended the power to issue bonds to specialized banks (financial bonds) and enterprises (enterprise bonds), initially in five cities only. These bonds could be sold to individuals on a voluntary basis. In August 1986, an experimental market for enterprise bonds was established in Shenyang, rapidly followed by markets in Shanghai and Shenzhen. These measures led to an upsurge in non-Government bond issues. 1987: An illegal black market in treasury bills spread rapidly, spurred by rising inflation and more attractive alternative investments. Black market discounts on treasury bills could be 50 percent or greater. Phase 2: OtEcial Development of Secondary Markets 1988-9: The Ministry of Finance further reduced the maturity of treasury bills, to three years. From April 1988, the trade of treasury bills was permitted, two years after their issue. Over-the-counter markets were permitted and by the end of the year, all major cities had treasury bill markets. However, only trade within the locality was In the same year, the tradability of securities was extended to other major bonds, and also to shares, commercial paper and certificates of deposit. Meanwhile the PBC permitted banks to issue short term CDs to individuals (subject to PBC approval, and an overall local quota. In 1989, the Ministry of Finance issued the first floating rate bonds. 1990:Trade in treasury bills was permitted as soon as a new issue was completed. Later in the year, the transfer of bonds between cities was permitted (October 1990).The PBC established a Quotation Center to provide market volume and price data to dealers in different regions. In November, STAQS began, providing a satellite link with real time prices to dealers in six cities. Bond prices began to converge. In December 1990, the Shanghai stock exchange officially opened, and permitted the listing and trading of bonds. The annual volume of treasury bill trading for the year was Y 10.4 billion. Phase 3: Voluntary PIacement of Treasury Bills; Growth of Secondary Markets 1991: In April this year, the Ministry of Finance began experiments with the voluntary placement of treasury bills. A part of the years issue was undertaken by an underwriting syndicate who placed the treasury bills with their clients on a voluntary hasis. The volume of treasury bill trading volume for the year was Y 34 billion. 1992:The Wuhan Securities Exchange Center was officially established in April, the nation's largest bond trading center. Later, the newly established official equities market attracted funds away from the bond market, and consequently, trading volume slumped. Nevertheless, treasury bill trading for the year had grown to Y 105 billion 1993: At the beginning of the year, the yield at issue offered on treasury bills was unattractive due to the booming stock and real estate markets. Placements via syndicated underwriting fell considerably short of target, and the Ministry of Finance partially reverted to mandatory placement. The Ministry of Finance also launched a new method of voluntary placement, via a system of nineteen primary dealers. Unlike previous bonds which paid a lump sum at maturity, the five year treasury 1)illissued this year paid annual interest. The PBC took a more active interest in the debt market, issuing short term finance notes and lifting previous restrictions on the holding of treasury bills by banks and insurance companies. The PBC also had a major role in the establishment this year of the NETS satellite trading system. Futures contracts in bonds began, established at the Shanghai stock exchange. The treasury bill trading volume for the year was Y 83 billion. 1994: There was a dramatic rise in volume of treasury bill issues this year, due to the government's decision to cease to fund any part of the budget deficit through borrowing from PBC. The Ministry of Finance issued treasury bills with a range of maturities from 6 months to three years. Ministry of Finance experimented with first paperless (annual interest-paying) treasury bill issue, aimed for the first time at wholesale investors. Government bond listing and trading on the Shenzhen securities exchange began. The Ministry of Finance decided to issue exclusively treasury bills, moving away from the placement of other treasury bonds, fiscal bonds or special state issues. Bond trading in aggregate is estimated at Y 3,000 billion. Sources: Bi (1993). Spencer (1994). IMF (1991, 1994), Zhang (1994).Rowles & White (1992). SEEC (1995).  and financial bonds, issued by banks, is illustrated in Figure 2.2 Outstanding Debt Composition Figure 2.2. The growth in the supply of this non-gov- Disaggrevated ernment paper reflected (i) the increased liquidity of capital markets from 1990 and therefore the increased Government Bonds likelihood of using debt issues as financing instru- lMX)I ments; (ii) increases in bond prices, due to increased liquidity, which further raised their attractiveness for enterprises; (iii) the desire of banks for funds to finance their own capital market activities, or those of their TIC subsidiaries; and (iv) the use of debt issues to tap local sources of finance.' Debt issues by the government have not been homoge- nous. Other treasury issues consisted principally of securities earmarked for specific budgetary purposes, lPBl 19811W IW 1% 1% 1687 lSe0 IPW lSa, IWI IW2 IW3 broadly following the compartmentalization of fund Inflation-pmofBond 8;;i:'i:i;i Fiscal Bonds flows under the credit plan, rather than any significant Special National Bonds Tbills difference in the issue terms.' In some cases the com- ConstructionBonds partmentalization was based on the target market to be 'taxed' with the bond issue, rather than the end use.3 Corporate Debt The coupon offered on a specific bond was not always homogeneous, but varied with the purchaser, typically with a lower coupon rate for enterprises, relative to individuals. The maturities offered have also varied from year to year. Such differentiation was feasible largely