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The International Bank for Reconstruction and Development/THE WORLD BANK

1818 H 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 member 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 studies-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 infrastructure 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 contributions 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 in Text 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 in Text 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 1 7 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 2 7 4.3 China: International Syndicated Loans 2 9 4.4 China: Maturities and Spreads on International Syndicated Loans 30

Appendix Tables 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$)

ABC BOC BOCOM C D CIB CITIC

CSRC CSTS FDI GDP GITIC

GNP ICBC IF1 IMF ITIC ITS MICEX MOF MOFTEC

MOU NETS NBFI

Year-end 1994 8.45 Year-end 1991 5.43 Average 1994 8.62 Average 1991 5.32



LIST OF ABBREVIATIONS

Agricultural Bank of China Bank of China Bank of Communications Certificate of Deposit China Investment Bank China International Trust and Investment

Corporation China Security Regulatory Commission China Securities Trading System Corporation Ltd Foreign Direct Investment Gross Domestic Product Guangdong Industrial Trust and Investment Corporation Gross National Product Industrial and Commercial Bank of China International Financial Institutions International Monetary Fund Investment and Trust Corporation Intermarket Trading System Moscow Interbank Currency Exchange Ministry of Finance Ministry of Foreign Trade and Economic Relations Memorandum of Understanding National Electronic Trading System Nonbank Financial Institution

OTC PBC PCBC PDB SAEC SCRES

SCSC SDBC

SEEC SETC

SEZs SFC SHSE SITICO

SOEs s o u s SPC STAQS SZSE T BILL T BOND TICS UCC YTM

Over-the-counter People's Bank of China People's Construction Bank of China Pudong Development Bank State Administration for Exchange Control State Commission for Restructuring the Economic System (abbrev. SRC) State Council Securities Policy Committee State Development Bank of China Securities Exchange Executive Council State Economic and Trade Corporation Special Economic Zones Securities and Futures Commission (Hongkong) Shanghai Securities Exchange Shanghai International Trust and Investment Corporation State-Owned Enterprises State Owned Units

State Planning Commission Securities Trading Automated Quotations System Shenzhen Stock Exchange Treasury Bill Treasury Bond Trust and Investment Corporations Urban Credit Cooperative 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 today is a market in transition, and is confronting critical conflicts between the requirements of efficiently functioning capital markets, and features inherited from the former planning system; (i) the Credit Plan, (ii) administratively determined interest rates, and (iii) the absence of market pricing of risk. Bond issuance is still essentially regarded as an alternative revenue mobilizing system, and an extension of the budgetary process, in terms of financing options under the Credit Plan. Coupon rates are set with regard to the administratively determined deposit rate and do not reflect secondary market yields. Since the default risk of enterprises is still relatively low, bond pricing has not adequately reflected risk differentials. Corporate bond coupon rate ceilings are determined by the government with reference to deposit rates and government coupon rates. The government is in a position to also change the relative rates of return on different securities, for example by boosting returns to equity through announcement

effects, if it is felt that the equity market is in need of support, or by raising coupon rates on bonds, when large new government securities issues are due to be

made. In these circumstances, the link between bond market activity and underlying real sector developments, in terms of raising or pricing capital, is con-

strained, and the bond market cannot act as an efficient allocation mechanism for capital, or pricing mechanism for risk.

Many of the market's features are contradictory: a secondary market in bonds using relatively sophisticated

trading technology, futures contracts and repurchase agreements coexists with interest rate regulation in the primary market and the money market; a system of underwriters and primary dealers has been established, but these entities continue to use a retail distribution system that was originally used for forced placements of bonds. The approach to capital market development in

China has been cautious and experimental. The problem with this approach is that eventually its internal contradictions will distort capital market development

These problems today affect the primary markets far more acutely than secondary markets. The closer one gets to primary markets, the more apparent are the conflicts due to controls imposed under the remnants of the former system. And reform in primary markets will be difficult without parallel reforms in other basic features of China's transitional economy. The primary process of bond issue in China still retains many features which

arose from its historic origins as an obligatory tax mechanism. In particular, the continued reliance on administered or quasi-administered placement, the lack of effective competition between underwriters, the large and infrequent nature of government bill issues, instead of issues based on a preannounced year-round schedule, the targeting of the retail investor base rather than recognizing and differentiating between wholesale and

retail investors, the system of coupon determination,

based on deposit rates rather than market yields, the lack of coupon payments and the method of determina-

tion of redemption amounts, are issues to be addressed to improve the efficiency of the primary issue process.

In terms of the development of secondary markets, China has made considerable progress since 1990. Transactions on the exchanges of Shanghai and Shenzhen, and even some of the larger regional bond trading centers, are sophisticated, with screen-based, satellite-linked trading systems, continuous order

matching and the capacity for T+O settlement. The form of the markets is advanced, compared to other developing countries and even relative to the standards of advanced economies. Yet, the market needs to increase its liquidity and to achieve greater price unity. Key factors in improving market liquidity are the pri-

mary issue design features referred to above. In addi-

tion, present constraints on the operation of the money market need to be addressed, to ~ rov ide funding for bond portfolios and a reliable short-term yield benchmark. Greater price unity across different regions today

requires the creation of a centralized depository (or existing depositories will be required to agree on a common set of operating standards).

Today the role of the bond market in China's economy is relatively small, despite recent rapid growth. The share of outstanding fixed income securities in 1993 was less than 10 percent of GDP; assets and liabilities

of securities traders are estimated to be at most 6 percent of the financial sector's total assets / liabilities, and contributions to real investment have been at most 20 percent (and more likely closer to 10 percent) of

investment financing. Controls on the growth of China's securities markets under the Credit Plan imply that the

extent to which they are able to support the investment requirements of the real sector is also predicated upon the limits imposed under the Credit Plan. As such,

whether China's capital markets will lend support to the financing of infrastructure investment, or to the raising of equity capital for enterprises, depends today on whether these investments are approved under the credit plan, and whether capital markets are the chosen vehicle for the financing of these investments. In the case of bonds, the problems of illiquidity of the bond market additionally make investors reluctant to hold

instruments of long maturity, and this effect is rom- pounded by the relatively high levels of inflation China has experienced in recent years.

The contribution of the bond market to the financing of

the government's deficit, and its potential aid to macroeconomic management is not being realized to the extent desirable. Yet, this role is growing rapidly, espe-

cially with the decision to cease to finance the government deficit through recourse to central bank borrowing. Treasury bond new issues alone increased threefold

in a single year from 1993 to 1994. As a result, the importance of a well-functioning bond market in China has grown sharply. The government's strategy of targeting of retail investors for bond issues and use of administrative placement techniques when voluntary purchase is not forthcoming, has its limitations, which are growing increasingly obvious. The government realized these limitations after the mid 1980s, when it was obliged to shorten maturities and permit the development of secondary markets, to prevent the illicit sales of bonds at heavy discounts. Another solution, sought more recently by the government, has been the raising

of coupon rates on government issues. Coupon rates on

government securities have been set with reference to, and at a relative premium to, deposit rates of comparable maturities, rather than with reference to secondary market yields. Illiquid secondary markets compound the difficulty of pricing at market rates.

The difficulty with this strategy is that it could prove very expensive in the long run, as the stock of outslanding debt cumulates. For example, secondary mar-

ket yields are shown to have been low in the latter half of 1994 (around 8 percent), but the government had

issued its new debt for the year in the first half of 1994, at rates varying between 10 and 14 percent. The implication is that the government may be adopting an undu-

ly expensive financing strategy. With increased reliance on government debt issues to finance the deficit due to restrictions imposed since 1994 on treasury borrowing from the central bank, the problem will become more

important over time. A fortiori, should the invisible (quasi-fiscal) deficit currently covered through PBC lending to the financial system be transferred to the vis-

ible budget, costs of government borrowing will be an increasingly serious issue.

The limited participation of wholesale and institutional

purchasers of securities refers not only to the limited development of contractual savings institutions, but also, to the limited (voluntary) participation by large

financial institutions such as banks in the wholesale market for government securities. The causes lie deep in the evolution of the financial system. Insurance was

banned at the outset of reform in 1979, and until the present, remains limited, although its accumulations

are growing faster today than pension funds or social security systems, which have suffered primarily from largely unfunded pension schemes. The growth of sig-

nificant funds here for investments in securities could take time. Meanwhile, participation in wholesale securities markets by financial institutions has only recent-

ly begun to develop because of their limited active liquidity management; itself partly the outcome of restrictive regulations, branch-level liquidity management and difficulties in intra-bank transactions. Neither has the design of securities issues by the government, with typically limited transferability and administrative placement, facilitated the participation by financial institutions.

To reduce speculative tendencies, the volume and quality of information in the market needs to be increased. This applies particularly to enterprise and financial

bonds. This entails the improvement of disclosure requirements and the standardization of listing requirements. Another element of this concerns improved standards for credit rating agencies, and the development of a class of informed institutional investors.

The regional participation of China's provinces in the emerging securities market is still limited. The regional primary market for bonds, like equities, is driven by a combination of quotas (for corporate bond issues) and administrative placement (for government securities). In terms of secondary markets, integration in the bond markets has been facilitated by the growth of the automated electronic quotation systems; STAQS and NETS, which have greatly helped reduce regional price differentials. However the national integration of the debt market is impeded by the multiple independent depositories, and the lack of mutual recognition of bond certificates issued by different centers. Market segmentation by investor type, which is a major problem in equities markets, has been greatly reduced in debt securities (where formerly the coupons payable to individual and enterprise investors differed for the same security), although segmentation by wholesale and retail investors (in favor of the latter) persists.

China today is not vulnerable to a destabilizing domestic backlash, if flows of portfolio investment to China were to be sustained. Indeed, China needs to achieve a better balance of its foreign resource inflows between direct and portfolio investment. China's domestic fixed income securities market is today closed to foreign participation. For the time being, strengthening the domestic market should be the first priority. China, like other countries, has greatly increased its presence in the international bond market, and to date enjoys favorable terms, relative to most other emerging market economies. While the high international ratings enjoyed by China until end 1994 are commendable, China is likely to face deteriorating terms in the future, on two counts: any general reduction in international enthusiasm for emerging markets which could follow the Mexico crisis and the rise in developed country and especially US interest rates, and second, persistent symptoms of macroeconomic imbalance, particularly concerning inflation, in China. Chinese overseas bond issues have begun to trade at a discount in secondary markets. China could try to further expand the maturity of its bond issues, in view of domestic needs. Streamlined domestic procedures for issuing international bonds would benefit from greater flexibility. In overall terms, broadening of overseas funding options should be the

strategy for the Chinese authorities to pursue.

Finally, bond markets need an appropriate environment in terms of a regulatory framework. The proposed new government Bond Law, to be issued in 1995, and the recently issued regulations on futures trading in bonds are welcome steps in this direction. Two major issues concerning the regulation of China's bond markets are raised here. The first concerns the extensive role of the government in the operation of the markets. First of all, access to the bond market in China is restricted in several ways. (i) The State Council, through the SPC, regulates the volume of securities issued and their terms, by setting annual limits on the amount of bond (and share) issues, and the maximum interest that can be paid on corporate bonds. (ii) Access to overseas issues or listings of bonds by individual enterprises is also defacto restricted, to one of the approved banks or major TICS. (iii) The local government of the province in which a company is located must approve companies for public offering of bonds (or equities), and additionally, local SPC approval is also required for bond issues.

A second key area of concern in the regulatory structure for bond markets in China today is the fragmentation of oversight, both functionally, for different segments of the securities markets, (and for different parts of the market for each security, ie, primary and secondary markets), and regionally, between central and regional authorities. The CSRC and SCSC are the principal central authorities. The PBC's role in securities regulation is largely effected through its branch offices. Additionally, the MOF has begun to assume a role in this area, and regional governments have powerful bodies of securities legislation.

Thus, (i) in primary markets, the fragmentation of authority is the outcome of the historical variety of bond issues by different government departments. Although there is now some move towards a consolidation of these issues, the oversight still remains fragmented. (ii) In secondary markets, the PBC remains responsible for overseeing trading activities of bonds (except bond futures, which are now under the CSRC). In practice, the CSRC and local governments also remain involved, as regulators of the exchanges on which the securities are traded. (iii) With regard to regulations concerning bond market dealers and their activities, the split in responsibilities is the most evident. Although the PBC no longer has a major role in the supervision of equity markets, it has retained responsibility for the licensing 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 report to the SCSC. One recently introduced exception is the licensing of bonds futures dealers, which is now under the MOF and the CSRC. However, this requirement does not apply to securities firms which exclusively trade treasury bonds since they are supervised by the MOF who has apparently said that the PBC's approval is not necessary. This means that the role of licensing intermediaries and the on-going supervision of dealers is split between the PBC and the SCSCICSRC. The PBC remains responsible for all bond trading activities, including financial futures on T Bills, and the supervision of mutual funds. Unlike the CSRC, the PBC has a regional presence, through its branch offices. In the future, efficient supervision of China's bond markets will require a clarification and consolidation of these functions.

RECOMMENDATIONS

First of all, the goveinment would have to determine whether it is prepared to launch upon reforms on a broad front, in terms of those features of the economic system that impede capital markets from performing efficiently: financial sector reforms which allow a greater role for the interest rate as a pricing mechanism; a reduced role to credit and investment plans for capital allocation, the transformation of banks into entities which lend on the basis of risk evaluations and creditworthiness of clients rather than their credit plan quotas, and reforms of state enterprise which permit them to face a real environment of risks and returns; ie, a 'binding budget constraint'. Such major decisions can perhaps not be taken solely on the basis of the future development of capital markets alone.

The question which clearly follows is, how, in the context of capital market development, are such changes to be implemented? It is recognized at the outset that abandoning the credit plan in the absence of indirect instruments of monetary control, or the simultaneous decontrol of all interest rates, will lead at least initially to chaotic conditions, and the more germane question therefore is, what are the next incremental steps that can be taken towards realizing these objectives? Three broad suggestions are proposed here, before interest rate deregulation, and reduced reliance on the credit plan, are embarked upon.

The government must better coordinate its monetary

and fiscal policy. If the government intends to exer-

be certain, in a deregulated environment, that the volume of debt sold will not cause interest rates to rise to levels which damage both the real economy and the developing capital market. So far, this has not been a problem, but as the volume of treasury debt outstanding escalates, it will be an increasingly important concern. In parallel, the government must establish better knowledge of its cash flow requirements, so that debt issues can be better coor- dinated with its spending requirements.

In terms of the banking sector, the speedy imple-

mentation of the separation of 'policy' and commercial lending is required, so that banks grow more aware of the need for risk management. In parallel, banks must begin to acquire the capacity to manage interest rate risk, and also attend to the current mis- match between their assets and liabilities.

Turning to interest rates, deregulation could begin in

the areas which most affect primary markets; short term rates and money market rates. Liberalizing interest rates in these areas would help establish a better defined short term yield curve and thus help the pricing of new short and medium term government securities issues.

Second, turning to securities markets themselves, the most important area for attention, where the greatest problems lie, is the primary market. In the bond market, the government could consider the following:

clearly distinguish between wholesale and retail investors, and increase the relative emphasis on the former category. Focus on a wholesale investor base will permit the offer period to be reduced, and will permit the eventual adoption of an auction system. The present distribution system, parcel sizes and title transfer systems are poorly suited to a wholesale market, or to the development of a liquid secondary market. An effort can be made to gauge wholesale investors'

demands for bonds, and their preferences in maturities. Bonds could then be targeted for sale to this group,

and retail investors should be treated separately. To achieve this, the government would need to have

a preannounced issue calendar for the year for its debt issues, for its longer term financing requirements, spread over the year, to improve liquidity management at the level of the wholesale buyers,

and assist the development of benchmark issues.

The government, or the central bank, can also issue short term bills for liquidity management purposes. Electronic registration and transfer of title can be

adopted a s the standard for wholesale issues. The yield at issue could be related to current sec-

ondary market yields, rather than to deposit rates.

All bond issues for wholesale investors could be

tradable. Any remaining administrative placement of bonds

would need to be eliminated.

