Abstract: This article probes into the macro-level causes for recent volatilities in the Chinese bond market, including inflation abroad reaching an inflection point, tightened liquidity in the domestic market, and boosted expectations for future economic growth as a result of China’s COVID and real estate policy adjustments. These factors have triggered huge market turbulences at the micro level which were further exacerbated by redemption-driven negative feedbacks. The volatilities have also exposed some of the structural problems with the Chinese bond market. Several policy suggestions are proposed to improve China’s bond market liquidity management and protect financial stability.
I. VOLATILITIES IN THE CHINESE BOND MARKET: MACRO-LEVEL CAUSES AND MICRO-LEVEL MECHANISMS
In mid-November, the Chinese bond market suffered a wave of unexpected volatilities. Many wealth management products saw their net worth slashed or even recorded losses, triggering wide concerns.
As a matter of fact, the fluctuation this time is not exceptionally violent compared with previous bond market downturns; but it did trigger beyond-expectation market feedbacks. Three macro-level factors have caused this round of turbulence.
First, inflation abroad has reached an inflection point, and global asset portfolios are starting to change. Weakened macroeconomic statistics on real estates and consumption indicate that the U.S. economy is entering a downward track. Inflation data published on November 10 has also been interpreted by most institutional investors as showing an implicit inflection point. Later, the USD index fell, accompanied by rebound in stock markets at home and abroad, leading to adjustments in global asset portfolios.
Second, market liquidity in China has tightened to a more appropriate range. During the first three quarters in 2022, interbank liquidity in China was generally ample, with the DR007 continuously lower than the policy rate represented by the 7-day reverse repo rate, for two reasons: 1) favorable policies, including profit contribution from the People’s Bank of China, increased fiscal expenditure and sustained structural policy moves; 2) sluggish market demand for borrowing, especially from households, resulting in some of the funds remaining in the financial system.
All factors above have seen changes since October. And with more foreign capital leaving the Chinese bond market as a result of widened interest rate spread between China and the U.S., market liquidity began to stabilize, and the short-term cost of debt of financial institutions started to pick up. But the financial institutions did not adjust their asset structure accordingly. That made the price of bonds more vulnerable to the shocks, leaving the financial institutions’ balance sheets in a worse shape.
Third, China’s adjustment of COVID policy and the introduction of policies aimed to shore up financial support for the real estate sector have significantly boosted the expectation of Chinese market participants for the economic outlook.
At the micro level, this round of bond market volatilities can be decomposed to four phases. Phase 1 is a “warm-up” period: during October 10 and November 10, the interbank market liquidity tightened up, and the interest rate began to rise. Phase 2 saw drastic turbulences, with the three macro-level factors mentioned above triggering a sweeping change in domestic investors’ expectation for economic recovery. Phase 3 featured negative feedbacks: higher interest rate drove down the net worth of asset management products, setting off a wave of redemption among households and some of the institutional investors, which forced asset management institutions to further sell their assets and thereby pushed up the interest rate again, thus forming a negative feedback loop. At this stage, market sentiment also amplified the household sector’s panic and reinforced the chain reaction in the market. In phase 4, the panic subsided owing to timely policy moves by the central bank to curb the volatilities; net lending by large banks returned to the level in late October, and money funds resumed net purchase rather than net sales.
II. STRUCTURAL PROBLEMS WITH THE CHINESE BOND MARKET EXPOSED BY RECENT VOLATILITIES
The worst is behind for today’s Chinese bond market, but it is still more fragile compared with the first three quarters of the year. Meanwhile, the volatilities this time have also exposed some of the structural problems with the Chinese bond market.
First, the Chinese bond market is poorly-structured and undifferentiated, offering very limited portfolio options for asset management institutions. In contrast, a well-structured bond market would provide various bonds with diverse risk-return features so that asset management institutions could have ample choices based on their risk preferences. A good financial market is always a clearly-tiered one; only in this way can it cater to more diverse types of financial institutions and different allocation strategies, and be more inclusive and resilient. An outstanding problem with the Chinese bond market is product homogeneity, and most of the bonds are traded at an interest rate of 2-5%, a very narrow range. When the different risk preferences of various market participants cannot be fully met by the market, it will gradually homogenize the asset structure and allocation strategy across different institutions.
Second, most of the asset management products today have a short maturity, and that means most of the funds in the bond market are short-term money. Most of the products offered by wealth management subsidiaries of banks and publicly offered funds mature within 6 months, pretty similar to money funds; closed-end products, in contrast, are scarce. It indicates that the funds in the Chinese bond market mostly come from short-term investments, with a lack of demand for and participation from long-term stable funds.
Third, there is a lack of diversity in terms of the trading mechanism. Amid the recent turmoil, most of the financial institutions chose to dispose of rate bonds first to relieve the liquidity crunch, pushing up the interest rate on government bonds and national development bonds. And when this was not enough, they had to sell their credit bonds. However, because the Chinese credit bond market has yet to fully adopt the market maker system and therefore faces insufficient liquidity, these institutions had to sell their credit bonds at heavy discounts to compensate for the lack of liquidity.
Fourth, Chinese asset management institutions are in general homogenous. In recent years, these institutions, represented by wealth management subsidiaries of banks, have operated under similar models with increasing risk aversion, giving larger proportion of their asset portfolio to standardized assets, especially bonds. Credit bonds have been exceptionally hailed among all bond assets, including municipal bonds and high-grade industrial bonds. That have resulted in extreme concentration of institutional investment, and their asset allocation have also narrowed the credit spread and distorted the risk premium. That means that the bond market is prone to stampedes whenever it fluctuates and the price mechanism leads financial institutions to adjust their portfolio.
III. POLICY IMPLICATIONS
Going forward, to contain market volatilities and protect financial stability, regulators should consider building a more broad-based liquidity management mechanism for the Chinese bond market. Specifically:
First, prevent sudden surge in the interest rate. A robust bond market is critical to China’s financial stability. The government should work to prevent market stampedes and liquidity runs as a result of interest rate surge.
Second, regulators should implement crisis disposal mechanisms for various risk scenarios, and intervene in a timely and effective manner at the early stage of unexpected fluctuations. Such mechanisms include monitoring of abnormal fluctuations, liquidity injection under proper circumstances with appropriate means, and sending policy signals to stabilize market expectation, etc. This would help iron market fluctuations and prevent financial crises.
Third, improve the liquidity management mechanism for the secondary market. Possible moves include wider adoption of the market maker system in the bond market; reforming the debt management framework and encouraging bond issuers to take a proactive approach to debt management when facing abnormal bond market fluctuations; establishing financial stability funds for the bond market based on foreign experience, and giving full play to their role in stabilizing the market in difficult times.
This article is based on discussions at a recent closed-door seminar held by CF40 on “Recent bond market volatilities: causes, implications and coping strategies”. The views expressed herewith are the participants’ own and do not represent those of CF40 or any other organization. It is translated by CF40 and has not been subject to the review of the speakers.