because of administered placement, combined with restrictions on tradability. A consequence of the lack of homogeneity in bond issues has been that even after trading has been per- mitted in many bond types, markets have remained thin, due to segmentation. The government is aware of 1981 1982 198) 1% 1985 1986 19811988 1989 1990 1991 1992 some of the drawbacks of the large variety of issues, and State Enterpr~seBonds Short Term Paper in recent years, there has been a trend towards reduc- rn Inter-enterprise debt Local EnterpriseBonds ing their variety, and placing more emphasis on trea- sury bills. This trend should be encouraged. Greater Financial Debt homogeneity in government debt issue will undoubted- ly assist liquidity in the secondary market. However, administered placement of debt and focus on a retail investor base continue to have support and these factors encourage the persistence of 'targeted' (and thus differ- entiated) bonds. Treasury bonds have been the principal form of debt on issue throughout this period. Treasury bonds in China include treasury bills, which are used for general bud- getary financing purposes, as well as a number of trea- sury bonds earmarked for special purposes. Rather like budgetary line items, treasury bond issues were often IInvestment .......... .......... Fund Bonds ijjCDs ....... targeted to specific investments, and earmarked by use. ITrust Income Securities IFinance Bonds Thus, 'construction bonds' were used for the financing of infrastructure, and 'key national construction bonds' Source: Dala provided by the Slate Council Securities Cornmillee.  were earmarked for a handful of projects deemed to be untary basis to client^.^ Underwriting was used again in of national importance. Alternatively they were classi- 1992, to distribute Y 3.6 billion of treasury bills in fied by the 'tax base' on which they were administered, combination with the traditional administrative alloca- and thus 'fiscal bonds' were bonds which were placed tion for the balance (Y 36.7 billion) of the years issue. at banks, which were then prohibited from trading Although this represented a larger absolute sum than them, effectively 'taxing' the banking system. Bonds the previous year, it represented a smaller proportion of issued on a similar mandatory basis to enterprises or total issues (9.7 percent, versus 12.5 percent in 1991). contractual savings institutions were known as 'special The relative success of underwriting at the time can be national bonds'; these were merged with fiscal bonds in partly attributed to the relatively attractive (fixed) 1992. Bonds which were index-linked to inflation, coupon offered on bond issues, compared to other avail- which were first issued in 1989, were initally ear- able forms of investments. marked as a separate category of 'inflation-proof' bonds, but from 1990, the distinction in nomenclature In the following year, 1993, underwriting failed to sell between these and other treasury bill issues was the desired quantity of treasury bills, due to competi- dropped. tion from the booming equity and property markets and The market for derivative financial instruments began higher (unauthorized) returns on enterprise debt. The in late 1992, with the listing of selected treasury bond government reverted to mandatory administrative allo- futures, and the beginning of trade in repurchase agree- cation; localities which did not meet their quota were ments. It was not until December 1993 that a market in severely discouraged from both issuing their own debt these instruments seriously began to develop. and from listing companies from their region on the stock exchanges. The government nevertheless made an ISSUE METHOD effort to improve bond distribution and accordingly, nineteen financial institutions were appointed as pri- Treasury Bills mary dealers. In return for underwriting a certain vol- Methods used to issue government debt have evolved ume of debt, primary dealers were entitled to receive over the past decade, reflecting attempts to move away privileges in kind, allowing them priority in bringing from administered placement, towards more market- equity offerings to market. The selection of primary based methods. The degree of success achieved so far, dealers was based upon guidelines which included cap- expressed in terms of total debt issued, is still limited. ital adequacy and past performance, in terms of the Initially, all debt was placed administratively, and on a previous year's trading volume on the primary and sec- mandatory basis. Quotas were assigned by the Ministry ondary market. In principle, primary dealers have an of Finance (not markedly different from tax 'contracts') obligation to act as market makers, but this function to financial departments of provincial and local govern- does not appear to have been exercised in practice." ments, and at the local level, quotas were distributed among production units. These units in turn frequently With some revival in the bond market in 1994,' the 'levied' bonds on workers, as an automatic deduction government ventured to experiment with four different from wages. methods of issue for treasury bills, representing a com- promise between those who desired more market-ori- Limits to the government's ability to force bonds on ented issuing procedures and those who doubted the workers became apparent with the appearance of an effectiveness of the underwriting system in China. (i) illegal secondary market in bonds. As part of its Thirteen billion yuan of six month and one year paper- attempts to tailor bond issues to voluntarily held instru- less treasury bills were issued via underwriting agree- ments, the Ministry of Finance adopted an underwriting ments. The underwriters (many of whom were designat- syndicate to launch a bond issue for the first time on an ed primary dealers) were given a week to place the experimental basis in 1991. The syndicate was entrust- debt, after which it was listed on the Shanghai stock ed