China’s Bond Market Opening Up: Significance and Strategies

Author: GAO Zhanjun GAO Jian ZHOU  Aimin

With the development of China's economy and the gradual improvement of the pattern of financial opening-up to the outside world，China's bond market has become an important place for global capital allocation. At a roundtable discussion organized by China Forex，GAO Zhanjun，the Executive Editor-in-Chief of China Forex，GAO Jian，the former Vice President of China Development Bank，and ZHOU Aimin，the Deputy General Manager of Industrial and Commerical Bank of China，shared their views on policy suggestions on China’s bond market. The conversation，which follows in edited form，was moderated by GAO Zhanjun.

GAO Zhanjun: The Chinese bond market has been opening up to the outside world at a rapid pace. In August 2010，the Global Connect was launched，enabling overseas institutions to directly participate in the market. In July 2017，the Northbound under China’s Hong Kong’s Bond Connect was launched，and in September 2021，the Southbound Trading under China's Bond Connect program was officially came into practice. In addition，overseas investments in domestic renminbi bonds have grown from 600 billion yuan at the beginning of 2015 to as much as current 4 trillion yuan. These developments and numbers are epitome of the bond market opening up since China resumed government bond issuance in 1981. What’s your insight on this?

GAO Jian: As early as the early 1990s，it was not long after China’s government bond market was established that the opening up of China’s bond market was put on the agenda. Since 2000，the opening up of the bond market has taken a new step，marking an important milestone in integrating China’s bond market with the international capital market. In 2001，China joined the World Trade Organization (WTO)，speeding up the opening of the financial sector. Since the beginning of the 21st century，China’s bond market has started a new chapter of opening to the world. In 2010，an interconnection mechanism between the domestic bond markets was established. Since 2018，more than 50 opening up measures have been introduced successively，including several measures to open up the bond market. The accelerated opening of the bond market mainly benefited from: First，China’s rapid economic growth and expansion in the process of globalization. After four decades of adjustment and growth since the reform and opening up in 1978，China has surpassed Japan to become the world’s second largest economy only after the United States. In 2021，China’s GDP comprised 18.67% of the world’s total. The world has high hopes for China in the future globalization. Second，the quickening pace of the RMB internationalization. It has been accompanied by a continued increase in cross-border payments processed through the RMB Cross-border Interbank Payment System (CIPS) since the third quarter of 2020. According to the latest data from the Society for Worldwide Interbank Financial Telecommunication (SWIFT)，in December 2021，the share of the RMB in international payments rose to the fourth place，surpassing the Japanese yen. Third，the acceleration of financial opening up. At present，the opening up of China’s financial sector including banking，securities，funds，futures，and insurance industries is gathering pace，with the foreign ownership limitations completely removed. Fourth，the development of the bond market infrastructure and convenient settlement and custody methods. Fifth，the interconnection between bond markets actively promoted by the regulatory authorities. They have launched a series of opening up policies to continuously relax market access requirements，simplify access procedures，and expand investment channels. At present，the bond market is one of the most open markets in China’s financial sector. The above proves that the conditions are in place for the full opening of China's bond capital market.

Generally，the growth rate of emerging economies is higher than that of developed economies，so is the interest rate. In light of the situation，insurance and pension funds will often be partly allocated to risky assets to improve overall returns. Out of need for the RMB settlement and exchange rate risk hedging，companies holding the RMB will also invest in safe RMB bond assets and related derivative assets. In addition，institutional investors will reasonably allocate or rotate between equity assets and bond rights assets according to changes in asset prices. They will also invest in both developed and emerging bond markets，and adjust quickly to monetary policy trends. These constitute the basic investment strategies of institutional investors.

The opening up and reform of the bond market can promote and complement each other. The opening up of the bond market can introduce mature institutions and advanced investment concepts and management methods，which will promote competition among investment and service institutions in the domestic market to improve market efficiency. At the same time，the entry of foreign financial institutions will change the current investor structure in the market and improve market liquidity.

ZHOU Aimin: Finance is the core of economy. A strong economy will produce a prosperous financial market. A prosperous financial market will further promote the development of the economy. Although the development pace of the two is not necessarily strictly synchronized，the direction is consistent. The scale of China's bond market has ranked second in the world，which is an inevitable result of China's economic development and GDP leaping to the second place in the world. Similarly，the opening of China's bond market is also a necessary result of China's economic opening. In recent years，the investment scale of foreign investors in domestic RMB bonds has increased significantly，which is the result of the efforts to continuously promote the opening-up of China's bond market，and also fully reflects that foreign investors are optimistic about China's economic development prospects and market potential.

GAO Zhanjun: When Robert Zoellick，then president of the World Bank，mentioned about avoiding a financial crisis in 2007，he argued that Asia lacked the shock absorption mechanisms provided by bond markets，despite the region’s fast economic growth. Asia should learn a lesson from the 1997 Asian financial crisis: a buffer zone. For instance，a bond market should be in place for investors to transfer funds when asset prices plummet. Otherwise，funds will only flow out of these Asian countries. According to Zoellick，the growing capital flow might evolve into potential risks if Asia does not pay attention to its bond markets. Do you agree?

