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The Chinese Government Bond Market: Opportunities

and Challenges

S. Ghon Rhee, Ph.D.S. Ghon Rhee, Ph.D.K. J. Luke Distinguished Professor of Finance K. J. Luke Distinguished Professor of Finance

Executive DirectorExecutive DirectorAsia-Pacific Financial Markets Research CenterAsia-Pacific Financial Markets Research Center

University of HawaiUniversity of Hawai‘‘ii

Presentation at US Central Intelligence Agency March 26, 2004

Asia-Pacific Financial Markets Research Center, University of Hawaii

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Size of China’s Economy GDP 2002GDP 2002

(($ Billion)$ Billion) GDP per Capita GDP per Capita

Japan 3,986 $31,300China 1,237 980Korea 503 10,560Taiwan 289 12,500Indonesia 180 810Hong Kong 163 23,700Thailand 126* 1,990*Malaysia 95 3,870Singapore 90 20,900Philippines 76 980 * Estimates

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Asian Stock Market Performance

1995 – 20001995 – 2000 20012001 20022002 20032003

ChinaChina 20.32%20.32% -24.70%-24.70% -18.79%-18.79% 10.05%10.05% Hong KongHong Kong 10.1910.19 -28.10 -28.10 -20.01-20.01 29.9529.95 IndonesiaIndonesia -2.01-2.01 -6.01 -6.01 8.068.06 48.7548.75 JapanJapan -5.97-5.97 -39.67 -20.61 -39.67 -20.61 21.8721.87 KoreaKorea -11.85-11.85 31.82 31.82 -10.02-10.02 25.6125.61 MalaysiaMalaysia -5.95-5.95 2.392.39 -7.42-7.42 20.5720.57 Philippines Philippines -10.38-10.38 -24.64 -13.71 -24.64 -13.71 34.8034.80 SingaporeSingapore-2.51-2.51 -17.12 -19.12-17.12 -19.12 27.4427.44 TaiwanTaiwan -6.78-6.78 15.72 15.72 -22.06 -22.06 27.9927.99 Thailand Thailand -27.00-27.00 12.11 12.11 15.9715.97 77.2977.29 USA USA 17.24 17.24 -7.36-7.36 -18.35-18.35 22.5722.57

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Foreign Exchange Reserves of Major Asian Economies

0.00

100.00

200.00

300.00

400.00

500.00

600.00

700.00

Billion US$2001

2002

2003

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Foreign Holdings of US Treasury Securities

Unit: US $ billion

Economy December

2003 December

2002 December

2001

Japan 545.2 378.1 317.9 China 149.2 118.4 78.6 Hong Kong SAR

57.5 47.5 47.7

Taipei,China Korea

46.3 37.4 35.3

43.4 38.0 32.8 Singapore 17.7 17.8 20.0 Thailand 11.0 17.2 15.7 Total (Asia) 870.3 654.4 548.0 Total (Foreign) 1,531.1 1,238.6 1,040.1

Source: Department of the Treasury/Federal Reserve Board Http://www.ustreas.gov/tic/mfh.txt

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Government Bonds Outstanding (2003)

(In Bill RMB)

T-bond210957%

F-bond114731%

E-bond1113%

PBC Note3339%

Corporate Bonds Outstanding: RMB 50 billion (2003)Corporate Bonds Outstanding: RMB 50 billion (2003)Equivalent to less than 1% of GDPEquivalent to less than 1% of GDP

Quick Summary: Bond MarketQuick Summary: Bond Market

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T-Bonds Issued in 2003

Unit: Billion RMBUnit: Billion RMB

Assigned Assigned Issue IssueTypeType Secondary MarketSecondary Market Amount Amount

Book-EntryBook-Entry 377.88 377.88 BondsBonds

Inter-Bank Market Inter-Bank Market 335.50 335.50Exchange Market Exchange Market 42.38 42.38

Savings BondsSavings Bonds OTC Market OTC Market 250.46250.46TotalTotal 628.34628.34

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Idiosyncratic Features of the CGB Market (I) 1.1. Fragmented Regulatory Structure of Fragmented Regulatory Structure of Government Bond MarketsGovernment Bond Markets a. Dual Supervisory Structure of Primary Marketa. Dual Supervisory Structure of Primary Market

T-Bonds and E-Bonds: T-Bonds and E-Bonds: MOFMOF

F-Bonds:F-Bonds: PBOCPBOC

b. Tripartite Structure of Secondary Marketb. Tripartite Structure of Secondary MarketInter-Bank Market:Inter-Bank Market: PBOCPBOC