with the issue of Y 2.5 billion, out of a total of Y 19.9 exchange. (ii) Twenty eight billion yuan of two year billion of the treasury bond quota issue for that year. A bearer treasury bills were sold via local financial private agency, the Securities Exchange Executive departments, which applied for allocations.' The bal- Council (SEEC), acted as coordinator of the undeiwrit- ance of the year's planned issue then becoming avail- ing, which involved 58 financial institutions.Vhe able for distribution via other channels. The local underwriters received a commission of 0.15 percent of finance departments signed 'underwriting agreements' the underwritten amount and sold the bonds on a vol- with financial institutions at the local level, which then  Types of Debt Securitieson Issue: A Summary Government Securities (Treasury bonds) (a) Treasury Bills These were first issued in 1981, by MOF in association with financing the State budget. Voluntary subscription is a recent development. They are mainly in bearer form although a scripless issue was made in 1994. Treasury bills are traditionally issued over an extended period in the first half of the year at a predetermined coupon and price. The issue is primarily targeted, at retail investors. Available maturities have varied, generally downwards. In 1994, maturities ranged from 6 months to 5 years. Bills on issue are not homogeneous and formerly, bills issued to enterprises carried a lower coupon than issues to individuals. Differences in issue methods have also affected homogeneity.Treasury bills are tradable. The three year bond of 1994 is not tradable but early encashment, within six months, is permitted. Early encashment (after three years) was also permitted for the five yenr bond of 1993. (b) Fiscal Bonds These were first issued in 1988. No issues were made in 1994 and MOF intends to terminate them. They were mandatorily assigned to banks and other financial institutions to raise funds for capital constructionand to cover budget deficits. The 1988 issue was not redeemed on maturity in 1991 and is regarded by the MOF as a permanent loan. Their maturity has been 2 to 5 years. They were not tradable, but could be pledged. (c) National Construction Bonds These were first issued in 1988, by MOF, to the public, financial institutions and enterprises, to provide funding for SOEs and infrastructure. 'They have been tradable and are income tax exempt, for individuals only. (d) Key National Construction Bonds These were issued only between 1981 and 1987, to fund major state construction projects. (e) Special National Bonds These were first issued in 1989 and were merged with fiscal bonds in 1992. They were issued by MOF to enterprises, insurance companies and pension funds by mandatory assignment. They were created to make a distinction between treasury bills issued to individuals and those issued to institutions. They were not tradable but were interest tax exempt. (Q Inflation-Proof Bonds They were first issued in 1989. Bonds with an inflation adjustment were also issued in 1992 (3 year and 5 year), 1994 and 1995. (g) National Investment Bonds These were first issued in 1991, by provincial governments, with the approval of the SPC, to fund regional development. State Investment Corporation Bonds (a) Key Enterprise Bonds First issued in 1987, by SOEs in petroleum, electricity and metals industries, to client enterprises (mandatory).Issued through state investment corporations and guaranteed by the state government. Three to 15years maturity. Can be pledged. (b) Capital Con.~tructionBonds First issued in 1988, by the State Energy Investment Corporation, the State Transport Investment Corporation and the State Transit Railway. Financial Institution Bonds (a) Financial Bonds First issued in 1985, by banks to individuals. to provide liabilities on which to base longer- term lending. Often project-specific. One to five year maturity. Unlike treasury bills often pay annual interest. Tradable. (b) Transferable High-value Fixed Deposit Certi/icate First issued 1988. Issued by banks to enterprises and individuals. Quota assigned by PBC. Maturity of 30 days to 1 year. Tradable. (c) Trust Income Securities Issued by provincial securities companies and TICs. Regulated by the PBC. (d) Investment Fund Bonds Issued by provincial securities companies and TICs. Regulated by PBC. Corporate Bonds (a) Local EnterpriseBonds First issued in 1984 initially to employees and clients. Some pay interest in kind, others pay annual interest. More recently they have been issued to a wider public. Issued by SOEs under a quota administered by the local PBC and SPC. Used to finance investment.2 to 5 year maturity. Tradable. Very low default risk due to socialized ownershipof enterprises. (b) Short term Enterprise Financing Bills Similar to local enterprise bonds but used to finance working capital. 3 month to a year maturity. (c) Inter-enterpriseBonds Issued by enterprises to their employees to tackle short term liquidity needs. Loosely regulated. (d) Housing ConstructionBonds Issued at the local level. Regulation not known. (e) Local Investment Corporation Bonds Issued at the local level. Regulation not known. PBC Bonds (a) Financing Bills Issued July 1993. Y 20 billion 3, 6 and 9 month maturities. Placed through interbank centers to redistribute bank excess reserves. Proceeds lent to banks and NBFIs in regions with a shortage of reserves. Sources: Hong Kong Stock Exchange (1993).Bi (1993).  