For retail investors, an on-demand savings bond type issue should be designed, which would have the effect of spreading retail sales over the year. The interest rate

offered could be altered to stimulate or dampen retail demand. Since such issues will be difficult to trade

because of the variety of maturity dates, it should be

possible to redeem them early at a penalty. For corpo-

rate bonds, the determination of capacity to issue is

based more on evaluations from credit rating agencies than quota-driven decisions by local authorities.

The third area for action is secondary market development. Many of the problems here stem from underlying primary market problems. In the bond market, the

problem of poor liquidity impedes price discovery and is reflected in the ill-defined present yield curve. China

has still to develop a benchmark issue to enable more

efficient security pricing. These problems will be

assuaged by the measures recommended above, for the

primary market, especially: issues more evenly spaced out over the year, on a preannounced schedule, targeted primarily towards wholesale investors. Additionally (although detailed recommendations are beyond the scope of this study), constraints on the operation of the money market must be addressed.

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 recognition 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

this). (ii) The greatest challenge in this area lies in aug-

menting the sources of funds, through pension and social security reform, where the mobilization of funds

is limited, due to the prevalence of pay-as-you-go pen-

sion systems.

Fifth, regarding the participation of foreign investors in

China's securities markets, (i) China can afford to

encourage foreign portfolio equity investment today,

vis-k-vis foreign direct investment; and should reduce the fiscal incentive bias in favor of FDI. (ii) But present restrictions against foreign participation in the domes-

tic debt securities market need to be maintained, until the domestic bond market is considerably strengthened. (iii) In terms of China's participation in overseas

bond markets there is still scope for expansion. A greater variety of domestic firms could be permitted to

access this market.

Sixth, there is clearly a problem of the fragmentation of

functional oversight in the bond market. While the CSRC (and defacto the regional regulatory authorities) have oversight on trading activities at authorized exchanges, the PBC has the authority to supervize bond trading at these exchanges. Yet the CSRC supervises the trading activities of securities dealers, but again, only the PBC can grant them licenses, or revoke these 1 ~censes. '

Finally, another key legal issue to be addressed is the

clarification of the separation of bank and non-bank

activities. So far this appears to have been handled by administrative regulations under the PBC, but in view of the close institutional ties between deposit taking

institutions and securities dealers, as well as the rapid growth of the latter, a clarification and strengthening of these laws is required. This could be addressed through

the proposed (commercial) banking law.

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 FINANCIAL SECTOR

ecurities markets in China have evolved in tandem with the gradual but impressive deepening and diversification of the financial system.

Reform of the financial system began with the breakup of the monobank system in 1979, and the restoration of the Peoples's Bank of China to the role of a central

bank. Four large specialized banks' were carved out of the former monobank system, and around ten smaller universal banks have since been e s t a b l i ~ h e d . ~ Diversification in the last five years has taken the form

of accelerated growth of hundreds of new non-bank financial institutions; rural and urban credit cooperatives, trust and investment corporations, leasing companies, securities firms and insurance companies, many of whom are major participants in securities markets. Despite difficulties in its operation and regulation, the rapid growth of an interbank market has also contributed to the development of an integrated nation-

al financial market. Financial deepening accompanied

institutional change and the ratio of financial assets to GDP grew from 127 percent in 1987 to 170 percent in 1993.

China today is making efforts to accord a greater role to financial markets for resource allocation, and move away from the central allocation of credit. Yet at present the credit plan remains the primary vehicle for resource allocation. Rapid financial innovation has eroded the effectiveness of older instruments, but new instruments and institutions are as yet not sufficiently developed to ensure the stability of the macroeconomy. This has led to periodic cycles of liberalizing reform followed by partial reversions to old instruments and market con- traction. It has also led to the imposition of conflicting government objectives on financial institutions. Thus the central bank (People's Bank of China, or PBC) has

been assigned the dual roles of carrying out monetary

policy to control aggregate demand, as well a s the quasi-fiscal function of channelling credit in accor-

dance with national priorities, or so called 'policy-lending'. While theoretically endowed with the ability to undertake monetary policy through the use of indirect instruments such as the interest rate, reserve requirements and a discounting facility, its use of such instruments has been restricted as its capacity to make independent decisions has been limited. Approval from the State Council has been required for most decisions, including interest rate adjustment. The role of the interest rate mechanism is rnarginal a s adjustments are infrequent and relatively small. The ability of the PBC to control money creation has been hampered by the rapid growth of the relatively unregulated interbank market, and transfers of funds out of the banking sector to nonbank financial institutions (often for the purpose of participation in securities markets) via the illicit participation of the latter in the interbank market. With the

recent passage of a Central Bank law (March 1995), the

role of the central bank is expected to be strengthened.

Specialized banks continue to dominate China's finan-

cial system, and have undertaken the implementation of policy lending. PBC refinancing of these credits has expanded the specialized banks' lending ability. In 1994 however PBC has shown remarkable control in limiting relending to commercial and specialized banks. Policy lending has also implied that a large part

of specialized banks' total lending is directed towards loss-making state owned enterprises (SOEs), with adverse implications for portfolio quality and commercial orientation. Bad debts are estimated at around 15 to 2 0 percent and provisioning levels are insignificant. In 1994, the government announced major changes to support the 'commercialization' of banks by separating policy lending and comrnercial lending; transferring the former to three newly-created development banks;

the State Development Bank of China (SDBC), the

Export-Import Bank and the Agricultural Development Bank of China.

The role of capital markets in China's financial sector

is small relative to the banking system, but has been growing. Total assets of non-monetary financial institutions grew from 6 percent in 1989 to a high of 8 percent

in 1992, of the financial sector's assets, declining once again to 5 percent by 1994. The pattern reflects the growth of enthusiasm for securities with the legalization 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

Appendix Table A l . l ) .

There are nevertheless strong institutional links

between the real sector, the banking system, and capital markets, provided by members of the large group of

'non-bank financial institutions' (or non-monetary

financial institutions, according to the new PBC definition). NBFIs include a variety of Trust and Investment Corporations (TICs) finance companies, leasing companies, as well a s insurance companies and securities dealers. Not all these institutions participate in the cap-

ital market, but a number of large securities dealers come from the ranks of the TICs. Moreover, many of the TICs, and most of the largest securities dealers, were set up as wholly or partially owned subsidiaries of China's specialized or cornmercial banks. Several were bank departments and were spun off as independent companies as their operations grew. China's urban credit cooperatives are also participants in securities markets. Of the 80 UCCs in Shanghai at the end of 1993, 2 6 were registered brokers of the Shanghai Securities exchange, 58 were dealers in state bonds, and 2 3 were involved in the insurance business as pol-

icy agents. TICs and securities companies can under-

take a range of capital markpt L l L ; i ~ n s ; brokerage, dealing on their own account, and underwriting securities issues. Banks have also participated directly in certain capital market activities, acting as 'underwriters', since 1992, for the issue of government bonds by certificate. Bank branches have been used as the vehicles for distribution to retail investors.

Figure I . I Securities Markets in China's Financial Sector (Y billion)

Scurtbs oulrtandhg

~curtbr (annul beus)

Note: Securi1ie.i oulslanding d n ~ a for 1994 are estimales. Source: World Bank and IMF &la.

At present, administrative regulations of the PBC effectively prevent easy transfers of funds (apart from the

initial equity) from parent to subsidiary, borrowing from the parent company, or maintaining close manageria1 ties. While the 'firewalls' appear to be fairly effective so

far, it is disquieting that they take the form of administrative regulations rather than law. A draft law on commercial banking was prepared by the authorities in 1994, but it made little reference to the issue of banks and their subsidiaries operating in securities markets. Supervision is clearly an issue.

The principal vehicle for the transfer of funds between banks and NBFls3 appears to have been the interbank market. China's interbank market has permitted the participation of banks as well as NBFIs.~ The principal instruments on the interbank market are short term

loans, although since 1992, a growing repurchase

agreement (repo) market is emerging. Although loans

on the interbank market are intended to be strictly short

tenn, for liquidity management purposes, short term loans have tended repeatedly to become long term, through 'roll-over' agreements, which the PBC periodically attempts to curtail. NBFI participation on the interbank market was virtually unrestrained prior to the 16-point program of 1993 but has since been sharply

curtailed.

FISCAL MANAGEMENT AND THE BOND MARKET

When China first resumed the issue of domestic debt in 1981, the primary purpose was to finance the budget deficit of the central government. In 1994, the objec- tive of issuing government debt to finance the budget deficit took on new significance, due to the decisions to (i) cease to resort to deficit financing through loans from the central bank; and (ii) gradually transfer subsi-

dies to state enterprises, hitherto funneled largely through commercial bank lending, to the budget. The

threefold increase of new issues of treasury bonds in 1994 over the previous year, to Y 113.2 billion, is particularly large in view of the fact that the total stock of outstanding treasury bonds at the end of 1993 amounted to only Y 167 billion. New issues planned for 1995 are estimated to be Y 150 billion.

Figure I .2 Central Government Budgetary Deficit and Treasury Bond Issues

o VisbleDeficii 0 Net treasury band i s m D Net issues of treasury bills 0 Overseas Bond Issues

Source: World Bunk and IMF d a a .

Historically, as Figure 1.2 suggests, the contribution of bond issues to the financing of the budget deficit has

not been very large. Measurement difficulties preclude

a precise measure of the proportion of treasury bond

issues used for this purpose, especially as in earlier years, bonds were frequently eannarked by purpose, and linked to construction projects or 'key investment'

projects. A broad comparison of orders of magnitude is presented here (details of definitions and data used are in Appendix Table A1.2). Looking first at the visible budget deficit, net issues of treasury bonds (gross new issues less annual redemptions) have had a highly vari- able volume, relative to the size of the overall deficit;

over 50 percent as early as 1988 and 1989, when net annual issues were Y 1 7 and 21 billion respectively. In 1990 and 1992, the relative size of bond issues fell to around a third. But in 1994, the estimated end-of-year visible deficit was Y 8 5 billion, and (gross) new issues of treasury bonds amounted to Y 113.2 billion; or around 133 percent of the current year's deficit.

Taking account of quasi-fiscal operations of transfers to state enterprises, which should in a conventional accounting framework be financed through the budget,

but which have instead been financed through PBC lending to the banking system, we can estimate the consolidated central governnient budget deficit. If, at a lower bound, 6 0 percent of PBC lending to the banking sector is estimated to cover the financing of 'policy loans', the (consolidated) deficit increases, and the size of annual treasury bond issues compared to the (consolidated) deficit consequently falls. The annual volume of net treasury bonds issued over 1989 to 1993 has varied between 11 and 2 3 percent of the consolidated

deficit, while the annual volume of treasury bills alone has varied between 5 and 2 3 percent of the consolidated 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 government made a comeback in overseas bond markets in 1993, with issues of around US8600 million (Y 3.4 billion), and a huge increase in 1994, with issues of USg1.6 billion (Y 13.6 billion). If these are added to the measures of the relative size of government bond issues and the budget deficit, the role of securities markets increases; to around 38 percent in 1993 (33 percent from domestic bond issues, and another 5 percent from overseas issues).

BOND FINANCING O F R E A L SECTOR Chinese enterprises have also approached the interna- INVESTMENT tional bond markets for resources. Although direct

The contribution of bond markets, and securities markets in general, to the investment needs of the real sectors of the economy, so far has clearly been small (Appendix Table A1.3 and summarized in Figure 1 .3).4 Looking at treasury bond issues alone, the volume of issues, relative to the volume of investments, was 5 percent in 1987, increasing to 9 percent in 1989, and fluc- 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 corporations), the upper limit for both categories rises to 10 percent over the period 1987 to 1992.

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 sector investment shows a discernible upward trend between 1987 Gust after they were first permitted), when their contribution was only 1 percent, rising steadily to 11 percent of total SOU investment by 1992. Adding all categories, the maximum possible contribution of debt securities to investment finance grew from 8 percent in 1987 to 2 1 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

800 r

@ Equity issues Treasury bonds lssues

Enterprise bond issues Total lnvestment in State Owned Units a lnvestment bond issues

access of individual firms to these markets has been allegedly relaxed, in practice, the bulk of foreign bond issues takes place through the 'windows'; large TICS, and certain banks, which have been allowed access to the overseas bond markets by the SAEC.5

Figure 1.4 Share of Bonds in China's Overseas Borrowing

Committment Bonds

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 China have taken the form of foreign direct investment. Portfolio equity only constituted 5.5 percent of aggregate net resource flows to China in 1993, and bonds

Source: Stat? PLanning Commission and Slale Council Securities accounted for only 2.7 percent of new borrowing corn- Commit~re. mitments in 1993.

The key factor to bear in mind, regarding the contribu-

tion of capital markets to resource inflows to the real sectors of the economy is that at least at present, this contribution is controlled by the government, and

embedded within the mechanisms of the investment and credit plans. Thus quotas are determined for the

issue of domestic debt and equity securities, as well as for overseas bond issues, by a combination of the SPC, PBC, and in the case of overseas issues, the SAEC. Thus the extent to which the capital markets contribute is largely determined by the extent to which the government permits them to contribute, and the issuers of securities are determined by the distribution of quotas for each of these heads by the central and regional offices of the authorities cited.

ISSUES TO BE EXAMINED

China first resumed the issue of domestic securities in 1981, shortly after the launching of its economic reform program, after a twenty year hiatus. The motivation at

the time was the emergence of a budget deficit, and the need to raise financing for the deficit. Accordingly, treasury bond issues were introduced, essentially as a vehicle for purpose of government resource mobilization. Early bond issues bore a strong resemblance to taxes; subscription to bonds was obligatory, and quotas

for bond placement had to be fulfilled by enterprise and by administrative district, in parallel to tax contracts under the fiscal contracting system. Bonds were non- negotiable and non-transferable.

Today, fifteen years later, the capital market in China is still viewed essentially as a vehicle for resource mobilization. The bulk of bond issues are still administratively placed, and are non-tradable. But while the

mobilization of resources is one of the functions of a capital market in a market economy, capital markets also have other functions: aiding the efficient allocation of resources, by increasing the transparency of pricing, of risks and returns, and assisting investors with risk- management. The function of resource mobilization is

in fact subordinated to the effective channeling of large

volumes of resources, which can be mobilized by a vari-

ety of means, to specific ends, and in short periods of time. The central question to be examined in the present study is, to what extent do China's bond markets contribute to these manifold functions of efficient

resource allocation, efficient risk and return pricing, and risk management, and how can their efficiency be enhanced? How can bond markets help allocate resources efficiently to the real sector, and how can it help establish the efficient pricing of risks and returns across different investment alternatives?