Over-the-Counter (OTC) Market:Over-the-Counter (OTC) Market: PBOCPBOCExchange Market:Exchange Market: CSRCCSRC

C. Meaning of the OTC Market in China? C. Meaning of the OTC Market in China?

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Idiosyncratic Features of the CGB Market (II)

2.2. Secondary Markets: Money Market Secondary Markets: Money Market rather than Bond Marketrather than Bond Market

Trading:Trading: 10% Spot Transactions10% Spot Transactions90% REPO Transactions90% REPO Transactions

Inter-bank Market: Inter-bank Market: REPOs are bond collateral REPOs are bond collateral loans among banksloans among banks

Exchange Market: Exchange Market: REPOs are short-term REPOs are short-term loans among loans among

securities securities companiescompanies

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0

2000

4000

6000

8000

10000

12000

Bill RMB

1996 1997 1998 1999 2000 2001 2002 2003

Spot Inter-bank Spot EX Repo Inter-bank Repo EX

Trading Value of Government Bonds

(1996-2003)

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Idiosyncratic Features of the CGB Market (III) 3.3. Missing Links in the MarketMissing Links in the Market

a. T-Bills: a. T-Bills: Money Market in China has been Money Market in China has been developed without T-Billsdeveloped without T-Bills

Maturity Structure of Bonds Issued in 2001Maturity Structure of Bonds Issued in 20012 years: 4% of total issues2 years: 4% of total issues3 years: 34%3 years: 34% 5 years: 21%5 years: 21%7 years: 14%7 years: 14% 10 years: 16%10 years: 16% 15 years: 3%15 years: 3% 20 years: 8%20 years: 8%

b. Interest Rate Risk Hedging Instrumentsb. Interest Rate Risk Hedging InstrumentsBond Futures: Bond Futures: Banned in 1995 Banned in 1995 Short-term Interest Rate Futures: Not AvailableShort-term Interest Rate Futures: Not AvailableNo Short Sales No Short Sales

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Maturity Structure of T-Bonds (Book-entry) and F-Bonds T-Bonds (Book-entry) and F-Bonds Issued in 2003Issued in 2003

ItemItem T-Bond T-Bond (Book-entry)(Book-entry) F-BondF-Bond

Bond issued (Billion RMB)Bond issued (Billion RMB) 377.88377.88 452.0452.0

Weighted Average Maturity (yr)Weighted Average Maturity (yr) 7.277.27 5.425.42

Weighted Average Int Rate(%)Weighted Average Int Rate(%) 2.862.86 2.872.87

MaturityMaturity(count)(count)

≤≤1yr1yr 22 1010

2-10yr2-10yr 77 1212

≥≥10yr10yr 44 1212

Par ValuePar ValueBillion RMB Billion RMB

≤≤1yr1yr 35.535.5 120.0120.0

2-10yr2-10yr 252.0252.0 152.0152.0

≥≥10yr10yr 90.3890.38 180.0180.0

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Idiosyncratic Features of the CGB Market (IV)

4.4. Missing Links in the Market-ContinuedMissing Links in the Market-Continued

c. c. Foreign Participation in Primary and Foreign Participation in Primary and Secondary Markets Secondary Markets except QFIIsexcept QFIIsd. d. Asset-Backed and Mortgage-Backed Asset-Backed and Mortgage-Backed SecuritiesSecurities

e. e. Municipal BondsMunicipal Bonds Revenue Source: 1/2 from Municipal GovernmentsRevenue Source: 1/2 from Municipal Governments Expenditures: 2/3 by Municipal GovernmentsExpenditures: 2/3 by Municipal Governments

Municipal Bonds may rely on ABS scheme using future Municipal Bonds may rely on ABS scheme using future cash flow of municipal governments cash flow of municipal governments

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Idiosyncratic Features of the CGB Market (V) 5.5. Benchmark Interest RatesBenchmark Interest Rates

a. Deposit interest rates are serving as a. Deposit interest rates are serving as benchmarkbenchmark

Corporate bond yields should stand at 40% above Corporate bond yields should stand at 40% above the deposit interest rates?!the deposit interest rates?!b. Why very little differences are observed b. Why very little differences are observed between savings bonds and book-entry between savings bonds and book-entry bond yields?bond yields?Savings Bonds:Savings Bonds: Syndicated UnderwritingSyndicated Underwriting

Book-Entry Bonds:Book-Entry Bonds: Uniform Price Auction Method Uniform Price Auction Method