sold the securities to individuals and others. (iii) Two ments' interest in boosting investment. The PBC also billion yuan of five year bearer treasury bills were regulates the aggregate volume of issue of corporate placed directly with institutions; but (iv) the largest bonds in response to-liquidity conditions. On past occa- part of the year's issue, Y 70 billion, three years matu- sions when enterprise bond issues have appeared to rity, was issued in the form of certificates, allocated by threaten bank deposits, or the banks' ability to meet PBC to the headquarters of the specialized banks which lending quotas, the PBC has clamped down on enter- in turn allocated them to branches at various levels. prise bond issues. The allocation of the quota between The branches then sold the treasury bills locally to companies is based on a combination of financial and individuals and others. These certificates were (de facto) political criteria. While an acceptable rating redeemable at the bank of issue after six months, by a credit rating agency is required, the priorities of although their listing and trading was not permitted. industrial policy are given greater weight in practice. This issue was the outcome of an intention to develop a purely retail debt in~trument.~ ISSUE SIZE, FREQUENCY AND ISSUE PERIOD Of the four distribution channels used in 1994 the Y Another drawback of the primary issue process for gov- 13.2 billion placed via underwriting is the furthest ernment securities is that treasury bills typically have removed from the old administered distribution chan- been offered in a small number of issues, in the first nels. Under this system, underwriters were supposed to half of the year, rather than in several offerings spread compete for an allocation of treasury bills, through a over the year. Sales have been made on what is effec- three part bid covering: the amount to be underwritten, tively a tap basis over a period which typically takes the speed at which funds received from the sale of trea- several months. The sale of paperless treasury bills sury bills would be repatriated back to government and aimed at wholesale investors in 1994was an innovation the underwriting fee. The institutions involved in this which permitted a much shorter issue period. Thus in part of the issue (mostly TICsj have more recent origins 1994, the two paperless issues took less than a week than the specialized banks and the local finance each (the six month paperless issue was placed departments, and the target market, for the first time, is between January 25 and January 31, and the one year wholesale (institutions) rather than retail (individuals). paperless issue was placed between February 1 and 3). However, this still accounted for only 11.7 percent of But the two year bearer issue took two months to place the year's issue; even less than the 9.7 percent placed (1 April to 31 May) and the three year treasury bill cer- by underwriting in 1991.The real difficulty is that mov- tificate took longer still; from 1 April to 30 July, or four ing away from administrative placement systems is dif- months altogether. For the paperless issues, the under- ficult, within the framework of the credit plan, since the writers were required to sell the bills within a specified fulfillment of 'placement' quotas could no longer be issue period, at the end of which funds for bills sold, assured. Another major difficulty with the transition is together with any unsold subscriptions, had to be the administered interest rate, and consequently bond remitted to the Ministry of Finance. The issues were coupon rate, which effectively removes a major plank of then declared tradable with immediate effect. By con- price competition for underwriters or primary dealers. trast, for the two and three year treasury bills with the Third, for reasons discussed further below, institutional long issue period sales proceeds were remitted to the buyers are not at present accustomed to government Ministry of Finance's account at the PBC by each bond purchase. China is still a long distance from more underwriter, according to the terms of their individual sophisticated bond issue techniques, such as auctions. underwriting agreements, rather than on a daily basis. The final payment occurred after the close of the issue Enterprise Bonds and ShortTerm Bills period. The retail investor base to which most issues Approval to issue bonds is given to local state enter- are targeted and the long distribution channels for this prises by the local State Planning Council and the local prolong the placement time and reinforce the tendency PBC, within the quota allocated to the locality by the towards large issues spread out over a few months. credit plan. The aggregate volume of enterprise bond issues (permitted only to SOEs) is nominally super- The current practice has several undesirable implica- vised by the PBC head office. Central regulation of the tions. First, in the absence of regular maintenance of quantity of local bond issues has not always been suc- sufficient a volume of short term debt on issue, the cessful and the issue quantity has occasionally been development of a liquid secondary market is not possi- larger than the aggregate quota, due to local govern- ble. Consequently a short term market yield curve can-  not develop. Moreover, the absence of a liquid short MATURITY term market presents problems for the use of indirect methods of monetary control. Second, the absence of a When the government first resumed debt issue in the regular supply of debt of any maturity to the market early 1980s, the maturity of government debt issues implies that there is no 'current' issue to provide a reflected, exclusively, government needs. This was pos- 'benchmark', either long or short term.. Third, since sible due to the administered placement mechanism issues are made in the first half of the year, there is lit- adopted By the late 1980s the authorities were forced tle scope for synchronizing the timing of the sales with to acknowledge investor discontent, expressed by the the State's cash flow requirements.'' This raises the emergence of secondary markets where government cost of funds to the government.'' Fourth, investors debt traded at large discounts. In response, the govern- cannot plan orderly acquisitions of new issues over the ment was obliged to progressively shorten maturities on year in line with their cash flows. A one-off issue peri- treasury bills from ten to five, and then to three