Of great concern to the authorities today is the question of the extent to which the government can successfully implement its proposed major reforms of eliminating reliance on PBC borrowing for the financing of its deficit, and at the same time, reducing quasi-fiscal

operations and transferring 'policy lending' to the budget. If these aims are to be realized, it is critical that

the government secures stable and additional sources of financing, and in this context, the report explores the extent to which the bond market can be developed to provide financing for the government. The extent to which securities markets can provide support for the adoption of indirect instruments of monetary control, although highly relevant, is however omitted from the

scope of the present study, apart from an investigation of the extent to which the bond market can presently provide support to this process through the establishment of a benchmark issues which would assist the process of pricing of government securities issues. The issues investigated are, to what extent do current difficulties in the development of China's bond market stem from factors related to the primary issue process (issue size, pricing, placement methods, timing) and to what

extent are problems observed in the operation of secondary markets. Markets for debt securities (although currently dominated by government issues in China) are also important for providing appropriate leverage for enterprise financing, and the constraints on the 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 G R O W T H OF THE DOMESTIC Early government bond issues were essentially a rev- PRIMARY B O N D 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 1 7 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 1 percent in 1981 to 9 percent in 1993. The pace 1987, initially by the state investment corporations of growth continued to escalate, and between 1993 and ('key enterprise bonds' and 'capital construction 1994 annual debt securities issues nearly trebled, from bonds'), banks ('financial bonds'), some non-bank Y 38 billion to Y 113 billion of new treasury bills. New financial institutions ('trust income securities' and issues of Y 150 billion 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 98 1 - 1993)

Debt Securities YlOOm

Equities

Y 100m

I Redemption p z q 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: B o n d Issues Resume, a s a pa r t of t h e State Credit P lan

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)ill issued 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 (1 993). Spencer (1 994). IMF (1 991, 1994), Zhang (1994). Rowles & White (1 992). SEEC (1 995).

and financial bonds, issued by banks, is illustrated in

Figure 2.2. The growth in the supply of this non-government paper reflected (i) the increased liquidity of capital markets from 1990 and therefore the increased likelihood of using debt issues as financing instruments; (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 homogenous. Other treasury issues consisted principally of securities earmarked for specific budgetary purposes, broadly following the compartmentalization of fund flows under the credit plan, rather than any significant

difference in the issue terms.' In some cases the compartmentalization was based on the target market to be 'taxed' with the bond issue, rather than the end use.3

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 permitted in many bond types, markets have remained

thin, due to segmentation. The government is aware of some of the drawbacks of the large variety of issues, and in recent years, there has been a trend towards reduc-

ing their variety, and placing more emphasis on trea-

sury bills. This trend should be encouraged. Greater 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 budgetary financing purposes, as well as a number of treasury bonds earmarked for special purposes. Rather like budgetary line items, treasury bond issues were often targeted to specific investments, and earmarked by use. Thus, 'construction bonds' were used for the financing of infrastructure, and 'key national construction bonds'

Figure 2.2 Outstanding Debt Composition Disaggrevated

lMX)I Government Bonds

lPBl 1981 1W IW 1% 1% 1687 lSe0 IPW lSa, IWI IW2 IW3

Inflation-pmof Bond 8;;i:'i:i;i Fiscal Bonds

Special National Bonds Tbills

Construction Bonds

Corporate Debt

1981 1982 198) 1% 1985 1986 1981 1988 1989 1990 1991 1992

State Enterpr~se Bonds Short Term Paper

Inter-enterprise debt rn Local Enterprise Bonds

Financial Debt

.......... .......... I Investment Fund Bonds ijj ....... CDs

I Trust Income Securities I Finance Bonds

Source: Dala provided by the Slate Council Securities Cornmillee.

were earmarked for a handful of projects deemed to be

of national importance. Alternatively they were classified by the 'tax base' on which they were administered,

and thus 'fiscal bonds' were bonds which were placed at banks, which were then prohibited from trading them, effectively 'taxing' the banking system. Bonds

issued on a similar mandatory basis to enterprises or contractual savings institutions were known as 'special national bonds'; these were merged with fiscal bonds in

1992. Bonds which were index-linked to inflation, which were first issued in 1989, were initally earmarked as a separate category of 'inflation-proof'

bonds, but from 1990, the distinction in nomenclature between these and other treasury bill issues was dropped. The market for derivative financial instruments began in late 1992, with the listing of selected treasury bond futures, and the beginning of trade in repurchase agree-

ments. It was not until December 1993 that a market in these instruments seriously began to develop.

ISSUE METHOD

Treasury Bills Methods used to issue government debt have evolved over the past decade, reflecting attempts to move away from administered placement, towards more market- based methods. The degree of success achieved so far, expressed in terms of total debt issued, is still limited.

Initially, all debt was placed administratively, and on a

mandatory basis. Quotas were assigned by the Ministry of Finance (not markedly different from tax 'contracts') to financial departments of provincial and local governments, and at the local level, quotas were distributed

among production units. These units in turn frequently 'levied' bonds on workers, as an automatic deduction from wages.

Limits to the government's ability to force bonds on workers became apparent with the appearance of an

illegal secondary market in bonds. As part of its attempts to tailor bond issues to voluntarily held instruments, the Ministry of Finance adopted an underwriting

syndicate to launch a bond issue for the first time on an experimental basis in 1991. The syndicate was entrust-

ed with the issue of Y 2.5 billion, out of a total of Y 19.9 billion of the treasury bond quota issue for that year. A private agency, the Securities Exchange Executive Council (SEEC), acted as coordinator of the undeiwrit- ing, which involved 58 financial ins t i tu t ions .Vhe underwriters received a commission of 0.15 percent of the underwritten amount and sold the bonds on a vol-

untary basis to client^.^ Underwriting was used again in

1992, to distribute Y 3.6 billion of treasury bills in combination with the traditional administrative allocation for the balance (Y 36.7 billion) of the years issue.

Although this represented a larger absolute sum than the previous year, it represented a smaller proportion of

total issues (9.7 percent, versus 12.5 percent in 1991). The relative success of underwriting at the time can be partly attributed to the relatively attractive (fixed)

coupon offered on bond issues, compared to other available forms of investments.

In the following year, 1993, underwriting failed to sell the desired quantity of treasury bills, due to competition from the booming equity and property markets and

higher (unauthorized) returns on enterprise debt. The government reverted to mandatory administrative allocation; localities which did not meet their quota were

severely discouraged from both issuing their own debt and from listing companies from their region on the

stock exchanges. The government nevertheless made an effort to improve bond distribution and accordingly, nineteen financial institutions were appointed as pri-

mary dealers. In return for underwriting a certain volume of debt, primary dealers were entitled to receive privileges in kind, allowing them priority in bringing

equity offerings to market. The selection of primary dealers was based upon guidelines which included capital adequacy and past performance, in terms of the

previous year's trading volume on the primary and secondary market. In principle, primary dealers have an

obligation to act as market makers, but this function does not appear to have been exercised in practice."

With some revival in the bond market in 1994,' the

government ventured to experiment with four different methods of issue for treasury bills, representing a com-

promise between those who desired more market-ori- ented issuing procedures and those who doubted the

effectiveness of the underwriting system in China. (i)

Thirteen billion yuan of six month and one year paperless treasury bills were issued via underwriting agreements. The underwriters (many of whom were designat-

ed primary dealers) were given a week to place the debt, after which it was listed on the Shanghai stock

exchange. (ii) Twenty eight billion yuan of two year bearer treasury bills were sold via local financial departments, which applied for allocations.' The balance of the year's planned issue then becoming available for distribution via other channels. The local finance departments signed 'underwriting agreements' with financial institutions at the local level, which then

Types of Debt Securities on 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 construction and 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 15 years maturity. Can be pledged.

(b) Capital Con.~truction Bonds 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 Enterprise Bonds 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 ownership of 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-enterprise Bonds Issued by enterprises to their employees to tackle short term liquidity needs. Loosely regulated. (d) Housing Construction Bonds 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 (1 993). 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

part of the year's issue, Y 70 billion, three years maturity, was issued in the form of certificates, allocated by

PBC to the headquarters of the specialized banks which in turn allocated them to branches at various levels. The branches then sold the treasury bills locally to individuals and others. These certificates were

redeemable at the bank of issue after six months,

although their listing and trading was not permitted. This issue was the outcome of an intention to develop a purely retail debt i n ~ t r u m e n t . ~

Of the four distribution channels used in 1994 the Y 13.2 billion placed via underwriting is the furthest

removed from the old administered distribution channels. Under this system, underwriters were supposed to

compete for an allocation of treasury bills, through a three part bid covering: the amount to be underwritten, the speed at which funds received from the sale of treasury bills would be repatriated back to government and the underwriting fee. The institutions involved in this part of the issue (mostly TICsj have more recent origins than the specialized banks and the local finance departments, and the target market, for the first time, is wholesale (institutions) rather than retail (individuals). However, this still accounted for only 11.7 percent of

the year's issue; even less than the 9.7 percent placed by underwriting in 1991. The real difficulty is that mov-

ing away from administrative placement systems is difficult, within the framework of the credit plan, since the fulfillment of 'placement' quotas could no longer be assured. Another major difficulty with the transition is

the administered interest rate, and consequently bond coupon rate, which effectively removes a major plank of

price competition for underwriters or primary dealers. Third, for reasons discussed further below, institutional

buyers are not at present accustomed to government bond purchase. China is still a long distance from more

sophisticated bond issue techniques, such as auctions.

Enterprise Bonds and Short Term Bills Approval to issue bonds is given to local state enterprises by the local State Planning Council and the local PBC, within the quota allocated to the locality by the credit plan. The aggregate volume of enterprise bond issues (permitted only to SOEs) is nominally supervised by the PBC head office. Central regulation of the quantity of local bond issues has not always been successful and the issue quantity has occasionally been larger than the aggregate quota, due to local govern-

bonds in response to-liquidity conditions. On past occa- sions when enterprise bond issues have appeared to

threaten bank deposits, or the banks' ability to meet

lending quotas, the PBC has clamped down on enterprise bond issues. The allocation of the quota between companies is based on a combination of financial and (de facto) political criteria. While an acceptable rating by a credit rating agency is required, the priorities of industrial policy are given greater weight in practice.

ISSUE SIZE, FREQUENCY AND ISSUE P E R I O D

Another drawback of the primary issue process for gov-

ernment securities is that treasury bills typically have

been offered in a small number of issues, in the first half of the year, rather than in several offerings spread over the year. Sales have been made on what is effectively a tap basis over a period which typically takes several months. The sale of paperless treasury bills aimed at wholesale investors in 1994 was an innovation which permitted a much shorter issue period. Thus in 1994, the two paperless issues took less than a week each (the six month paperless issue was placed between January 25 and January 31, and the one year paperless issue was placed between February 1 and 3).

But the two year bearer issue took two months to place (1 April to 31 May) and the three year treasury bill certificate took longer still; from 1 April to 30 July, or four

months altogether. For the paperless issues, the under-

writers were required to sell the bills within a specified issue period, at the end of which funds for bills sold, together with any unsold subscriptions, had to be remitted to the Ministry of Finance. The issues were then declared tradable with immediate effect. By contrast, for the two and three year treasury bills with the

long issue period sales proceeds were remitted to the Ministry of Finance's account at the PBC by each

underwriter, according to the terms of their individual underwriting agreements, rather than on a daily basis. The final payment occurred after the close of the issue period. The retail investor base to which most issues are targeted and the long distribution channels for this prolong the placement time and reinforce the tendency towards large issues spread out over a few months.

The current practice has several undesirable implications. First, in the absence of regular maintenance of sufficient a volume of short term debt on issue, the development of a liquid secondary market is not possible. 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 regular supply of debt of any maturity to the market

implies that there is no 'current' issue to provide a 'benchmark', either long or short term.. Third, since issues are made in the first half of the year, there is lit-

tle scope for synchronizing the timing of the sales with the State's cash flow requirements.'' This raises the cost of funds to the government.'' Fourth, investors

cannot plan orderly acquisitions of new issues over the year in line with their cash flows. A one-off issue peri-

od puts considerable strain on the liquidity management and risk management capabilities of banks and institutions. In a market economy such an issue pattern would limit the number of bidders and cause a liquidity squeeze, both of which would operate to raise interest rates and the government's cost of funds.

On account of these reasons, it would be more desirable for the government (Ministry of Finance) to (i)

announce a schedule for the year's issue of longer term debt, based on the government's term financing need, spread throughout the year; and in parallel, (ii) undertake regular issues of shorter term debt (one to twelve months maturity) to meet short term liquidity needs.

(iii) In addition, the central bank (PBC) should issue

short term paper as required, to meet short term liq-

uidity management needs.

Challenges for China in MovingTowards a Debt Management Program for a Market Economy

First, the pattern of the governments cash ilows over the year would need to be determined with sufficient accuracy.

Second, the government should differenciate between retail and wholesale investors. Continued reliance on retail investors will necessitate prolonged issue periods due to the administrative burden of handling small sums or money. If the government continues to rely on a retail investor base, it should design a tap issue available throughout the year, and adjust the interest rate on this issue periodically according to not only deposit rates, but also, governments' desire to attract runtls.

Third, to meet the estimated demand of the institutions which form the wholesale market, scripless treasury bill issues should be made according to a preannounced calendar at intervals throughout the year. As these institutions develop increasing emphasis should he placed on the wholesale market.

When the government first resumed debt issue in the early 1980s, the maturity of government debt issues

reflected, exclusively, government needs. This was possible due to the administered placement mechanism adopted By the late 1980s the authorities were forced

to acknowledge investor discontent, expressed by the emergence of secondary markets where government

debt traded at large discounts. In response, the government was obliged to progressively shorten maturities on treasury bills from ten to five, and then to three years.

The 1994 treasury bill issue included six month and one year maturities for the first time, tailored to meet the needs of banks and wholesale investors for the bal- ancing of short term assets and liabilities. This demon- strates that while the market is still far from fully investor responsive, the authorities are now more con-

scious of investor preferences and the advantages of taking them into account when structuring an offering.

There is still a need to widen the range of maturities offered to satisfy a wider range of investor preferences.

On the shorter end, extending the range of short term maturities to include 3 0 and 9 0 day paper and increas-

ing the volume of short term offerings would assist financial institutions with liquidity management and encourage the development of a short term yield curve. Financial institutions in China are beginning to grow

aware of the need for, and advantages of, liquidity management, especially as new options for investment develop. On the longer end, in view of the central and

local governments accelerating need for financing infrastructure investment, there would certainly be an interest on the part of these authorities in the issue of

long maturity bonds. However, from the perspective of the investor, there is a lack of enthusiasm for debt of

long maturity today due to a number of reasons: (i) the lack of payment of coupons, and the long intervals to redemption;" (ii) high and uncertain rates of inflation,

which make the real value of the redemption amount difficult to predict, and usually (in the experience over the last few years) less attractive than the nominal value, (iii) due to the low incidence of default on most forms of investment within the framework of a planned economy, investor perception of, and allowances for, risks, are low. Consequently, the local markets focus on 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

implication is that even if the government were to issue bonds of longer maturities today, it would find these difficult to sell, and would have to resort again to admin-

istrative placement.

THE INVESTOR BASE F O R PRIMARY SALES

Historically and currently the major target market of debt sales is individuals. This stands in contrast to

developed debt markets where the major target market of primary issues consists of wholesale investors such as banks, insurance companies and mutual funds. Table 2.1 gives estimated figures for the division of government debt sales between individuals and enterprises. The data cover a range of different government debt types including treasury bills, construction bonds and fiscal bonds.I3

Table 2.1 Government Debt Purchases: Households and Non-Households

Year Households (Y billion)

1982 2 .O 1983 2.1 1984 2.2 1985 3.8 1986 4.0 1987 4.5 1988 5.6 1989 18.1 1990 9.3 1991 19.9 1992 33.9 1993 30.0 1994 98.0

Enterprises & Households Institutions

(%) (Y billion)

45.5 2.4 50.0 2.1 52.4 2.0 63.3 2.2 63.5 2.3 38.5 7.2 30.0 13.2 80.8 4.3 47.4 10.3 71.0 8.1 78.0 9.3 78.5 8.2 86.6 15.2

Enterprises (%)

54.5 50.5 47.6 36.7 36.5 61.5 70.0 19.2 52.6 29.0 22.0 21.5 13.4

Source: Minurry of Finance and SEEC.

The table shows that there is no systematic trend reduction in the proportion of debt issued to households, over time. Indeed, ratios for household purchases are high in the 1990s. The Y 13 billion paperless issue in 1994 was the first attempt to explicitly target wholesale buyers via voluntary treasury bill sales. Prior to 1993, the PBC did not permit banks to hold Government securities except those issued to them on a mandatory basis. Pension funds and insurance companies have also been encouraged to hold treasury bills since late 1993.

Institutional Investors and China's Securities Markets The absence of professional investors in China is notable even relative to other emerging market economies. A first difficulty concerning the participation of institutions for contractual savings in the securities market in China, is that such participation has been limited by restrictive regulations. Such institutions have been obliged to invest their resources primarily in

bank deposits and some non-tradable government securities (sometimes at a lower rate than that offered to retail investors), which have often paid low or some-

times negative rates of returns. Aware of the conse- quences of such restrictions, the government is considering the gradual lifting of these constraints, with appropriate safeguards against speculative investments that may lead to large-scale losses for individual savers. Yet China's contractual savings institutions today also face a second serious handicap; the problem of low relative levels of contractual savings, of only three percent of GDE 'This is an apparent anomaly in a country with

a record high savings rate: 40 percent of GDE Yet contractual savings as a proportion of GDP in China are much lower than other developing East Asian coun-

tries, such as Korea (18 percent), Malaysia (48 percent) or Singapore (78 percent). A primary reason is that under the system of central planning, the state assumed the functions of providing pensions, housing and social security primarily through state enterprises. Services such as domestic insurance were not permitted. With the transition towards a market economy, China today has to face the problem of how to build up such institutions

The insurance industry is growing rapidly but is domi-

nated by a single large state-owned company. It is still structurally biased towards non-life insurance, which provides relatively shorter term funds for investment,

compared to life insurance. While both the life and non-life business appear relatively well managed, the restrictions on investment, lack of profitable financial investment opportunities, in the face of the relatively high inflation rate, lower the real financial performance of PICC. Yet, the insurance industry is better poised today to potentially contribute investible funds to China's capital markets in the medium term than pension funds. These may take time to emerge as a reform of the current unfunded pension system and reduction of its high contribution rates may first have to be undertaken and such a reform program is unlikely to be implemented in the short-run. While the difficulties of

China's pension system are sometimes attributed to its

enterprise-based nature, the real drawbacks of the system lie on the complete reliance on pay-as-you-go schemes. Today pension funds have negligible accumulated balances to invest in capital markets, and the building up of these balances through pension reform must occur before their serious participation in capital markets can begin. Meanwhile, other contractual savings funds are beginning to take shape but are still very small. Housing funds are effectively still forced saving

schemes with very low real returns and with little incentive to attract investors' funds. Prospects for mutual funds have been constricted by the lack of an appropriate supervisory framework, and ad hoc changes in the regulations they face, reflecting the government's concerns about their possible effect on diversion of bank deposits.