GAO Jian: I basically agree with this point of view. Like other developing countries in Asia，China’s financial system is dominated by banks，and the bond market is underdeveloped. This brings about a series of issues. First，the inefficient indirect financing of banks makes the comparable loan interest rate higher than the corporate bond market interest rate. Second，banks require loan guarantees，which is not conducive to the financing of small and medium-sized enterprises and technology companies. Third，pension funds and social security funds are not well developed and lack long-term capital，resulting in a lack of capital investment in the long term. If China’s current financial system is not developed，it will hinder the innovation-driven economy and undermine financial stability.

The franchise hierarchy in China’s banking system causes a credit spread between large and small banks. The liquidity obtained by large banks from the central bank can be lent to medium-sized banks and joint-stock banks; medium-sized banks can lend it to city and rural commercial banks to obtain credit arbitrage income. The high turnover rate in the interbank lending market contributes to considerable credit spreads. This way the money circulates in the banking system. Since the main investors of rate securities are commercial banks，the funds that they can put into the real economy will decrease.

As banks typically hold bonds to maturity and rarely trade them in the market，their large holdings of bonds will reduce the liquidity of the market. At present，domestic individual investors mainly invest in stocks，while those who invest in the bond market are mainly banks and institutional investors. In order to match assets and liabilities，banks tend to invest in bonds，especially interest rate bonds，lowering returns of these bonds. Coupled with relatively low returns of corporate credit bonds in the primary market，a reasonable credit spread cannot be formed. Historically，individual investors would rather invest in volatile stocks than bonds，but long-term professional individual investors also consider bond investing.

There is a trade-off between the size of the banking system and the size of the bond market. Deposits and loans at the US commercial banks have been largely replaced by corporate bonds. Combined with the adequate social security funds，pension funds and various university funds，there is no shortage of long-term capital in the US economy. In addition，the government bond market of developed countries has set the interest rate benchmark for the entire financial market. The allocation of assets between government bonds and corporate bonds，as well as between bonds and stocks，can be adjusted freely according to market interest rates; the allocation between bonds and bond derivatives can also be adjusted with hybrid capital instruments. The role of the bond market as the benchmark for the entire financial market will become prominent with its further improvement.

ZHOU Aimin: The shock absorption mechanism of the bond market plays a role in many aspects. Generally，investors will maintain a reasonable balance between the allocation of bonds and stocks. When the stock price falls，an appropriate bond position can provide a buffer for investors and reduce losses. In addition，I also agree with the two reasons put forward by Senior Researcher Gao Zhanjun in 2021. First，a developed bond market helps to convert domestic savings into investment and reduce dependence on foreign capital. Second，when asset prices collapse and other financing channels such as stocks and loans are not smooth，the bond market can provide another channel for corporate financing.

However，there are some preconditions for whether the bond market can smoothly play the role of the shock absorption mechanism in the crisis，which is not only related to the development of the bond market，but also closely related to the perfection of the exchange rate formation mechanism，cross-border capital management policy，and macro-prudential management policy.

GAO Zhanjun: On December 1，2015，the International Monetary Fund(IMF) announced that the Chinese currency the yuan is eligible to join the Special Drawing Rights (SDR) in October 2016. According to Christine Lagarde，then IMF Chair and Managing Director，this was a milestone in China’s integration into economic globalization，marking a new historic stage of reform and opening-up. Some would argue that the renminbi's inclusion in the SDR promoted the development and opening of the bond market. Meanwhile，the improvements in the bond market contributed to the renminbi's inclusion in the SDR. The renminbi being added to the SDR currency basket，major central banks will increase renminbi bonds in their portfolio，contributing to the future inclusion of renminbi bonds in major international bond indices. To what extent do you agree or disagree?

GAO Jian: Joining the Special Drawing Rights (SDR) basket suggests the RMB’s importance in international trade and capital markets has been recognized by the International Monetary Fund (IMF). It has greatly raised the RMB’s status in the global currency market，reduced the concerns of foreign central banks and sovereign funds that hold the RMB，and increased the global market’s investment needs for the RMB assets. At the same time，inclusion in the SDR basket means that the RMB has truly become one of the world’s major currencies. It will be more widely used as a settlement currency，which will help mitigate the exchange rate risk of domestic companies and improve the pricing power of the RMB for commodities. With the booming demand of various central banks for the RMB assets in large quantities，China’s bond market is favored by central banks and sovereign funds of many countries，especially because China’s interest rate bonds have great safety，liquidity and profitability.

Joining the SDR basket may have an indirect impact on the bond market，while its direct impact is deepening China’s financial reforms. The RMB’s inclusion in the SDR basket requires the Chinese government to further advance financial reforms. It is expected to ease restrictions on cross-border issuance of the RMB bonds，including relaxing restrictions on foreign governments and sovereign issuers entering the panda bond market，and also supporting the Chinese government agencies，financial institutions and domestic enterprises to issue the RMB bonds overseas. China’s Ministry of Finance (MOF) has issued bonds on behalf of the Chinese government in the international capita