years. od puts considerable strain on the liquidity manage- The 1994 treasury bill issue included six month and ment and risk management capabilities of banks and one year maturities for the first time, tailored to meet institutions. In a market economy such an issue pattern the needs of banks and wholesale investors for the bal- would limit the number of bidders and cause a liquidi- ancing of short term assets and liabilities. This demon- ty squeeze, both of which would operate to raise inter- strates that while the market is still far from fully est rates and the government's cost of funds. investor responsive, the authorities are now more con- scious of investor preferences and the advantages of On account of these reasons, it would be more desirable taking them into account when structuring an offering. for the government (Ministry of Finance) to (i) announce a schedule for the year's issue of longer term There is still a need to widen the range of maturities debt, based on the government's term financing need, offered to satisfy a wider range of investor preferences. spread throughout the year; and in parallel, (ii) under- On the shorter end, extending the range of short term take regular issues of shorter term debt (one to twelve maturities to include 30 and 90 day paper and increas- months maturity) to meet short term liquidity needs. ing the volume of short term offerings would assist (iii) In addition, the central bank (PBC) should issue financial institutions with liquidity management and short term paper as required, to meet short term liq- encourage the development of a short term yield curve. uidity management needs. Financial institutions in China are beginning to grow aware of the need for, and advantages of, liquidity man- Challenges for China in MovingTowardsa Debt agement, especially as new options for investment Management Program for a Market Economy develop. On the longer end, in view of the central and local governments accelerating need for financing First, the pattern of the governments cash ilows over the year infrastructure investment, there would certainly be an would need to be determined with sufficient accuracy. interest on the part of these authorities in the issue of long maturity bonds. However, from the perspective of Second, the government should differenciate between retail the investor, there is a lack of enthusiasm for debt of and wholesale investors. Continued reliance on retail investors will necessitate prolonged issue periods due to the administra- long maturity today due to a number of reasons: (i) the tive burden of handling small sums or money. If the government lack of payment of coupons, and the long intervals to continues to rely on a retail investor base, it should design a redemption;" (ii) high and uncertain rates of inflation, tap issue available throughout the year, and adjust the interest which make the real value of the redemption amount rate on this issue periodically according to not only deposit difficult to predict, and usually (in the experience over rates, but also, governments' desire to attract runtls. the last few years) less attractive than the nominal Third, to meet the estimated demand of the institutions which value, (iii) due to the low incidence of default on most form the wholesale market, scripless treasury bill issues should forms of investment within the framework of a planned be made according to a preannounced calendar at intervals economy, investor perception of, and allowances for, throughout the year. As these institutions develop increasing risks, are low. Consequently, the local markets focus on emphasis should he placed on the wholesale market. return rather than risk adjusted return and as such the The development of a market in short term debt is dependent security of a long term government bond which may be upon the development of a wholesale market. The requirement attractive elsewhere carries little premium in China for frequent rool-over would be too administratively cumber- today. (iv) Liquidity in the bond market is still low. If some in a retail market. liquidity increased significantly, investors would be  more tempted to hold bonds of longer maturities. The Institutional Investors and China's Securities implication is that even if the government were to issue Markets bonds of longer maturities today, it would find these dif- The absence of professional investors in China is ficult to sell, and would have to resort again to admin- notable even relative to other emerging market istrative placement. economies. A first difficulty concerning the participa- tion of institutions for contractual savings in the securi- THE INVESTOR BASE FOR PRIMARY SALES ties market in China, is that such participation has been limited by restrictive regulations. Such institutions Historically and currently the major target market of have been obliged to invest their resources primarily in debt sales is individuals. This stands in contrast to bank deposits and some non-tradable government secu- developed debt markets where the major target market rities (sometimes at a lower rate than that offered to of primary issues consists of wholesale investors such retail investors), which have often paid low or some- as banks, insurance companies and mutual funds. times negative rates of returns. Aware of the conse- Table 2.1gives estimated figures for the division of gov- quences of such restrictions, the government is consid- ernment debt sales between individuals and enterpris- ering the gradual lifting of these constraints, with es. The data cover a range of different government debt appropriate safeguards against speculative investments types including treasury bills, construction bonds and that may lead to large-scale losses for individual savers. fiscal bonds.I3 Yet China's contractual savings institutions today also face a second serious handicap; the problem of low rel- Table 2.1 Government Debt Purchases: ative levels of contractual savings, of only three percent Households and Non-Households of GDE 'This is an apparent anomaly in a country with a record high savings rate: 40 percent of GDE Yet con- Enterprises & Year Households Households Institutions Enterprises tractual savings as a proportion of GDP in China are (Y billion) (%) (Y billion) (%) much lower than other developing East Asian coun- tries, such as Korea (18 percent), Malaysia (48 per- 1982 2.O 45.5 2.4 54.5 cent) or Singapore (78 percent). A primary reason is 1983 2.1 50.0 2.1 50.5 that under the system of central planning, the state 1984 2.2 52.4 2.0 47.6 assumed the functions of providing pensions, housing 1985 3.8 63.3 2.2 36.7 and social security primarily through state enterprises. 