The PBC has recently begun to encourage institutions

to hold treasury bills as it is examining its ability to control bank liquidity via secondary market treasury bill transactions. The PBC's interest in open market operations stems from a recognition that control of monetary and credit conditions via the credit plan is increasingly impractical. But before secondary market

treasury bill transactions can be used as a policy tool, the relevant institutions must hold a stock of treasury bills and a liquid secondary market needs to exist.

ISSUE PRICE AND COUPON

Government bonds are issued at par and the majority carry a predetermined coupon. There is no auction process to determine the yield in the primary market. Coupons are administratively set at a margin above deposit rates of comparable maturity, without reference to the secondary market yield on issues of comparable maturity. The lack of reference to secondary market yields reflects the administratively determined interest rate structure, and the role that debt issues continue to play in the Credit Plan.

Most government issues of three years or more in maturity, since 1992, have had a coupon related to the inflation rate; the 1992 three and five year bills; the 1994 three year issue of treasury bills in certificate form, and more recently, the proposed five year issue of Y 100 billion for 1995 Only two treasury bills pay an annual coupon; the five year 1993 issue and the scripless issue of 1994.14 All other bonds pay a redemption amount consisting of principal plus accumulated simple interest estimated on the basis of the coupon at issue. The

authorities may see some advantage in paying the

coupon in a lump at maturity as it makes it more likely that treasury bills will trade on the secondary market at a price above par. In a less sophisticated market this assists primary sales. Another explanation may be that since most bonds are held by individuals in the form of bearer certificates, there are no easy channels for coupon payment.

Table 2.2 compares coupon rates, comparable deposit

rates and YTM at issue for bond issues to 1993.'' The yield to maturity (YTM) at issue is less than the coupon rate. For example, a Y 100 bond with a 13 percent coupon rate and a two year maturity would pay Y 126 on maturity (before adding any inflation adjustment). This is equivalent to a YTM on a semi-annual basis of only 11.9 percent (before adding any adjustment). If the inflation adjustment were known in advance, its inclusion would widen the difference between the two yield calculations. Table 2.3 compares these rates and in addition comparable secondary market yields for the 1994 treasury bill issues. In 1994 both the two and

three year issues, aimed at retail investors, were issued at yields above those in the secondary market. The fact that they were sold at above secondary market yields

indicates that there are potential benefits to the government from targeting wholesale investors (who dominate secondary market trading) and from taking account of

secondary market rates. Had the two and three year issues been sold at secondary market yields the cost saving would have been in the region of Y 3 billion per

annum, not allowing for the inflation adjustment on the

three year issue. The most market responsive way to take account of market yields would be to sell the bonds

by auction.

Prior to 1992 the coupon on debt sold by mandatory

la cement to institutions was less than that on debt sold to individuals. This is illustrated in Table 2.4. All treasury bills have carried the same coupon regardless of

purchaser since 1992.

Some enterprise and financial bonds pay an annual coupon while others pay on maturity.16 The coupon on enterprise bonds is restricted to no more than 40 percent above the deposit rate.17 In addition the Ministry of Finance has imposed the restriction that the coupon should not exceed that on treasury bills in order to reduce competitive pressure on treasury bill sales. However, the restriction has been avoided by the use of fees and discounts. In practice corporate bond yields are two to three percentage points greater than treasury

bill yields at issue. The more attractive rate offered on Table 2.4 Comparison of Coupon on Treasury enterprise securities was one factor contributing to the Bills Sales by Purchaser: Households, failure of the voluntary placement of treasury bills in Enterprises, and Financial Institutions 1993. Until recentlv. entemrise bonds were ~art icular- , , ly competitive with treasury bills as default was not sig- Financial

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 R a ~ e (96)

Note: a 'Yield at issue' here implies the yield reestimated on a YTM baris. b Plw the injkion a&wtmeni at maurity. Sources: Zhang (1994). IMF (1991). World Bank staff calculaioru

Table 2.3 Comparison of Coupon and Deposit Rates, and Secondary Market Yielda

(At Time of Issue: 1994 Treasury Bill Issue)

Co~nparable Secondaq Retail

C o ~ ~ p o n at Yield Comparable Market Price Maturity Issue at issue Deposit Yield Index

Issue (years) (%) (%) Rate (%) (B) (%)

Notes: a Yield a issue restates the coupon on a yield to maturity bark. Comparable secondnry market yield is representaiue of the yield (YTM basis) of a bond of similar rnaurity on the Shanghui stock achunge during the primary issue period b The 1994(4) issue k inflat ion indaed and is nontraduble. The raes here are rates before in& adjustmeni. Source: Zhung 1994. Shanghai stock ezchange, World Bank staff calculations

Note: a Rae on Special State Bonh given for Enterprises Source: IMF (1 991)

TRADABILITY

Another feature of bond design in China is that much of it has been non-tradable by regulation.'' The tradability of government bonds is affected by the evolving nature of the debt issue process which has resulted in lack of homogeneity in the outstanding stock of treasury bills. Even in recent years the treasury bill issue has not been homogenous. The 1994 issue of Y 113 billion was the largest issue to date and represents 55 percent of the treasury bills outstanding at the end of 1994. However, a breakdown of the 1994 issue shows that the bulk of it is not tradable or is at least illiquid Fable 2.5). Trade in other issues, such as enterprise bonds, is often hindered by lack of issue volume for individual issues.

CREDIT RATING AGENCIES

The development of credit rating agencies has been encouraged since 1991. Rating companies must be approved by the PBC before they can publish their ratings. The PBC's headquarters have approved only two agencies so far, although some other agencies have been approved by PBC at a local level. In all, 82 credit rating agencies have been approved, about 30 of which operate at a national level.

Not all the rating agencies call themselves credit rating agencies; some are accounting firms and others are consultant firms. The ownership structure is also diverse, reflecting the variety of entry points into the

Table 2.5 Tradability of 1994 Treasury 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 is from an individual bank, which carries the responsibility for redeeming it, resulting in a diversity of

instruments. Large investors (Y 20m and above) have faeed delays in obtaining redemption. Source: Ministry of Finance.

new industry. Some regional rating companies are subsidiaries of the local PBC. Of the two credit rating companies in Shanghai, one is a subsidiary of the Shanghai Academy of Social Sciences and the other is a subsidiary of the Shanghai University Institute of Finance and Trade.

Rating agencies are used in the process of selecting the enterprises to be granted permission to issue bonds. At present their role is of marginal importance to the government and investors. In the debt issuing process rating agencies distinguish the poorly performing compa-

nies from those with an acceptable performance. However, among the acceptable companies the right to issue debt is not determined solely, or even primarily, on the basis of the rating agencies' assessment. The local PBC and SPC give weight to policy priorities. Investors do not place much weight on the rating agencies assessments because of a general excess supply of investible funds and because enterprises rarely fail due to state ownership. As long as socialized ownership cre- ates soft budget constraints on enterprises the risk assessment role of rating agencies will be marginalized.

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

spontaneously, through the emergence of large numbers of multiple illegal curb markets in

government paper, often at the doors of the PBC bureau charged with the task of administrative placement. Individuals would seek to sell their paper, at a discount, and use their increased liquidity for more attractive

investments, emerging elsewhere in the economy. Such trade was gradually legalized by the government, which began to see the difficulties of placing paper on unattractive terms. Bond maturities declined and coupon rates increased, relative to deposit rates, as issues were gradually tailored to public preferences. 'The develop-

ment of secondary markets was greatly boosted from 1990, with the establishment of official stock

exchanges, which could list bonds, and the onset of regionally interlinked electronic trading through the STAQS system. China began to experiment with the use of more market-based distribution systems through 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 permitted officially from December 1990, accelerated even

less than a tenth of securities on issue, the value of

trade in equities, by 1993, was five times as high as in debt (Figure 3.1, and Appendix Table A3.1).'

The secondary market for China's debt securities has therefore clearly improved immeasurably in recent years in terms of increased liquidity, greater geogaph-

ic price unity and more sophisticated trading. But in comparison to debt markets in other countries the market remains illiquid; liquidity is not sufficient to meet the transaction needs of larger participants, and uni- form pricing and trading practices across different exchanges and trading networks are still to be achieved.

The concept of a benchmark issue has not developed, and trading activity and pricing continue to be driven largely by the weight of liquidity available.

Figure 3.1 Secondary Markets in China's Securities

more rapidly. From Y 1.8 billion in 1990, it exceeded Y In Equities I 730 billion in three years, by the end of 1993. The volume of trade has been twenty five times as high as the Source: China State Securities Cornmit~ee and 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 Ministry of Finance. Financial and enterprise bonds are listed according to the requirements of the local trading center. The Shanghai stock exchange will list bonds provided the issue amount is greater than Y 100 million, the maturity is greater than two years and the credit rating is A+ or higher.

SECONDARY MARKET TRADING VOLUMES AND LIQUIDITY

The first aspect of secondary market efficiency examined here is the extent to which secondary markets have been able to achieve reasonable volumes of turnover, ie, the degree of market liquidity. As shown in Figure 3.2, annual treasury bill trading volume rose steeply from Y 10.5 billion in 1990 to a peak of Y 105 billion in 1992. Although individuals hold the majority of bonds, institutions account for the majority of trading. Trading volumes 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 without approval from headquarters. This restricted the diversion of credit to uses outside the credit plan. In late 1993 the PBC permitted banks and insurance companies 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 equity and real estate returns, and the new ability of banks to buy treasury bills directly, have stimulated the secondary bond market.

The improvement in market liquidity since 1987 is illustrated in Figure 3.3. Both as a percentage of debt stock outstanding and as a percentage of GDT: China's bond market liquidity rose markedly from negligible levels in 1987 to over 120 percent of outstanding stock and almost 6 percent of GDT: in 1992. The diagram also illustrates the fall-off in 1993.

Trade in Bond Futures In addition to the cash (spot) market in bonds, China has bond futures markets, and a market in repurchase agreements. Futures contracts based on treasury bills trade mainly on the Shanghai (since 1993) and Shenzhen (since 1994) stock exchanges.' Contracts are marked to market daily. The contract calls for physical delivery but the majority of contracts are closed out prior to settlement. Contracts are designed to hedge

interest rate fluctuations on the secondary bond market. The PBC publishes an inflation si;Ssidy each month which adjusts the interest rates on individual deposit accounts and the adjustment for inflation payable on most bonds of maturities of three or more years. Individuals have used the futures contract to speculate against the amount of the inflation top-up and the expectation of the top-up has a large influence on futures trading.Vhe apparent large increase in bond trading in early 1995 was virtually entirely driven by futures contracts, which also enhanced the liquidity of the underlying spot market (Table 3.1)."

Figure 3.2 China:TradingValue of Bonds

Annual Trading Value: All China ( 1 987-93)

'" r

• other Local Enterpr~se Bonds

Short Term Enterpr~se Debt TB~lls

Flnanclal Bonds

TradingValue: Shanghai Stock Exchange (1991-94)

Total . TBills

Sowe: Data ~rovided by the PBC, the State Council's Securities Committee, A l m a m of China> ~inQnre and Banking and the Shanghai Stock Exchange.

Figure 3.3 Ratios ofTradingVolume of Debt to Yet, relative to more mature bond markets, the degree Debt Stock and to GDP of liquidity is still poor. Treasury bills, relative to other

Percentage of Stock Outstanding

-Short term Enterprise Debt ."".Financial Bonds

Local Enterprise Bonds T B l l l s

Percentage of Nominal GDP r

T r a d i n g as a % of GDP

Source: Dala provided by the Stare Council Securifies Committee, World Bank.

Table 3.1 China: Spot and FuturesTrading of Bonds (Turnover,Y million)

T-Bond T-Bond T-Bond spot Repurchases Futures

Jan-94 993.8 91.6 2,528.4 Feb-94 1,461.3 3.1 360.2 Mar-94 2,551.0 0.7 2,780.9 Apr-94 2,660.6 35.9 11,305.1 May-94 3,463.5 311.9 20,827.8 Jun-94 2,936.5 855.8 64,643.5 Jul-94 3,136.4 562.4 101,026.9 Aug-94 6,375.6 425.5 121,141.4 Sep-94 4,512.1 384.0 123284.7 Oct-94 3,498.9 655.5 56,620.2 Nov-94 6,592.2 1,156.0 513,126.6 Dec-94 7,545.3 1,832.7 888,424.5 Jan-95 5,172.6 1,566.6 1,436,063.8

Source: Shanghai Securities Exchange: Monlhly Markel Staristics.

debt instruments, are the most liquid security, but even for these securities, while a bid and offer price is always available, large cash trades can take time to ~omplete .~ Other debt issues are much less liquid. Figure 3.4 compares the ratio of trading volume, as a percentage of GNC with more mature markets. Debt on issue as a percentage of GDP exceeded 13 percent in China, by 1992. But in the US and in Japan, debt stock as a percentage of GDP is on a different plane; 90 to 120 percent in the US, between 1987 and 1993, and 60 to 80 percent in Japan over the same period.

Comparing the traded volume of debt to outstanding stock, the results are similar, even if developing countries are included (Table 3.2).

Table 3.2 Ratio of Bond Trading Value to Stock Outstanding

China " 0.07 0.19 0.41 Japanb 4.56 4.98 Koreac 0.33 0.41 0.48 0.57 Indonesia 0.1

Noles: a All lypes of deb1 on issue. b Japan is reporled on a nel basis c Korea is reported on a gross basis.

Source: World Bank Asian Bond Markel ~ ~ u d y , Salomon Brolhers.

CAUSES OF THE LACK OF LIQUIDITY: (1) PRIMARY MARKET PRACTICES

A first group of the causes of the lack of liquidity stems from practices alluded to above, in the primary market, and are themselves a reflection of the uneasy coexis- tence of such markets with controls on the financial sector (such as the credit plan, and controlled interest rates), which are the legacy of planning. The impact of these primary market characteristics on secondary market liquidity is discussed below. First, the lack of homogeneity in the stock of debt reduces the amount of any one type of debt which is available to trade. Second, the focus on retail investors as the primary target market for debt issues reduces liquidity, because while households hold the majority of debt securities, they do not trade as much as instit~tions.~ Treasury bills are sold in small parcels of Y 100 to Y 1,000 to suit this market,

and securities firms have a major problem in accumu-

lating sufficient bonds from individuals to form a wholesale parcel. Third, the yield at issue is not related to secondary market yield. Due to linking the coupon

to deposit rates, and issuing at par, the YTM of a treasury bill at issue may be either above or below the secondary market yield. If the issue yield is below sec-

ondary market yields, the treasury bill sells, as the coupon is competitive by comparison with alternative

returns on deposits (for households) and loans (for banks). But an issue yield less than secondary market yield inhibits secondary market trading as investors are

reluctant to sell at a loss.

Figure 3.4 Ratios of Debt Stock Outstandimg to GDP: China to Other Countries

(Percentage of GDP)

China

-Total debt on Issue Total trading volume

Table 2.3 compared the coupon rate, effective yield at

issue, secondary market yield and deposit rates for the 1994 treasury bill issues. In each case the coupon was greater than deposit rates of comparable maturity. However the effective yield at issue was less than the secondary market yield for certain issues; (the 6 month and one year issues) and greater for others (the two and

three year issues). The 6 month issue sold well due to the demand for short term paper but the one year issue only sold with difficulty. This is not surprising given that the yield was nearly 700 basis points below the secondary market yield.