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Idiosyncratic Features of the CGB Market (VI) 6.6. Segmented Secondary Markets Segmented Secondary Markets

a.a. Yield Differentials between Interbank and Yield Differentials between Interbank and Exchange Market are PuzzlingExchange Market are Puzzling

b.b. The only way to block arbitrage The only way to block arbitrage transactions are institutional constraints transactions are institutional constraints imposed by the Chinese authoritiesimposed by the Chinese authorities

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1. 00

1. 40

1. 80

2. 20

2. 60

3. 00

3. 40

3. 80

0. 5y 2y 3y 5y 7y 10y 15y 20y 30y

●Interbank Market ◆Exchange Market

Interbank vs. Exchange MarketsInterbank vs. Exchange Markets

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Recommendation 1: Benchmark Interest Rates Make T-Bond Yields Serve as Benchmark Interest Rates

a. Stop MOF’s practice of setting a range of bidding spreads at the primary market auctionb. Introduce T-Billsc. Create Balanced Maturity Structured. Make all T-bond issues fungible

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Recommendation 2: Consolidation of Primary MarketUnder the current structure, PBOC does not serve as “ears and hands” of MOF.a. Allow PBOC serve as the Fiscal Agent for All Government Bondsb. Regulatory Harmonization and Functional Delineation among PBOC, MOF, and CRSC c. CSRC as the Market Regulator for both Primary and Secondary Marketsd. Clearing & Settlement by PBOC: DVP for All Government Bonds d. Regularity of Issue Cycle

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Recommendation 3:Consolidation of Tripartite Secondary Market

Mere functional integration cannot achieve consolidation of three markets into a single marketa. Interbank market will remain as the money market mainly for PBOC’s open market operations b. Exchange market has limitations because automated trading system can not offer pre-trading negotiations and personal relationships among bond dealers……Korea’s Experience c. Create a “true” OTC market with all types of financial institutions participating

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Korea Stock Exchange’s Experience

Unit: $ Unit: $ billionbillion Exchange Market .Exchange Market .

YearYear Gov’t BondsGov’t Bonds Corp BondsCorp Bonds TotalTotal OTC MarketOTC Market19971997 $0.14 $0.14 $2.25 $2.39 $82.27 $2.25 $2.39 $82.271998 5.42 7.46 12.88 359.171998 5.42 7.46 12.88 359.171999* 1999* 248.87248.87 10.32 259.19 658.32 10.32 259.19 658.322000 18.58 2.88 21.46 736.362000 18.58 2.88 21.46 736.362001 9.45 1.56 11.01 1,066.44 2001 9.45 1.56 11.01 1,066.44

*KSE Introduced inter-dealer broker system for government bond *KSE Introduced inter-dealer broker system for government bond trading in March 1999trading in March 1999

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Recommendation 4: Infrastructure Building

1.1. Interest Rate Risk Hedging InstrumentsInterest Rate Risk Hedging Instruments

Is Repeat of Pre-1995 Bubble Valid Is Repeat of Pre-1995 Bubble Valid

ConcernConcern??

2.2. PBOC-Based C&S SystemPBOC-Based C&S SystemClearing: Multilateral netting basis

Settlement: DVP through PBC-wire system

IIs China Government Securities Depository s China Government Securities Depository

Trust Trust & Clearing Co. up to the Task?& Clearing Co. up to the Task?

3.3. Introduction of When-Issued TradingIntroduction of When-Issued Trading

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Recommendation 5: Infrastructure Building

3.3. Bond Fund Bond Fund

a.a. Institutionalization of Individual Bond Holdings Institutionalization of Individual Bond Holdings

4.4. Inter-Dealer Broker System Inter-Dealer Broker System

a. Brings market makers togethera. Brings market makers together

b. Disseminates to the market via telephone,b. Disseminates to the market via telephone, screen or a screen or a combination of the two combination of the two

c. Promote secondary market liquidity, depth, transparencyc. Promote secondary market liquidity, depth, transparency

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Recommendation 6: Infrastructure Building

5.5. Credit Rating Culture Be Promoted Credit Rating Culture Be Promoted

6.6. Credit Guarantee and Credit Enhancement Credit Guarantee and Credit Enhancement Mechanism are urgently needed for SMEsMechanism are urgently needed for SMEs

7.7. Fiscal Autonomy for Municipal Governments:Fiscal Autonomy for Municipal Governments:Development of a municipal bond market is an Development of a municipal bond market is an extremely important policy agenda extremely important policy agenda

Asia-Pacific Financial Markets Research Center, University of Hawaii

Thank You!For Further References,

Please visit http://www2.hawaii.edu/~rheesg

Asia-Pacific Financial Markets Research Center, University of Hawaii