1986 4.0 63.5 2.3 36.5 Services such as domestic insurance were not permit- 1987 4.5 38.5 7.2 61.5 ted. With the transition towards a market economy, 1988 5.6 30.0 13.2 70.0 China today has to face the problem of how to build up 1989 18.1 80.8 4.3 19.2 such institutions 1990 9.3 47.4 10.3 52.6 1991 19.9 71.0 8.1 29.0 The insurance industry is growing rapidly but is domi- 1992 33.9 78.0 9.3 22.0 nated by a single large state-owned company. It is still 1993 30.0 78.5 8.2 21.5 structurally biased towards non-life insurance, which 1994 98.0 86.6 15.2 13.4 provides relatively shorter term funds for investment, Source: Minurry of Finance and SEEC. compared to life insurance. While both the life and non-life business appear relatively well managed, the restrictions on investment, lack of profitable financial The table shows that there is no systematic trend reduc- investment opportunities, in the face of the relatively tion in the proportion of debt issued to households, over high inflation rate, lower the real financial performance time. Indeed, ratios for household purchases are high of PICC. Yet, the insurance industry is better poised in the 1990s. The Y 13 billion paperless issue in 1994 today to potentially contribute investible funds to was the first attempt to explicitly target wholesale buy- China's capital markets in the medium term than pen- ers via voluntary treasury bill sales. Prior to 1993, the sion funds. These may take time to emerge as a reform PBC did not permit banks to hold Government securi- of the current unfunded pension system and reduction ties except those issued to them on a mandatory basis. of its high contribution rates may first have to be under- Pension funds and insurance companies have also been taken and such a reform program is unlikely to be encouraged to hold treasury bills since late 1993. implemented in the short-run. While the difficulties of  China's pension system are sometimes attributed to its authorities may see some advantage in paying the enterprise-based nature, the real drawbacks of the sys- coupon in a lump at maturity as it makes it more likely tem lie on the complete reliance on pay-as-you-go that treasury bills will trade on the secondary market at schemes. Today pension funds have negligible accu- a price above par. In a less sophisticated market this mulated balances to invest in capital markets, and the assists primary sales. Another explanation may be that building up of these balances through pension reform since most bonds are held by individuals in the form of must occur before their serious participation in capital bearer certificates, there are no easy channels for markets can begin. Meanwhile, other contractual sav- coupon payment. ings funds are beginning to take shape but are still very small. Housing funds are effectively still forced saving Table 2.2 compares coupon rates, comparable deposit schemes with very low real returns and with little rates and YTM at issue for bond issues to 1993.'' The incentive to attract investors' funds. Prospects for yield to maturity (YTM) at issue is less than the coupon mutual funds have been constricted by the lack of an rate. For example, a Y 100 bond with a 13 percent appropriate supervisory framework, and ad hoc changes coupon rate and a two year maturity would pay Y 126 in the regulations they face, reflecting the government's on maturity (before adding any inflation adjustment). concerns about their possible effect on diversion of This is equivalent to a YTM on a semi-annual basis of bank deposits. only 11.9 percent (before adding any adjustment). If the inflation adjustment were known in advance, its The PBC has recently begun to encourage institutions inclusion would widen the difference between the two to hold treasury bills as it is examining its ability to yield calculations. Table 2.3 compares these rates and control bank liquidity via secondary market treasury in addition comparable secondary market yields for the bill transactions. The PBC's interest in open market 1994 treasury bill issues. In 1994 both the two and operations stems from a recognition that control of mon- three year issues, aimed at retail investors, were issued etary and credit conditions via the credit plan is at yields above those in the secondary market. The fact increasingly impractical. But before secondary market that they were sold at above secondary market yields treasury bill transactions can be used as a policy tool, indicates that there are potential benefits to the govern- the relevant institutions must hold a stock of treasury ment from targeting wholesale investors (who dominate bills and a liquid secondary market needs to exist. secondary market trading) and from taking account of secondary market rates. Had the two and three year ISSUE PRICE AND COUPON issues been sold at secondary market yields the cost saving would have been in the region of Y 3 billion per Government bonds are issued at par and the majority annum, not allowing for the inflation adjustment on the carry a predetermined coupon. There is no auction three year issue. The most market responsive way to process to determine the yield in the primary market. take account of market yields would be to sell the bonds Coupons are administratively set at a margin above by auction. deposit