Fourth, the primary issue is not distributed over the year. The lack of a regular issue calendar inhibits liquidity in two ways. (i) Without a regular issue program, there cannot be a continual supply of short dated money market paper (maturity under a year) from which a short-end yield curve can develop. This inhibits money market development, reducing the supporting role the money market plays to the bond market. (ii) There are

no new issues to provide a 'trading' issue to act as a market benchmark. Typically as debt issues age, an

increasing proportion is held by end-holder investment portfolios rather than trading portfolios. Fifth, the limited range of maturities of primary issues also inhibits liquidity. The market is dominated by issues of original maturity of three to five years. There is a lack of money market paper to provide institutions with liquid

assets to match their short term liabilities and an absence of long term paper. A greater variety of maturi-

ties would stimulate trading by providing investors with

the opportunity to acquire assets of different maturities, ie, change the duration of their portfolios, as their view

of future risks changed. For example, an investor anticipating a rise in inflation would want to sell longer dated debt and buy shorter maturities. With an inade- quate range of maturities available such transactions will occur less frequently. The frequency of transactions for risk management purposes is also limited at present by the low level of development of treasury risk man-

agement functions in financial institutions.

Market participants are less likely to trade if they cannot easily agree on the price of a security. The method of coupon payment in China makes it difficult to accu-

rately price treasury bills in the secondary market. The first cause of uncertainty is the correct basis on which

1987 1988 1989 1990 1991 1992 1993 to quote bond yields: payment of accumulated simple - USA interest on maturity has led to bond prices being quoted on a current yield basis rather than a yield to matu-

Source: Slate Council Securi~ies Committee, Salomon Brothers and /ME rity basis. ~h~ second and more important cause of

uncertainty is the inflation subsidy. While inflation- instrument to act as a short term benchmark. (iv) The

like bonds may be easier to place in the primary mar- treasury risk management capability of banks and other

ket in some circumstances, the future payout on an inflation adjusted bond will always be open to differing expectations, which makes pricing it in the secondary market difficult. In a more developed market, this would seriously inhibit trading. The speculative nature

of the Chinese market reduces the extent to which pricing difficulties inhibit trading in China, and in fact increased trading volume over late 1994 and early 1995. But this short-lived burst of liquidity does not negate the generally less liquid nature of indexed

bonds.

CAUSES O F THE LACK O F LIQUIDITY: (2) MARKET INFRASTRUCTURE

The second group of causes concerns the supporting market infrastructure. First of all, the money market does not function in a manner which assists bond market liquidity. Normally, the money market plays an important role in assisting bond market liquidity through the provision of funding for bond portfolios via either loans or repurchase agreements. Repurchase agreements (repos) further assist liquidity by enabling investors to quickly obtain funds without having to sell their bonds.' Trading in repos in 1994 is estimated to have reached Y 314 billion as described in Table 3.3. This amounted to an estimated 10 percent of bond trading volume in 1994.

The more liquid the money market, the more certain bond owners can be that it is a stable funding source and the more they can rely on the short term yield curve

as representing the cost of carrying a bond inventory. The money market in China fulfills this role to an extremely limited degree. The core deficiencies of the money market, in terms of its potential support to the bond market are (i) its geographic segmentation, which implies that funds in the provinces are unlikely to be available to finance bond transactions on one of the

major exchanges, limiting bond market unity;' (ii) its institutional segmentation. Regulations control the par-

ties permitted to transact and the maturities that can be offered.Voreover, bank sub-branches manage their own liquidity on the basis of their allocated capital and credit. The lack of centralized liquidity management also acts as a factor preventing the development of a short term yield curve. (iii) Interest rate ceilings, on both loans and repos, preventing the development of a short term yield curve, as there is no regular supply of short dated treasury bills to provide a liquid low risk

financial institutions is very thin due to a lack of incen- tives to manage risk. Developing this capability will be

hindered by the cumbersome reserves methodology of PBC. The incentive and ability to manage liquidity risk and interest rate risk is necessary before a liquid money

market can develop. Estimates of money market trading volumes and assets of users are available in Appendix Tables A3.4 and A3.5.

Table 3.3 Trading in Repurchase Agreements (1 994,Y billion)

Trading Center 'hading Value Wuhan Securities Trading Center 160.0 STAQS 290.0 Shanghai Stock Exchange 63.0 Shenzhen Stock Exchange 1.3

Total 314.3

Source: SEEC.

Despite these difficulties, the PBC's financing centers (the 'tangible' component of the interbank market), have fostered the achievement of nearly unified interbank rates across China, by acting as a market benchmark. The PBC is aware of the shortcomings in the functioning of the money market, and intends, in the medium term, to create a nationally integrated market, to enable the introduction of open market operations."'

A second institutional difficulty hampering the achievement of secondary market liquidity concerns

the lack of a common depository, which reduces inter- regional trade. Since the bulk of debt issues are in bearer form and of small denominations, depositories are

vital to aggregate these into wholesale parcels that can be readily traded. Although regional depositories appear to function well in China, there is no central depository, or any mutual agreements between depositories, which would enable them to recognize each others depository receipts as good proof of title. This inhibits inter-regional trading.

SECONDARY MARKET PRICING EFFICIENCY: P R I C E UNITY

The second major aspect of secondary market efficiency in China's bond markets examined here is the question of a specific aspect of price efficiency; regional price segmentation. The black markets prior to 1988

and the government sponsored markets which followed them were characterized by significant price differences, especially between regions and between rural and urban areas, due to (i) the lack of information and (ii) the difficulty of transporting large amounts of phys-

ical scrip and cash between markets. Local prices thus reflected local liquidity conditions.

China's Bond Trading Centers

China's bond markets consist of four principal markets (Wuhan,

Shanghai, STAQS and Shenzhen), and a number of lesser

regional markets, whose size relative to the principal markets is

gradually declining (Appendix Table A3.3). All the major mar-

kets trade as exchanges. Electronic over-the-counter trade (ie,

trade directly between individual participants) has not yet

developed except at STAQS. Each market has satellite links

which provide members across the country with real-time quo-

tation and transaction data. Order placement and confirmation

is by telephone or fax on the Shanghai stock exchange, at

Wuhan, and on STAQS, although the possibility of undertaking

this through the satellite system is being explored. Dealers in

Shenzhen place orders via remote terminals. Shanghai also has

a unique system of record keeping and transacting using mag-

netic cards. The cards are mainlv used for individuals eauitv . ,

transactions but the scripless treasury bills issued in 1994 can

also be traded through this system. While repurchase business

at STAQS has grown, its physical bond trading has tended to

shift to the Shanghai stock exchange. The Shenzhen Stock

Exchange (SZSE) has been active in developing a bond market

since late 1993. The Wuhan, Shanghai and Shenzhen

exchanges have an estimated common membership of 100-150

brokers. Many of these brokers will also belong to STAQS.

Members cover the whole of China.

The opening of STAQS and the Shanghai stock exchange in late 1990 provided both a nation wide quotation system and an exchange with members from

many regions. These developments greatly assisted price convergence. Prices on the Shanghai stock exchange began to act as a benchmark for regional markets. Figure 3.5 indicates the size of the arbitrage opportunities that existed in 1990. By the end of that year, there were signs of price convergence between the larger markets (Shanghai and Wuhan), although looking at a spectrum of ten regional markets, including smaller markets, overall price convergence was slower. Regional price differences at the end of 1990 could exceed 700 basis points."

Figure 3.5 Regional Bond Yield Differentials (1 990)

800 r

1990 Jan April July Oct

Shanghai & Wuhan

1 10 markets including Shanghai & Wuhan

Source: Based on dntafrom Bi (1 993).

Price differences today are much smaller than those of the past. Prices on the major centers of trading (Shanghai, Wuhan, Shenzhen and STAQS) are very close to being unified. The barrier to unity in the major

centers is the lack of a unified depository system. While quotation and execution of trading on the major

markets is technically sophisticated, settlement procedures are lagging in relative terms. In the absence of a unified depository system, prices tend to be high in Shanghai, which has the greatest liquidity and a well regarded depository. Prices are relatively low in Wuhan, which has the least well regarded depository (Figure

3.6)

In early 1994, the Shanghai authorities grew concerned that depositories outside its system were permitting

short selling, by issuing depository receipts when the scrip was not in fact registered. Consequently, in May 1994, the Shanghai stock exchange ceased to recognize depository receipts from depositories outside its own system. This increased market segmentation by preventing debt held outside the Shanghai stock exchange's depository system from trading on the Shanghai stock exchange. The effect of this event on yield differences is also shown in Figure 3.6. Between January and September, the yield difference between Shanghai and Wuhan widened from around 100 to around 500 basis points. A similar increase in yield differences between Shanghai and Shenzhen appeared, after May 1994.

Figure 3.6 Yield Differentials between Treasury Bills on Principal Markets: 1994 Shanghai.

Wuhan and Shenzhen

Bmrlr Shanghai and Wuban ?ol.tr

600 ,

Shanghai & Shcozcn 500 ,

hImy June

Source: Calculationr based on data provided by the Shanghai and

Shenzhen exchanges and Wuhan Trading Center.

The Shanghai stock exchange signed an agreement on

depository procedures with STAQS in October 1994 and now recognizes their depository receipts. But by the end of 1994, no agreement had been reached with

Wuhan, or the Shenzhen stock exchange. Problems associated with multiple depositories could be solved if

the existing networks agreed on a common code of prac-

tice, or alternatively by the creation of a centralized depository. The Ministry of Finance is discussing the creation of a centralized depository, for government securities only. Ideally, depository practices for all classes of debt securities should be standardized.

Lack of liquidity in provincial markets especially affects debt issues which do not trade on the major markets, such as enterprise bonds and financial bonds, some of which trade only on a regional market. Provincial markets are also less technically developed and less informed than major markets. Consequently

prices on regional markets tend to be lower than prices

in the main trading centers.

BENCHMARK ISSUES, MARKET PRICING,

AND THE YIELD CURVE

The third aspect of the functioning of secondary mar-

kets for debt securities which is analyzed here is the extent to which bond market issues can provide a benchmark rate, and help establish a yield curve. The concept of a benchmark issue in relation to new debt issues is not operative in China today, due to (i) the

administered setting of yields in the primary market." The operative benchmark in China today is the interest

rate on bank deposits, which is administratively deter-

mined. (ii) Another factor which undermines the role of

a benchmark issue is that the pricing of credit risk is poorly determined, due to the lack of a hard budget

constraint on enterprises. It is hard to distinguish between the credit risk of a government owned company, and the risk of the government. Considerably

greater interest rate flexibility, combined with enterprise reform which enables credit risk to be credible,

will be required before benchmark issues can play a significant role in pricing debt.

Developing the role of benchmark issues in defining the

secondary market yield curve requires (i) a greater range of maturities;" (ii) a more regular issue calendar

so that fresh issues come to market throughout the year; and (iii) a greater focus on developing a wholesale market to enhance liquidity.

Figure 3.7 China: Secondary Marketyield Curve

5 ~ 0 " ~ ~ ~ " ~ ' 6 months 1.5 2.5 3.5 4.5

Source: Calculationr based on data provided by the Shanghai Stock

Exchange.

Figure 3.8 China: Bondyield, Deposit Rate and Inflation

- Retail Price Index - Average Yield: Simple ~ > > : ~ I year deposit rate .I, A~~~~ yield: YTM

Source: Calcularions bared on &a provided by the Shanghai Srock Exchange, PBC and rhe World Bank.

Due to the lack of a broad spectrum of maturities in the market, a yield curve has been discernible only since late 1992. The changing shape and position of the yield curve (YTM basis) is shown in Figure 3.7. Secondary market yields rose from June 1992 to June 1993 and then progressively declined; first at the long end of the curve (beyond 1.5 years) and finally at the short end. The unusual shape of the curve, rising at the long end, reflects the lower liquidity in the treasury bill with the longest maturity. The lower liquidity itself suggests a preference for short maturities, due to inflation.

The timing of the decline in yields, after June 1993, prima facie, is difficult to interpret, on two counts. First, PBC acted to tighten access to funds by regulating the money market in June 1993. Deposit interest rates were increased at the same time. Second, inflation began to rise more steeply from the end of 1993, yet yields continued to decline. The trends in secondary market bond yields and inflation are shown in Figure 3.8

One interpretation of these contrary developments is that the money market regulations of June 1993 resulted in a diversion of funds, away from the equity market towards the bond market. Banks' lending to securities companies and TICS via the money market was curtailed and this reduced liquidity to the equity and real estate markets, which declined. Second, banks themselves were for the first time given clearance to invest directly in bonds. Bonds are a relatively attractive investment for banks, compared to loans to favored industries, as they offer higher returns. This suggests

that the market from mid-1994 to mid-1995 has been dominated by actions based on regulatory change. A third influence on bond prices which became more relevant in late 1994 was the high announced level of the inflation subsidy and the speculative fever attached to anticipating its final value on a specific bond; the three year bond maturing in June 1995.'"ome evidence for the diversion of funds from equities to bonds is shown in Figure 3.9 which plots average yield and the Shanghai stock exchange A share index. The decline in equity prices is accompanied by a fall in yields.

Figure 3.9 China: Equity lndex and Average Bond Yield

Index percent

Source: Calcu.laions bated on dara provided by the Shanghai S~ock Exchange.

To summarize the answer to the question of the extent to Government Bond Markets in Russia and which securities issues have helped establish appropri- China: A Comparison. ate pricing, in terms of benchmark rates, for government bond issues, the broad conclusions are (i) that the

form of issue and design of debt securities so far have not been conducive to the establishment of a well- defined ~ i e l d curve; and (ii) to the extent that a yield curve exists, ~ i e l d s on the secondary market have not been taken into account in the pricing of new issues of government securities. In 1994, yields on the sec-

ondary market were well below interest rates offered on

Russia, another large country in transition between central planning and a market economy system, offers an interesting contrast to China, in terms of bond market development. There are striking differences in the evolution of the two systems, and the problems which each country faces

The Russian bond market is much smaller than in China. the volume of outstanding treasury bills amounts to only 1.8 percent of GDF!

new government S.ecurities issues. The is In terms of maturity, debt issues are concentrate,l at the that the government may today be adopting an unnec- short end of the market, and the medium and long ends of essarily expensive form of financing its borrowing. In the market have not been developed due to high inflation.

the past, however, the government paid rates below Virtually all debt issues are of three month maturities. By

those on the secondary market, and was able to do so contrast, China until 1994 had issued debt on two an0 three year maturities, and it was only in 1994 that it issued bills of

because the largely administrative placement tech- 6 month and one year maturities. The short end of the market niques used. In the future, if the government moves is relativelv undeveloned in China away from administrative placement (a move which

arguably has been limited so far), and a s the stock of There are very few non-government debt securities in

debt issues increases, the question of the Russia. Russian firms can and do default on their obligations. Russian hanks are likewise very aware of the credit risk of

cost of borrowing for government debt will become an clients and other banks, unlike Chinese banks.

issue of increasing concern.

Money markets in Russia are relatively free, with no interest Another issue regarding the role of bond markets and rate controls. There is no central credit plan. 'The central

nlacroeconomic management relates to whether the bank has a discount rate, changes in which triggers other

government can consider an increased use of treasury interest rate adjustments. Russia issues its three month bills at regular intervals, of three weeks. The implication of these

bills a s indirect instniments of monetary control, which factors is that (unlike China, the short term yield curve is

would permit a relaxation of reliance on the credit plan, relativelv well defined. ~ ~

and greater reliance on the control of base money for implementing macroeconomic objectives. The ability of Investors in government bonds in Russia, unlike China, are

the government to conduct open market operations is mostly wholesale, and mostly financial institutions.

also important for the use of sterilization as an instru- Unlike China, Russia faces major difficulties in the trading

merit for regulating the impact of capita1 of government bonds due to the lack of technology which inflows. These issues are not covered in detail in the would permit a nationwide market. Virtually all trade takes present study.15 However, to the extent that financial institutions need to hold portfolios of (tradable) government bonds to be able to participate in open market operations, it is pointed out that today such portfolio holdings are limited. The absence of a benchmark issue to help the pricing of such instruments, and the limited development of the money market limits the liquidity available to financial institutions to finance the holding of a sizable portfolio of government treasury bills.

