- Investors onshore are counting on Beijing for a significant liquidity injection and other essential reforms.
- Liquidity withdrawals globally and other factors have contributed to China's bond market selloff.
- IMF believes foreign investors don't have enough derivative tools to hedge against risks.
China’s rapidly growing $15tn mainland bond market is one of the markets with top prospects for pension funds and other institutional investors. Still, trading risk, low liquidity, a thicket of legal trouble, and a shallow market are some of the significant issues the Chinese government debt market needs to address.
There have been many regulatory restrictions in the Chinese bond market, allowing domestic, commercial banks to hold bonds to maturity. That lowers liquidity in the secondary market; thus, leading to high trading costs.
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The International Monetary Fund has advised that China’s bond market needs significant reforms to be a suitable place for foreign investors.
William Xin, head of fixed income at Eastspring China, the Asian asset manager, said:
“Apart from government bonds and bank policy bonds, liquidity in other segments of the market remains poor. However, this will improve with time as the market grows in terms of breadth and depth.”
Calls for reforms face resistances
The Chinese government bond issues a wide range of crucial tenors, unlike the US Treasury bonds, which focus on specific maturities such as ten and thirty-year bonds to help price discovery in the US fixed income markets and enhance liquidity.
China bonds lack liquidity, and it’s vulnerability to adverse shocks is higher because turnover solely depends on if the Chinese Central Bank is easing or tightening monetary policies.
China’s bond market is much lower than the international markets, but it is expected to increase, but it’s still unclear how far it will go. But government support for an implausibly low default rate will raise more questions about how determined Beijing will avoid implicit guarantees and whether credit risks will be priced correctly.
Bond ratings are a big issue as most bond ratings outside China take a more realistic view of potential defaults. Local credit rating agencies rate China’s government bonds and most corporate bonds as AA or AAA, which aren’t really as most Chinese bonds pay for positive ratings themselves. Nevertheless, the IMF says,
“China’s rating industry needs to rebuild credibility.”
Another resistance among foreign investors is if they can exit the bond market without any restriction, said the IMF.
More roadblocks with tax
Tax further complicates matters. The Chinese government declared a 3-year exemption from withholding tax and value-added tax (VAT) on interest earned from onshore bonds by foreign investors in 2018.
But investors still don’t know the fixed income the tax exemption covers. Tax regulations have proved inscrutable; thus, resulting in uncertainty in calculating tax bills among foreign investors. Investors still don’t know if the tax exemption will be extended.
Nevertheless, none of these difficulties have thrown foreign investors, investment banks, and even asset managers from promoting China’s bond market. But China needs to reform its bond market to become trustworthy.