rates of comparable maturity, without reference to the secondary market yield on issues of comparable Prior to 1992 the coupon on debt sold by mandatory maturity. The lack of reference to secondary market la cement to institutions was less than that on debt sold yields reflects the administratively determined interest to individuals. This is illustrated in Table 2.4. All trea- rate structure, and the role that debt issues continue to sury bills have carried the same coupon regardless of play in the Credit Plan. purchaser since 1992. Most government issues of three years or more in matu- Some enterprise and financial bonds pay an annual rity, since 1992, have had a coupon related to the infla- coupon while others pay on maturity.16 The coupon on tion rate; the 1992 three and five year bills; the 1994 enterprise bonds is restricted to no more than 40 per- three year issue of treasury bills in certificate form, and cent above the deposit rate.17 In addition the Ministry more recently, the proposed five year issue of Y 100bil- of Finance has imposed the restriction that the coupon lion for 1995 Only two treasury bills pay an annual should not exceed that on treasury bills in order to coupon; the five year 1993 issue and the scripless issue reduce competitive pressure on treasury bill sales. of 1994.14 All other bonds pay a redemption amount However, the restriction has been avoided by the use of consisting of principal plus accumulated simple inter- fees and discounts. In practice corporate bond yields est estimated on the basis of the coupon at issue. The are two to three percentage points greater than treasury  bill yields at issue. The more attractive rate offered on Table 2.4 Comparisonof Coupon onTreasury enterprise securities was one factor contributing to the BillsSales by Purchaser: Households, failure of the voluntary placement of treasury bills in Enterprises,and Financial Institutions 1993. Until recentlv.,,entemrise bonds were ~articular- Financial ly competitive with treasury bills as default was not sig- Households Enkerprises Institutions nificant." Yenr (Treasury bills) (Treasury Bills) (Rscal Bonds) Table 2.2 Treasury Bill Coupon Rate,Deposit Rates and Inflation Inflation: Yield Comparable Retail Maturity coup or^ at issuea Deposit b c e Index Year (years) (%) (%/ol Ra~e(96) Note: a Rae on Special State Bonh givenfor Enterprises Source: IMF (1991) TRADABILITY Another feature of bond design in China is that much of it has been non-tradable by regulation.'' The tradabil- ity of government bonds is affected by the evolving nature of the debt issue process which has resulted in Note: lack of homogeneity in the outstanding stock of treasury a 'Yieldat issue' here implies the yield reestimated on a YTM baris. bills. Even in recent years the treasury bill issue has not b Plw the injkion a&wtmeni at maurity. Sources: Zhang (1994). IMF (1991). WorldBank staff calculaioru been homogenous. The 1994 issue of Y 113billion was the largest issue to date and represents 55 percent of the treasury bills outstanding at the end of 1994. However, Table 2.3 Comparison of Coupon and Deposit a breakdown of the 1994 issue shows that the bulk of it Rates, and Secondary MarketYielda is not tradable or is at least illiquid Fable 2.5).Trade in (AtTime of Issue: 1994Treasury Bill Issue) other issues, such as enterprise bonds, is often hindered by lack of issue volume for individual issues. Co~nparable Secondaq Retail Co~~pon at Yield Comparable Market Price CREDIT RATING AGENCIES Maturity Issue at issue Deposit Yield Index Issue (years) (%) (%) Rate (%) (B) (%) The development of credit rating agencies has been encouraged since 1991. Rating companies must be approved by the PBC before they can publish their rat- ings. The PBC's headquarters have approved only two agencies so far, although some other agencies have Notes: been approved by PBC at a local level. In all, 82 cred- a Yield a issue restates the coupon on a yield to maturity bark. it rating agencies have been approved, about 30 of Comparablesecondnry market yield is representaiueof the yield (YTM basis) of a bond of similar rnaurity on the Shanghui stock which operate at a national level. achunge during the primary issue period b The 1994(4) issue k inflation indaed and is nontraduble. The raes Not all the rating agencies call themselves credit rating here are rates before in& adjustmeni. agencies; some are accounting firms and others are Source: Zhung 1994. Shanghai stock ezchange, WorldBank staff calcu- lations consultant firms. The ownership structure is also diverse, reflecting the variety of entry points into the  Table 2.5 Tradability of 1994Treasury Bill Issues Value (Y billion) Percentage Form of Issue Form of placement Commenta Y 13.2 billion 11.7 Paperless treasury bills Registered on the Trading low due to Shanghai stock exchange. insufficient issue volume. Y 28 billion 24.7 Bearer treasury bills lssued via local Sold mainly to individuals finance departments. who largely buy and hold. Y 70 billion 61.8 Certificate form Sold through Market listing not permitted." specialized banks. Y 2 billion 1.8 Certificate form Institutional placement Market listing not permitted Note: a Even illicit trade is dijficult ac the certfiate isfrom an individual bank, which carries the responsibilityfor redeeming it, resulting in a diversity of instruments.Large investors (Y 20m and above) havefaeed delays in obtaining redemption. Source: Ministry of Finance. new industry. Some regional rating companies are sub- nies from those with an acceptable performance. sidiaries of the local PBC. Of the two credit rating com- However, among the acceptable companies the right to panies in Shanghai, one is a subsidiary of the Shanghai issue debt is not determined solely, or even primarily, Academy of Social Sciences and the other is a sub- on the basis of the rating agencies' assessment. The sidiary of the Shanghai University Institute of Finance local PBC and SPC give weight to policy