In conclusion, it must be pointed out that many of the

problems faced by the bond market in China today are the problems faced by an economy in transition. Yet,

place at MICEX, the Moscow Interbank Currency Exchange, where the shortage of screens restricts trade to a virtual cartel of only 55 primary dealers. Brokers cannot trade at the exchanges, unlike China, which has a large network of brokers, and screen based trading at all its several major bond trading centers. The primary reason for this restriction is to preserve the integrity of the mnrket against fraud and default.

The problems of developing a national market in Russia is more severe than in China, due to the huge problems of the payments system, which imply that participants from regions outside Mosc:ow have difficulty accessing the market. This is in contrast to the intercity linkages of the major trading centers in China, and the unifying effects of the electronic trading systems of STAQS and NETS.

even among transitional economies, there may be inter- -

esting differences in approach, and there are lessons to be learned from the experience of other countries.

P A R T I C I P A T I O N I N I N T E R N A T I O N A L B O N D M A R K E T S

FOREIGN PARTICIPATION IN CHINA'S DOMESTIC BOND MARKET

hina has been very successful in attracting large private foreign resource inflows in recent

years. Total private flows (on a net basis) jumped to $36 billion in 1993, up from $5 billion in

1990, and are estimated to have reached $40 billion in

1994. The increase in private resource inflows to China parallels a global trend of rapidly increasing pri-

vate resource inflows to emerging market economies. Yet, the composition of external investment flows to China is strikingly different from comparator countries.

The contrast to other major emerging markets, is clear from Figure 4.1, which shows China's enormous share of developing country FDI, but its small relative share

in terms of securitized flows; bonds or equities. While the international experience suggests that foreign portfolio investment has been increasing the most rapidly,

resource inflows to China have been increasingly skewed towards foreign direct investment (FDI), which accounted for more than two-thirds of the total net private investment flows to the country in 1993.

Unlike stock markets, money and bond markets in China remain closed to foreign investment. In view of the large and growing needs of China's real sector, global partici-

pation in its financial markets is an important question. But the benefits of increased foreign investment must not be outweighed by the costs of reduced stability and autonomy. Until China has been able to develop money market instruments to conduct efficient policy actions, such a s sterilization, to deal with large inflows of foreign capital, and strengthen domestic bond markets, foreign access to the domestic currency denominated fixed income securities is not contemplated.

Figure 4.1 China and Other Emerging Markets: Participation in International Capital Flows

Portfolio Equity

Bonds

Foreign Direct Investment

Source: World Bank.

CHINA'S OVERSEAS BOND ISSUES In 1994, new US dollar bonds had an average maturity

of 9.3 years, compared to 5 years in 1992.2 Yen bonds China's access to international capital markets has expanded substantially in recent years, emulating the global trend.' The annual volume of new overseas bond issues has grown remarkably fast, expanding from less than $200 million a year, on average, over 1989-91, to over $2 billion per year for 1992-94. In 1994 overseas bond issues reached $3.5 billion, an all time high. In terms of currencies, China's overseas bond issues have been concentrated in two currencies, the Japanese yen and the U.S. dollar. Currency denomination of new bond issues has recently shifted away from the yen, which was the dominant currency before 1992, to the U.S. d o l l 3 due to the combined effects of the strengthening yen and relatively low dollar interest rates. In terms of rate structure, recent historically low interest rates in major markets led to a concentration of new issues in fixed rates (70 percent). The average maturity of new bond issues has increased every year since 1991.

Figure 4.2 International Bond Issues by Chinese Borrowers: Currency,Type and Maturity

US$m equivalent

1800

1600

1400

1200

lo00

800

600

400

200 0

in 1994 averaged close to seven years, compared to around five years in 1992 and 1993. Although growing, these maturities have not yet achieved the levels desirable for long gestation infrastructure projects.

Interest spreads on new issues, on average, have had some downward trend since 1989 until late 1994. While lower interest rates in the early 1990s partly reflect declining global interest rates, it is interesting that the relative spread on new issues for China, compared to other emerging markets, is low. In 1994 China enjoyed lower spreads than India or Thailand, (although not as good as Korea), and also countries outside the region, such as Hungary and Mexico (before its ~ r i s i s ) . ~ The favorable terms enjoyed by China until recently reflect in large part its good macroeconomic performance." Following the Mexico crisis, developing countries as a whole witnessed some decline in their terms. In the case of China, there was some deteriora- tion in secondary market prices on bonds.'

Table 4.1 Average Spread on Floating Rate Medium and Long-Term Bond lssues

(Basis Points Above LIBOR)

China 50 55 54 56 Hungary n/a n/a n/a 150 India n/a n/a n/a 218 Korea 36 56 5 0 35 Mexico n/a 250 313 139

1989 1990 1991 1992 1993 1994 Thailand n/a 4 3 4 3 89

l Yen fixed . $ fixed Yen noat Q $ noat . SFR conv fl DM fixed Source: World Bank, IEC.

China's credit rating enjoys an above-investment grade Yean to maturity by all major rating agencies. The country's sovereign

rating was upgraded to A3 by Moody's in September 1993, thanks to the agency's assessment of: strong potential to attract foreign investment; low external debt burden; and likely 'soft-landing' for successful transition to a more advanced market e ~ o n o m y . ~ This was followed by a similar upgrade for three major financial institutions; Bank of China, CITIC, and People's Construction Bank (Appendix Table A4.1).

IQe9 1980 19Bl 1992 1993 19W China has not been a major participant in overseas mar-

H Yen den. . $ den. Dm den.0 SFr den kets for bonds with derivative elements. Some engage-

Source: Euromoney Bondware; World Bank (IEC). ments in derivatives by Chinese enterprises led to large loss-making in 1994, as a result of which financial

operations in international derivatives markets grew Chinese Overseas Bond Issues more tightly controlled. Financial derivatives are under

the jurisdiction of CSRC (Futures Department). Overseas derivatives activities by Chinese entities are

usually confined to exchanges acceptable to the CSRC, such as the CBOE (Chicago Board Options Exchange) and clearing members of the exchanges. Large finan-

cial institutions are considering the use of overseas derivatives to hedge risks associated with international bond issues. An expansion of involvement in these

areas is inevitable, in view of the deepening domestic

financial market, and the increasing international integration of China's securities markets, and the govern-

ment should, with appropriate precautions, encourage

its development for risk-management capacity (hedg- ing) rather than speculative trading.

Looking at the domestic organization of overseas bond

issues, these, like other securities issued, still form a part of the annual credit plan, and specifically, part of

the foreign borrowing quota. The allocation is carried out in consultation with the People's Bank of China.

Priority is usually given to the central government and 'pre-approved' SPC projects; unallocated portions are then distributed to provincial borrowers, and other

Chinese entities. Approvals are also required by the State Administration of Exchange Control for medium-

to long-term issues. The SAEC imposes stricter controls

on bond issues, relative to commercial loans and short- term debt. Convertible securities are regulated by both the SAEC and the CSRC.

China's international bond issues have been carried out by certain financial institutions comprising selected banks and those trust and investment corporations

authorized to engage in international operations. By

1993, around ten such institutions had been authorized, referred to as the '10 windows.' The 'windows' act essentially as intermediaries, who on-lend to

domestic end-users (although a portion of their borrowing is for their own use). Among the 'windows,' CITIC and the Bank of China (BOC) have been the most active. In the late 1980s, these were the only two institutions issuing debt. Gradually, the government's authorization of additional bond issuers has reduced their share, which in 1994 accounted for 29.7 percent of all Chinese external bond issues (or 55.6 percent of non-government bond issues).

Chinese bond issuers have diversified their currencies and markets. Aside from the new entries to Yankee bond markets and continued Samurai issues, China entered the Dragon bond (Hong Kong dollar denominated) market for the first time in October 1993, with a $300 million 10 year issue. China's first Dragon was also the first sovereign issue in this market and the first with a maturity of 10 years. With Moody's rating of A3, it was also the lowest investment grade in this market. After a 6 year hiatus, China retuned to Eurobond market in September 1993 with a 5 year Y30 billion issue to finance infrastructure projects.

In early February 1994 China launched a $1 billion 10 year global bond issue; the largest global dollar bond issue by a developing country so far. It was China's second Yankee bond issue, following CITIC's pioneering 10 year issue in 1993. Despite the slack market, due to recent US rate hikes, China's first global issue was well received. The benchmark PRC offering was priced to yield 85 basis points over the comparable U.S. Treasuries.

There have been five international sovereign bond issues through end-1994:

DM30 million issue in October 1987, which was fully repaid in October 1992; Y30 billion 5 year Eum-yen issue in September 1993, canying 5.375 percent coupon; $300 million 10 year Dragon issue in August 1993, with 6.125 percent coupon; $1 billion 10 year global issue in February 1994, with 6.5 percent coupon; and Y60 billion Samurai issue in July 1994, in two tranches (Y30 billion, 5 year maturity, and 4.4 percent coupon, and another of Y30 billion, 10 year maturity, and a 4.95 percent c:ou pon).

Within the total borrowing approved in 1994 ($1.5 billion), the choice of specific markets is based on the combined considerations of: relative prevailing rates; listing costs; issue and listing processes (for example, the Euromarket is usually considered to have a simpler listing process); general market recognition and reception (Asian markets are relatively favorable to China); diversification; and market liquidity. International bond issues by the state government are conducted and managed by the MOE

Chinese borrowers remain relatively inactive in convertible bonds and bonds with derivative elements. Only three issues have been launched: China Textile Machinery's $23 million equivalent of SFR-denominated 5 year convertible bond, in November 1993, and two separate 7 year U.S. dollar bond issues, with a 'put' option, by Shandong Industrial Trust & Investment in July 1994 ($130 million) and September 1994 ($150 million).

These domestic procedures raise certain issues. First, it is Allocation of the 'residual' quota among provinces sug- difficult to ensure that proceeds from foreign bond issues gests, rather, that distribution criteria and bargaining eventually go to the projects with the highest returns. elements could be introduced. Onlending terms for

overseas loans to eventual domestic borrowers do not

appear to be clearly defined and may not be governed

by creditwortiness considerations alone.

Second, the merits of 'window-based' overseas borrowing requires careful thought. While this approach may accrue benefits to China, mainly in the form of cost savings due to the higher credit standing of some windows in the international capital markets, the system also has disadvantages. Some windows have weak balance

sheets leading to cost ineffectiveness, and market absorption could also be an issue. Exclusive emphasis on the windows can encourage back-door financing activities, such as inducing offshore borrowing by

Chinese enterprises through their foreign subsidiaries. Greater direct access by non-windows to overseas fund-

ing should therefore encourage for more efficient resource mobilization and allocation. Since 1993, the

authorities have been considering a more pragmatic approach, which allows domestic enterprises direct access to overseas bond markets. Yet as Appendix Table A4.3 indicates, this plan has not been actively implemented. Direct bond issues by manufacturing enterprises have been rare, and bond issues linked to spe-

cific infrastructure projects are unknown.7 Although increased flexibility has been afforded to some institutions (including CITIC) in the execution of individual borrowing program within the quota. A limited role has

also been conceded to internal credit rating agencies in assessing the financial adequacy of borrowing entities. lncreased direct market access would be advisable, with international creditworthiness being the principal criterion for selection.

Figure 4.3 China: International Syndicated Loans (US$ million)

1990 1991 1992 1993 1994 (end-July)

a BFR a ~ t t H K S U S $

rn S T G rn D M FFR

rn RMB S C H 0 Yen

SYNDICATED LOANS

Syndicated loans to Chinese borrowers rose in tandem

with new international bond issues, reaching $7.3 billion (equivalent) in 1993, compared with less than $3 billion in 1991. The firming trend sustained during the first half of 1994, exceeding $4 billion through the end of July. The continued buoyancy in international commercial banking flows to China is noteworthy because the global trend has been the slow new bank loans. Most commercial banks in major industrial countries have become extremely selective, at least through 1993, in extending new credits in the aftermath of debt

crisis of the early 1980s: their capital adequacy ratio has been under pressure and profit margins squeezed. This certainly bodes well with the China's track record

(ie, no history of loan rescheduling) and impressive macroeconomic performance and thus market credit-

worthiness.

China's new commercial bank credits have been arranged largely in U.S. dollars, unlike new bond issues which have been more diversified between dollar and

yen. Also in contrast with international bond issues, average maturity of syndicated loans for Chinese borrowers has been progressively shortened during the 1990s: from 8.4 years in 1990 to 5.5 years in 1994. This partly reflects some international banks (especially Japanese) concerns over large Chinese exposures built up during the period.

International syndicated loans to China are increasingly linked to project financing largely in support of infrastructure projects, and trend will likely intensify in the

coming years. While estimates vary considerably, infrastructure financing cost for China could amount to

hundreds of billion dollars through the end of the

decade. The Three Gorges project for the world's largest hydro dam is a good example, which alone would cost $24 billion, with as much as 80 percent of

the total cost to be financed by foreign resources. Greater activities in limited recourse project financing such as build-operated-transfer (BOT) schemes are as anticipated as the main vehicle to mobilize funds from commercial banks, which are less willing to engage in long-term financing. Malaysia is one of the countries more actively implemented BOT schemes by making them a major component of its privatization programs. Earlier in 1994, IFC helped launch Peregrine's planned $1 billion Asian Infrastructure Fund with Chinese projects being the main focus, emulating the AIG-sponsored Asian Infrastructure Fund. Efforts to Source: Eurornoney Loanware.

structure infrastructure financings for China have been going on across a broad front: JP Morgan recently arranged an innovative $80 million syndicated loan deal for a coal-fired plant providing 15-year debt, with the last five-year maturities guaranteed by the World Bank.

Figure 4.4 China: Maturities and Spreads on International Syndicated Loans

Years

-HK$ us$ -All currencies

Basis points

The State Development Bank (SDB), one of the three newly established policy banks (the others are the Export Import Bank of China and Agricultural Development Bank) has been designated with managing two-thirds of China's infrastructure financing needs. The SDB is therefore expected to play a major role in developing an environment conducive foreign investment. While the SDB funding will come primarily from the issuance of domestic bonds, the first SDB mandate that involves a foreign currency component is the $350 million Qinshan nuclear power plant in Zhejiang Province, based largely on OECD export credits.

In sum, the large volume of syndicated loans extended to Chinese borrowers in recent years reflects good credit perceived by risk-conscious international commercial banks, adding to the greater diversification of China's external funding sources. There is nothing inherently wrong with this form of financing to the extent that the fund is used productively and well managed. In view of the growing need for longer-term financing, overseas financing must be structured adequately to meet this changing need: eg, extending maturities with IF1 guarantees. Mexico's recent problems highlight the need for a prudent macro-level asset-liability management. Viewed from this perspective, more active bond issues, vis-h-vis bank loans, should be considered.

-Thailand . Hungary - India

-Korea C h i n a

Source: Euromoney Loanware and World Bank (IEC) Staff estimates.

v

T H E R E G U L A T O R Y F R A M E W O R K

NATIONAL AND REGIONAL REGULATORY establish a new, national regulator for the developing

STRUCTURES securities markets. Details were promulgated in Document No. 68 issued by the State Council (17

hina today has no national securities law.' Its December 1992). The new two tier structure has a first securities markets are governed by a series of arm which consists of the State Council Securities regulations, currently split between those that Policy Committee (SCSC). The SCSC is responsible for

apply nationally and those that are set at local level. macro policy issues relating to the securities markets. The regulation of bonds is a particular area of fragmen- Such matters include the approval for the establishment tation. Early securities regulations were promulgated in of new securities exchanges and the approval of new 1987 and were supplemented by a State Council circu- securities legislation and regulations. It is also the lar and PBC circular in 1989. The first national regula- body responsible for setting the level of securities tions on securities issuing and trading (the 'Interim Regulations on Share Issuing and Trading') were issued in May 1993 by the State Council Securities Committee (SCSC). This set of more than twenty regulations forms the framework within which the present regulators of securities markets, the SCSC and China Securities Regulatory Commission (CSRC) operate. A draft national securities law has been under preparation since 1993, and was put before the People's Congress in October 1994, but has still to be enacted. Meanwhile, a major step forward for securities market regulation was the new national Company Law, which came into effect on July 1, 1994. In the absence of a

issues over a given period both for bonds and shares at the national and provincial level, in conjunction with the SPC.' The second tier is the executive arm of the SCSC, the China Securities Regulatory Commission (CSRC).The CSRC has been established to operate as an independent legal entity. As such, it has taken over most of the functions previously performed by the Financial Administration Department of the PBC.

Regional Regulatory Structure Prior to November 1992, regional regulation was carried out by the provincial governments, in conjunction with strong central regulation by the PBC through its

Securities Law, the Company Law contains several pro- local branches and other government offices. Local visions regarding the issuing, trading and listing of securities regulatory bodies were established in 'public' securities which might more normally be Shanghai and Shenzhen by the local municipal govern- included in the securities law. The law does not replace ment, namely the Shanghai Securities Commission and or abrogate previous regulations and must therefore be the Shenzhen Securities Commission. The character incorporated as a new layer into the existing legal and regulatory authority of these offices is illustrated by framework. the example of Shanghai (Shenzhen is similar). In terms

of its role as a regulator, the main points of note are (i) National Regulatory Structure the Shanghai securities exchange commission does not Until 1992, all securities related matters, bonds and have authority in any area where there is a national reg- -

equities, were supervised by the Financial ulation. If however national regulations are silent on a Administration Department of the PBC. The PBC was point, then Municipal regulations including any from also closely involved at the regional level through its superseded regulations can be enforced. (ii) In terms of branch offices. Ebllowing the Shenzhen riots of August links between the regional and national regulators, the 1992 (concerning an IPO), authorities decided to Shanghai securities exchange commission still reports

on a day to day basis to the Shanghai Municipal Government and not the SCSC or CSRC.' Yet it is responsible to the CSRC for the proper administration of the national regulations and is required to bring to the attention of the CSRC any observed breaches or problems within the CSRC's jurisdiction. (iii) In terms of three-way links between the central and regional regulators and the PBC, the position is complex, especially with respect to securities dealers. Although the PBC is responsible for the licensing of securities dealers, and their ongoing financial soundness, the Shanghai securities exchange commission also feels some responsibility for their business performance. At the same time, the direct operation of the secondary market is overseen by the CSRC (equities), PBC (bonds), and in practice, the local government securities agencies. If a broker is in violation of the regulations, the CSRC is responsible for investigation and penalties. In the most serious situations it can suspend a broker from trading. On the other hand, it is only the PBC that can remove the broker from the exchange floor by revoking his 1' icense.

Role of the CSRC in Securities Regulation

The major functions of the CSRC officially are: (i) to draft securities legislation and regulations; (ii) to supervise and administer the public issuance, listing and trading of securities (examination of prospectuses, business activities etc.); (iii) to supervise and administer securities firms, custodians and institutions for settlement and delivery, mutual funds, and the pro- fessionals engaged in the securities industry; (iv) to set up qualification criteria and issue licenses for securities profes- sionals (such as accounting firms, asset valuers and legal firms engaged in securities business); (v) to supervise and monitor companies which issue securities (including the acquisition and merger of public companies); (vi) to regulate companies which want to list on overseas exchanges; and (vii) to supervise the operation of securities exchanges and automated quotation systems.

Meanwhile, although most of the PBC's regulatory functions were transferred to two these new bodies from December 1992, the PBC remains responsible for the licensing of all financial institutions including securities intermediaries. This occurred for historical reasons, since over 90 per cenl of brokers origi- nated as subsidiaries of banks.The implication is that the role of licensing intermediaries and their on-going supervision is split between two bodies.

THE REGULATION OF BONDS

The regulation of debt securities is less well defined and more fragmented than the regulation of equities. The SCSC and CSRC are essentially focused on the

supervision of equity markets. The roles of various bodies in the regulation of bonds are set out, first and fore- most, in Document No. 68, according to which (i) The MOF is in charge of the issue of state treasury bonds; (ii) the PBC is in charge of the approval of bonds issued by financial institutions and the securities of investment funds; (iii) The SPC is in charge of the inspection and approval of state investment bonds and bonds issued by state investment companies; (iv) the PBC and the SPC are together in charge of the approval of central enterprise (corporate) bonds; and (v) provincial or municipal governments are in charge of the approval of regional enterprise (corporate) bonds.

This division of responsibilities covers regulation of only the primary market, and its fragmentation reflects the great variety of government debt issued in China until 1993. The PBC is responsible for bond trading activities only to the extent that it approves securities trading centers. Monitoring bond trading on a daily basis, to the extent that this occurs on the two oficially recognized exchanges, is within the realm of the CSRC, which is meant to supervise the activities of the exchanges. But monitoring the actual trading of bonds, especially government bonds, has been a gray area. The PBC, while responsible for the trading of government securities, has not had the capacity for regular monitoring, and has tended to control by the issue of ad hoc regulations as problems manifest them~elves.~ Even at the oficial exchanges, the CSRC has hesitated to intervene, as this could be regarded as an encroachment on the PBC. Outside the two official exchanges, the CSRC does not have any rights of intervention. The government was recently made aware of the lacunae by the government bond futures trading debacle on the Shanghai exchange in February 1995 (see Chapter 3), and it is now drafting a Government Bond Law, which is expected to cover the supervision of bond trading activities.

REGULATION OF FINANCIAL DERIVATIVES

Until February 1995, there was no specific legislation for financial derivatives in China. At present, stock index futures, and products such as options and swaps, are not permitted in China, and the principal form of financial 'derivative' securities has been the futures contracts on treasury bonds, which were first offered on the Shanghai exchange at the end of 1992. Following the incident of runaway speculation on these securities on February 23, China rapidly promulgated (March 1, 1995, effective from February 23, 1995), new regulations on derivatives trading.6 The new regulations,

inter alia, provide (i) that only those individuals

approved by the CSRC and the Ministry of Finance are

eligible to trade; jii) brokers cannot lend their seats on

the exchange to smaller traders; (iii) daily price varia-

tion limits (set at Y 0.5 in Shanghai and Y 1.0 in

Shenzhen); (iv) limits on the number and volume of

contracts for individuals, brokers, and institutional

investors, (v) new margin deposit requirements, which increase a s the settlement date approaches, and the

right of regulators to change margin deposit require-

ments; (vi) daily markings of contracts to market and

(vii) new disclosure requirements for brokers to their clients and to the regulators. The nature of these pro-

visions reflects international practice.

THE R E G U L A T I O N OF CCIRPCIRATE BONDS

U N D E R THE COMPANIES LAW

China passed a Companies Law in December 1993,

which came into effect on 1 July 1994. In the absence

of a national securities law, the Companies Law has

some provisions which would usually be found in a

securities law. Many of these provisions are valuable and offer investor protection in the absence of a securi-

ties law. But some others may be considered unduly

restrictive.

The companies law requires that all bond issues must

be approved by the Securities Administration

Department of the State Council which will grant or withhold approval within limits prescribed by the State

Council. All bonds must be listed to facilitate transfer by, and among, existing and new bondholders. However, where the bonds are to be listed is not clear.

Bonds may be bearer or registered bonds. Bond issues

must he preceded by a n Information Memorandum, and

the Company Law sets out provisions relating to its con-

tents, and also relating to approval documents which

must be delivered to the Securities Administration

Department; and the form and contents of the bond cer-

tificates themselves. The issuer is also obliged to main-

tain a Register of Bondholders. Bonds may be issued by

shareholding companies with a t least two shareholders

which are state-owned entities or by wholly state owned companies.

The Companies Law also provides that a company may only issue bonds if: it satisfies conditions on (i) mini-

mum net asset value; (ii) a maximum ratio of bonds

issued to net assets; (iii) the ratio of distributable prof-

its to interest payments; (iv) the use of funds raised, which must h e invested in industries which comply

with the policies of thr: s: ,;tr :?rl-l IT?:> ,, T:.! !>I .!..v,i jo

cover losses or non-prodr~ctiw Q X P P ! ~ ~ , : I 1 l . i .. yr:i !he

interest rate, which rrlav no! rxc.pcd I hr. lirrs~t stxi i)! thr.

State Council; and (vi) any otht~r. cwnditior1.5 wtiio.lr ~rroy

be imposed by the Statr Co~lncil. A cotrlpiny wi!l not b r

permitted to issue bonds if: (vii) on tht: last occasion when it issued bonds, the c.ornpany (ai1c.d t . 6 ~ raisv tlir

full amount required, or (viii] t h ~ rr,r??panv h;ts d~f ;~ t r l t - ed in payment of principal or intrrcst on houris nlrr:3dv

issued. 'The State Council is also c.rnl,owr,r-!*rl to set Iiirl- its on the scale of all company bonil is.;~l!.i and thc

CSHC may only approve bond issues w i t i i i ~~ th i s ovc-r.ill limit. A company can also i:+s~.le c.nn\ertihlc notes if i t

satisfies the conditior~s aprjlirohlt. tn both a hnnd i~sufx and a public share i.;sut.. Thr- Cci?rlla;lr;- !.av, ,!iv-< not

envisage colnpanies issuing i~r~list:,r! .;c-r..i~-itrr..: : ; i ~ , . l r a s

short-term floating rate notes i.;sucd to a .;yrr(licatc: of

hanks. Some of these provisions nr(. * . R ~ ~ ~ . : ~ . i i !+-y ! iv\ .

(v) and (vi), and also thc provisif;r! t+nt :!:r \ ,t:?t.- ..:,riri-

cil is empowered to s ~ t limits nr, thc s r - I - - :tf cP.::t8;,;~:i;

bond issues. They rcflert thr, r*vr.-z~c:rnr~. j:f (.rt~!+ral

planning and the emerging rn:lrke* ~.oci,l:i-.

BOND DEALERS. RAN KIN(; I,.?Wc ANT) S E C U R I T I E S LAWS

Banks and Securities Market Pat.fic;par+c The role of the central bank, the F N : . in ; c c ~ I;::' li.0-

ulatior~ is at present define,' ;:; t!:c sr'r.:iri::.; Jc*'..iclatior~

described above; primarily I)nrr i i ~ ~ o t i t Fci 68. ;ir,ri t t ~ r

Interim Regulations. [ .:?:ks !IP+TAV,-* --; c . ~ ~ ; , - , : ?li;:;t,l t . 1 ~

commercial hanks, or nthcr Ti :; i ,i irt.L!i(:G,,, r,.;. ,21,il

securities dealerships at prc.ser.1 ;we riot 5i~eilcd out in

detail. A key issue of i~i~pt)rlarir:r +nr !:hir~a ~ r i ihis t:nn-

text is the extent to which hankh i h n ~ ~ i i t > r :rilr:;a.cd LO

participate directly, or. th1.01l~11 t!!rii. ~i;!:i.ic:i:-i.icas. in

securities markets. Given ~l iat t l l v !.!;::( i , ; ! t . i , . ; z C ::hi~.la

have a substantial or rn:iJnl.iiy s~;l k+: :TI :II~!I:!, .i ! vgt. rnos~

important and largcst src ~1t:tlrs ~lc.al:~f,, I ht (,t~c:>t~oti nl

the degree to which these act~vit:r.s arc. st-partite? tlv

law or regulation is ir-nportant. China is still ~ i w a ~ t i ! ~ g a

co~nrnercial banking lawt ;ir!d s r i far n ~ ~ i y ;. ;]raft ,: !:rsior,

exists. 'Thc draft Bankrn;: !.,;IW ?i (:tiitla ! , i l : i i c . i : 1')04) includes, in its definition t ~ i ' 'Bs:;klny, 13~:s1ires;, , ~ i ) L ! I ~ '

buying and selling ot ;tovr:rnnlr:rtt. c.~~i.!~ointe a~li.: {';?an-

cia1 securities (item .5i: and f ~ i l t h c ~ ~ , s ! ~ a n i ~ r : allrt ; I ~ * s c ~ -

tance, on agency basis. cf gc!vr-rii!r?rr~t -,?rl r-)r.r~~~r-atr bonds (item 12). But thr. 1:iw ai-ii; c : : l ! r :? : ~ i l a . iict-~rst,rl

banks may not trade h ~ n , hs fit;- ih;:il. ; , ; s 1 . . ) I jhl%t:- . . client's accounts (Ar+::- l , s T ' h ~ c , .: 1,:: ..,nl?c

appear contradir~ory. 9 l r n 1 - u!:ili. I - .: i;,,:.>-r.r nt' ;i

law, these activitirs , ~ r v :-c-v~;~;i:.-cl i-. -' t-; I:-, ,,:n thrt

PBC. It appears that at present the PBC requires the

separation of banking and securities activities and does not permit banks to transfer funds to securities markets affiliates. But in practice, these requirements can be circumvented and the absence of clear regulations makes it difficult to control such practices.

In the context of China today, here are several advantages in keeping the securities activities in separate sub-

sidiaries: (i) the securities firm can more easily be regulated by the CSRC, without jurisdictional conflicts with the PBC; (ii) the securities firm can be required to meet the usual capital adequacy requirements for brokers,

with separate capital from the bank; and (iii) the traditional deposit taking functions of banks can be protect-

ed from potential losses in the securities business.'

Brokers, Dealers and Underwriters The key issues here are that while the CSRC supervises most brokers' secondary market activities, the PBC licenses them in the first place. This separation is unusual in international terms. It arose because (i) the PBC was the original regulator, (ii) most major securities

dealerships were set up a s bank subsidiaries, so that the PBC would be in the best position to monitor their capital adequacy. The situation is unusual. It would be acceptable provided that the PBC takes a proactive role in ensuring ongoing compliance by brokers, but at present it is not clear that it fulfils this role. The CSRC however also has problems in regulating brokerage activities, as it has no branch offices and is thus effectively

dependent on information provided by the exchanges, and the local government. Approval of securities dealers is undertaken at a local level, by the respective branch offices of the PBC. Regulations governing securities

dealers are also at the local level. Rules are more detailed at Shenzhen relative to Shanghai, especially in

terms of capital adequacy requirements. Within this framework, the Shenzhen rules mainly require the members to exercise self-regulation.

Credit Rating Agencies China Chenxing Securities Rating Company Limited and Dagong International Securities Rating Company Ltd. are the only two securities rating institutions approved by the PBC. Some 20 or so rating institutions have been approved by various local departments (at the provincial and municipal level) and around eighty or so institutions are said to offer rating services. However many of these do not call themselves rating agencies at present, but rather, consulting firms, accountants, etc. Due to the belief in implicit state

guarantees on corporate bond issues, the role of credit

agencies is still undeveloped.

SOME ISSUES CONCERNING BOND MARKET REGULATION

Two major issues concerning the regulation of China's

bond markets are raised here. The first concerns the extensive role of the government in the operation of the

markets. First of all, access to the bond market in China is restricted in several ways. The State Council, through the SPC, regulates the volume of securities issued and

their terms, by setting annual limits on the amount of bond (and share) issues, and the maximum interest that can be paid on corporate bonds (see Company Law

above). Second, access to overseas issues or listings of bonds by individual enterprises is also defacto restricted, to one of the approved banks or major TICS. Third, the local government of the province in which a company is located must approve companies for public offering of bonds (or equities), and additionally, local SPC approval is also required for bond issues.

A second key area of concern in the regulatory structure for bond markets in China today is the fragmentation of oversight, both functionally, for different segments of

the securities markets, (and for different parts of the market for each security, ie, primary and secondary markets), and regionally, between central and regional authorities. The CSRC and SCSC are the principal central authorities. The PBC's role in securities regulation is largely effected through its branch offices.

Additionally, the MOF has begun to assume a role in this area, and regional governments have powerful bodies of securities legislation.