priorities. and Trade. Investors do not place much weight on the rating agen- cies assessments because of a general excess supply of Rating agencies are used in the process of selecting the investible funds and because enterprises rarely fail due enterprises to be granted permission to issue bonds. At to state ownership. As long as socialized ownership cre- present their role is of marginal importance to the gov- ates soft budget constraints on enterprises the risk ernment and investors. In the debt issuing process rat- assessment role of rating agencies will be marginalized. ing agencies distinguish the poorly performing compa-  I I I S E C Q N D A R Y M A R K E T S I N D E B T S E C U R I T I E S he development of a market in bonds began less than a tenth of securities on issue, the value of spontaneously, through the emergence of large trade in equities, by 1993, was five times as high as in numbers of multiple illegal curb markets in debt (Figure 3.1, and Appendix Table A3.1).' government paper, often at the doors of the PBC bureau charged with the task of administrative placement. The secondary market for China's debt securities has Individuals would seek to sell their paper, at a discount, therefore clearly improved immeasurably in recent and use their increased liquidity for more attractive years in terms of increased liquidity, greater geogaph- investments, emerging elsewhere in the economy. Such ic price unity and more sophisticated trading. But in trade was gradually legalized by the government, which comparison to debt markets in other countries the mar- began to see the difficulties of placing paper on unat- ket remains illiquid; liquidity is not sufficient to meet tractive terms. Bond maturities declined and coupon the transaction needs of larger participants, and uni- rates increased, relative to deposit rates, as issues were form pricing and trading practices across different gradually tailored to public preferences. 'The develop- exchanges and trading networks are still to be achieved. ment of secondary markets was greatly boosted from The concept of a benchmark issue has not developed, 1990, with the establishment of official stock and trading activity and pricing continue to be driven exchanges, which could list bonds, and the onset of largely by the weight of liquidity available. regionally interlinked electronic trading through the STAQS system. China began to experiment with the Figure 3.1 Secondary Markets in China's use of more market-based distribution systems through Securities underwriters and primary dealers, and in 1994 began to - issue scripless bills. Since 1994, the development of the bond market has achieved great prominence, as the government has accepted a restriction on financing its deficit through central bank borrowings, and is now obliged to turn to the bond markets for this purpose. From 1989 to 1990, annual trade in debt on issue increased almost fivefold in a single year, from Y 2.2 billion to Y 10.5 billion. Within three years, by the end of 1993, annual trade in debt had further dramatically increased, to Y 105 billion. Trade in equities, first per- mitted officially from December 1990,accelerated even more rapidly. From Y 1.8 billion in 1990, it exceeded Y InEquities I 730 billion in three years, by the end of 1993.The vol- ume of trade has been twenty five times as high as the Source: China State Securities Cornmit~eeand PBC volume of equities on issue. In contrast, the ratio of traded debt to debt outstanding has been less than one. There are no unified standards for listing bond issues in Thus while the primary securities market has clearly China. Bond listing standards are not as strict as those been dominated by debt, with equities accounting for for equities. All treasury bill issues are eligible for list-  ing, the timing of listing being determined by the interest rate fluctuations on the secondary bond market. Ministry of Finance. Financial and enterprise bonds are The PBC publishes an inflation si;Ssidy each month listed according to the requirements of the local trading which adjusts the interest rates on individual deposit center. The Shanghai stock exchange will list bonds accounts and the adjustment for inflation payable on provided the issue amount is greater than Y 100 mil- most bonds of maturities of three or more years. lion, the maturity is greater than two years and the Individuals have used the futures contract to speculate credit rating is A+ or higher. against the amount of the inflation top-up and the expectation of the top-up has a large influence on SECONDARY MARKET TRADING VOLUMES futures trading.Vhe apparent large increase in bond AND LIQUIDITY trading in early 1995 was virtually entirely driven by futures contracts, which also enhanced the liquidity of The first aspect of secondary market efficiency exam- the underlying spot market (Table 3.1)." ined here is the extent to which secondary markets have been able to achieve reasonable volumes of turnover, ie, Figure 3.2 China:TradingValue of Bonds the degree of market liquidity. As shown in Figure 3.2, annual treasury bill trading volume rose steeply from Y AnnualTradingValue: 10.5billion in 1990to a peak of Y 105billion in 1992. All China (1 987-93) Although individuals hold the majority of bonds, insti- '" r tutions account for the majority of trading. Trading vol- umes declined in 1993 because of competition from high returns on equities and real estate. In July 1993, the PBC tightened liquidity by increasing its control over the interbank market and reducing the ability of provincial branches of PBC to lend to other banks with- out approval from headquarters. This restricted the diversion of credit to uses outside the credit plan. In late 1993the PBC permitted banks and insurance com- panies to purchase treasury bills freely for the first time. The rise in secondary market trading in Shanghai from 1994 suggests that the reduction of the ability of banks to lend in the interbank market, declining equi-