Thus, first, in primary markets, the fragmentation of

authority is the outcome of the historical variety of bond issues by different government departments. Although there is now some move towards a consolidation of

these issues, the oversight still remains fragmented. Next, in secondary markets, the PBC remains responsible for overseeing trading activities of bonds (except bond futures, which are now under the CSRC). In practice, the CSRC and local governments also remain involved, as regulators of the exchanges on which the securities are traded. Third, with regard to regulations concerning bond market dealers and their activities, the split in responsibilities is the most evident. Although the PBC no longer has a major role in the supervision of equity markets, it has retained responsibility for the licensing of all financial institutions,

including securities exchanges, 'stock trading centers,' and securities dealers, under Document No. 68, although it is required to report to the SCSC. One recently introduced exception is the licensing of bonds futures dealers, which is now under the MOF and the CSRC. However, this requirement does not apply to securities firms which exclusively trade treasury bonds since they are supervised by the MOF who has apparently said that the PBC's approval is not necessary. This means that the role of licensing intermediaries and the on-going supervision of dealers is split between the PBC and the SCSC/CSRC. The PBC remains responsible for all bond trading activities, including financial futures on T Bills, and the supervision of mutual funds. Unlike the CSRC, the PBC has a regional presence, through its branch offices. In the future, efficient supervision of China's bond markets will require a clarification and consolidation of these functions.

A P P E N D I X

Y>b!a A i . l China: Securities Markets and the Financial Sector (Y billion ) ( 1989- 1994)

L i n ! z ~ & ~ , ~ . , .

~#t;,o~.,;,* ;..; t .iit*nc;d : ~ i ~ i ~ t a i i o ~ ~ s 987 1,237 1,646 2,179 2,680 3,273 5f,i.< I.,!;,:?.! and Ursive:ju; Eanks 798 992 1,330 1,748 2,140 2,%4 (,rcdi- ~ $ 8 1 ~ > ( : I c , : : -;<-,> 189 245 316 43 1 540 729

,, . : x : v ~ ~ - i L ~ i ~ ~ : k,.:! <! i ~ ) ~ a l hpvsi1.s ((70) 4% 3% 4% 6% 2% SYI. # I ! . L I - . *: : .*:~~h~~dir~g 1 To::ii !h:posits (Yo) 3% 6% 14% 15% 14%

$5' ole ... , I 1b:i I c:r ,nr;.!.zl,lr: .\l~crifi::allvl;:r,/inncr cornl~orric:~, srcrrriricrs conlpanics and lea~ing cornpanip-? ody,for 1992, when lheir assels w r e Y 19 billion.

!, !Itti1 l.,r I vY3 CL. r nrb~rraled. !kr.tn/br ::1'/5 i ~ r r !,:rinssLJrr.d m L: IWU / i n nm:,./br (111 ' n o r ~ - r ~ w n ~ f n r ~ j E w r u ~ ~ l instifufion.~' faken rogether.

.?,,,'I*.<!,

{ I Y I ! ! LO ''2ji,ZJ ' , , i r rk . t r , u ! r-li:ri.:r r.*,:;i..:r:it::.,.'; ::ir,rs and linhiliricr: IMF 1995 Article IV srnritriral mbler. 1994 &a are end-Sepfernber. 1994 &a on

rumrr--nr,neroru /irtaru:rl i ~ i r ~ i l ~ i , , ~ ' , (~.rr, /I.,,n r15e ,sr~rne .Torircc!. ( 1 9119) Hank and credir cooperaiue's as8ef.s and liabiliries: IMF 1994 Article IV report.

In~umnr.e , C:.;.;I~I:J d i ~ i l r l r . .,lir.w~rirri , J (;hin(r'r i!rcrrking nrul Finance; PlCC annual reports. Securilies dam are,frorn rhe Sfare Council Securiries (;o,~~r~ci.t:r.,; (.+PC ,lltl~c:rt&z >G,.>L::, A i . utui 11.2,.

AppendixTable A 1.2 Financing of the Government Deficit: Contribution of Bond Issues ( I 988- 1994) (Y billion)

Year 1988 1989 1990 1991 1992 1993 1994a

Government Budget Deficit Budgetary Revenue (Y billion) 280.3 326.4 355 367.2 392.8 481 511.9 Budgetary Expenditure 313.7 363.8 391.7 391.7 453.9 546 596.6

Visible Deficit -33.4 -37.4 -36.7 -24.5 -61.1 -64.9 -84.7

Fmancing of the Visible Deficit Domestic: Gross PBC Borrowing a 7.9 10.8 11.7 26.6 17.4 44.7 Change in Treasury Deposits 3.6 -16.7 5.8 -10.5 25.5 -27.2 -43.9 Purchases of Government Bonds by State Banks 0.9 6.2 9.1 18.5 14.6 Other domestic financing 14.1 28.4 3.5 8.7 3.8 7.3 23.8 Other domestic financing not elsewhere-classified -3.6 2.6 -3.5 4.2 -19.2 -2.6 3.7 Foreign 11.5 11.3 13.1 10 15.1 28.1

Consolidated Deficit PBC Lending to Financial System

(a) Policy loans, Lower bound b 42.2 49.6 56.6 50.5 60.1 160.0 % GDP 3 3.1 3.2 2.5 2.5 5.1 (b) Policy loans, Upper bound c 56.3 67.2 76.0 66.6 79.3 213.4 % GDP 4 4.2 4.3 3.3 3.3 6.8

Consolidated Deficit: lower bound -75.6 -87.0 -93.3 -75.0 -121.2 -227.2 Consolidated Deficit: upper bound -89.7 -104.6 -112.7 -91.1 -140.4 -280.6

Government Debt Securities Issues Treasury bond issuesd 18.9 22.4 19.7 28.1 46.1 38.1 113.2 Redemptions 2.1 1.3 7.6 11.1 23.8 12.3 Net treasury bond issues 16.8 21.1 12.1 17.0 22.3 25.8 Net issues of treasury bills 7.0 4.3 4.3 9.8 28.0 21.4

Treasury Bond Net Issues % of Visibile Deficit -50.3 -56.4 -33.0 -69.4 -36.5 -39.8 % of Consolidated Deficit e -22.2 -24.3 -13.0 -22.7 -18.4 -11.4

Treasury Bill Net Issues % of Visibile Deficit -21.0 -11.5 -11.7 -40.0 -45.8 -33.0 % of Consolidated Deficit e -9.3 -4.9 -4.6 -13.1 -23.1 -9.4

Overseas Sovereign Bond Issues (Y billion) 3.38 ($ billion) 0.59

% of Foreign Financing of Visibile Deficit 5.2

Memo Item: GDP (Y billion) Exchange Rate (Y per US$)

Notes: a Figures for 1993 and 1994 are estimates. b,cDefined as 6 0 and 80percent 4 P B C lending tofinancial system. d Treasury bonds include treasury bilh Special natwnul b o d (and i d & inflocion indexed b o d ) , as well as bond issued to financial irutit~ioru f ical bonds) and ban& earmarked for specific investmerus (National Corutruction B o d and National Key Roject Corutructwn b o d ) . e Lower bound Sources: Data pertaining to the government deficit and itsjnancing are based on IMF (1995 and em'ler years) Article IY; estimates ofthe conrolidakd d e f ~ i t are based on World Bank, CEM, 1994 (both using GFS dejinitioru). Data on securiries issues arejrom the State Council Securities Policy Commirke.

AppendixTable A 1.3 China: Contribution of Bond Issues to Investment (Y million) ( 1987- 1993)

1987 1988 1989 1990 Investment Total Investment in State Owned Units 229,799 276,276 253,548 291,864 Capital Const. Inv. in State Owned Units 134,309 157,431 155,174 170,382

Investment in Key State Projects 42,100 40,840 41,520

Investment Fmancing through Securities 1. Treasury bondsa 11,690 18,877 22,391 19,723

of which, earmarked investment bondsb 5,400 3,054 0 0 2. Investment bondsc 3,000 9,000 2,253 615 3. Enterprise bondsd 3,000 7,541 7,526 12,637

% Treasury Bonds in Total SOU Inv. 5% 7% 9% 7%

% TBonds+Investment bonds in Total SOU Inv. 6% 10% 10% 7% % Enterprise Bonds in Total SOU Inv. 1% 3% 3% 4%

Total contribution of bonds to SOU investment 8% 13% 13% 11%

(%) e

Equity: annual new issues 1000 2,500 662 428

Total contribution of equity to SOU investment 0% 1 % 0% 0%

(%I

Memo Items: Fmancing of SOU Investment State budget % 21% 15% 13% 13%

Domestic loans % 25% 24% 21% 24% Foreign investment % 7% 9% 10% 9%

Self-raised funds and other % 48% 52% 56% 54%

Notes: a These include b o d used for generalfinancing, such as treasury bilb, fucal b o d , injlation-proof b o d , as well as some b o d earmarked for

construction projects (see b below). See Appendiz Tabk AI.1. b National Construction bondr and National Key Project Construction b o d . c Earmarked inwtment bonds issued by provincial governments to aid regional development, as well as b o d iuued by the now largely defunct State

Investment Corporations. d These include bonds issued by central enterprises (Government-owned enterprise b o d in Appendiz Table AI.1) as well as local enterprise b o d ,

commercial paper, housing construction b o d , and a h , local investment corporation b o d (see Appendir Tabk AI.1). e This is the upper bound. crvwning all government bond issues are used to finance inmtment. The m t u d proportion of bond issuer used for

investment financing are ckarly likely to be lower. Sources: Data provided by the State Council Securities Committee and the State Planning Commission.

Appendix Table A 1.4 China. Overseas Debt and Portfolio Capital Inflows (1 987- 1993) (US$ billion and %)

1987 1988 1989 1990 1991 1992 1993

Yo Yo Yo % Yo Yo %

ANRF ANRF ANRF ANRF ANRF ANRF ANRF

Aggregate Net Resource8,575 10,272 9,685 10,047 9,777 23,785 41,235

Flows (ANRF)

LT Debt

Disbunemen ts

O/W bonds

commercial banks

Repaymen ts

olw bonds

commercial banks

Net Flows

bonds

commercial banks

Direct F1 2,314 27.03,194 31.1 3,393 35.0 3,487 34.7 4,366 44.711,156 46.925,80062.6

Portfolio Equity Foreign 0 0 0 0 0 0 0 0 653 6.7 1,194 5.0 2,278 5.5

Investment

Grants excl. TA 209 304 245 249 242 32 7 360

Ageregate Net Resource 8,575 10,271 9,685 10,048 9,777 23,785 41,236

Flows (ANRF)'

Commitments 10.3 10.1 8.3 10.0 8.3 16.8 21.8

bonds (%commitments) 1.0 (10.3) 0.8 (7.7) 0.7 (8.7) 0.0 (0) 0.3 (3.14) 0.9 (5.3) 2.7 (12.2)

Notes: a Aggregate Net Resource Flows =Longterm Debt +Direct Foreign Investment + PorcJolio Equicy Foreign Investment + Grams excluding technical

assistance. Source: C a k h i o n r based on daaj iorn the World Bank. IEC.

Appendix Table AZ. I China: Debt Securities lssued and Outstanding (Y 100 million)

1. lhxaq Bonds Issued 48.7 43.8 41.6 42.5 60.6

Redeemed

Outstanding 48.7 92.5 134.1 176.6 237.2

Treasury Bills

Issued 48.7 43.8 41.6 42.5 60.6

Redeemed

Outstanding 48.7 92.5 134.1 176.6 237.2

Fiscal Bonds

lssued

Redeemed

Outstanding

National Construction Bonds

lssued

Redeemed

Outstanding

National Key Project Construction Bonds

lssued

Redeemed

Outstanding

Special National Bonds

lssued

Redeemed

Outstanding

Idlation-proof Bonds

Issued

Redeemed

Outstanding

2. National Investment Bonds Issued

Redeemed

Outstanding

3. National Investment Corporation Bonds Issued

Redeemed

Outstanding

4. Government-owned Enterprioe Bonde lssued

Redeemed

Outstanding

AppendixTable A2. I (cont'd) China: Debt Securities lssued and Outstanding (Y 100 million)

5. F m c i a l Inatitutiona Debt lssued

Redeemed

Oubtanding

Financial Bonds

lssued

Redeemed

Outstanding

l u s t Fund Securities

lssued

Redeemed

Outstanding

Investment Fund Securities

lssued

Redeemed

Outstanding

6. Enterprise Bonds lssued

Redeemed

Outstanding

Local Enterprise Bonds

lssued

Redeemed

Outstanding

Sho~i-term Paper

Issued

Redeemed

Outstanding

Domestic Bonds

lssued

Redeemed

Outstanding

Housing Constmction Bonds

Issued

Redeemed

Outstanding

Local Investment Corporation Bonds

lssued

Redeemed

Outstanding

Subtotal

Issued 48.66 43.83 41.58 42.53 65.61 192.51 236.87 419.18 382.36 394.15 695.41 1.197.67 381.31 Redeemed 0.00 0.00 0.00 0.00 0.00 27.88 75.83 108.38 127.27 203.58 260.41 465.09 123.29 Outstanding 48.66 92.49 134.07 176.60 242.2 1 406.84 567.88 878.63 1,133.77 1,324.34 1,759.34 2,491.82 2,749.84

- cont'd .

Appendix Table A2. I (cont'd) China: Debt Securities Issued and Outstanding (Y 100 million)

7. Stocks Total

nf which:

A shalvs

13 sha~r s

I I shalrs

8. Iarge Sum Negotiable CDe

I s s ~ ? ~ Rrdeernrd

Outslanding

GDf'at Market l'licrs 4775 5182

Deht S.culities 1 .O I .8

Outstanding / 6111' (%)

Tolill Secu~itirs 1 .O 1.8

Outstandin8 I GDP (%)

Nares:

n The balance outstanding for treasury bod5 cited here does not equal last year's balance plus net new issues, because of a difference between he redemption amount and seltlement amount, owing to a split year au~ulment.

11 I n 1994, Y 75.8 billion of b o d were issued by rhr newly established State Development Bank, to orherjnnncial insthulions. The bondr are

nontradable, are of three andjlve-year maturities, and have coupon rates of 12.5percent and 14.0 percent, respectively.

.SOILTC~S: State Council Secl~rities Committee, circular &led Augur 1994.

Appendix B2. I Bond Yield Calculations: Current Yield and Yield To Maturity

Bonds in China have some unusual features in terms of interest payment as well as interest calculation, which

reduce the transparency of bond yields. Treasury bonds typically do not pay interest, but instead pay a lump sum at maturity. The lump sum payable at maturity is estimate by adding accrued annual simple (rather than compound)

interest over the total period, plus any inflation adjustment.

Secondary market bond yield quotations in China are now available in some publications, but these yields are quot-

ed on a variation of a current yield basis. This follows from the way in which the coupon is quoted in the primary market. This method is not consistent with standard market practice and is deficient in that no account is taken of the time value of money.

Secondary yields in China are quoted using the formula:

Y I E L D = (s-p) x 1 x l O O

P n

s = maturity value, which in China includes all interest payments as well as principle; p = market price

n = time left to maturity in years

The formula does not recognize that the further into the future a payment is received, the less its value is today. For very short maturities (months) the formula will be adequate. The longer the time to maturity the less appropriate the formula becomes.

Bond yields are normally quoted on a yield to maturity (YTM) basis. The YTM is the discount rate which equates current price with all future cash flows. The YTM formula is obtained from:

by solving for i, where

i = yield to maturity p=market price C = coupon

f=redemption value at maturity n=number of periods to maturity

In this study, daily yields for each individual issue have been estimated using a yield-to-maturity formula, from primary data on daily trading prices, maturity dates for each issue, and redemption value (in China this is the principal plus interest without compounding), with coupon=O, and additional assumptions on frequency of compounding; assumed to be semi-annual, and the basis of payment calculation (actua11365). No allowance is made for the

inflation adjustment, the full value of which is unknown until maturity. Daily yields have not been homogenous across different securities, and the 'average yield' has been estimated as the average of daily yields on outstanding Treasury Bill issues, at a given point of time.

AppendixTable A3.1 ChinxTrade in Securities (Y million)

1. lheeury Bonds Treasury Bills

Fiscal Bonds

National Construction Bonds

National Key Project Construction

Special National Bonds

Inflation-proof Bonds

2. National Investment Bonds

3. National Investment Corporation Bonds Key Enterprise Bonds

Capital Construction Bonds

4. Fmancial Bonds 12

5. Local Enterprise Bonds 91.63

6. Short-Term Enterprise 0

Negotiable Certificates

Subtotal debt securities' 103.63

7. Enterprise Stockb 8

8. Jumbo CDs 0

Total all securities 111.63

Notes: a Bond trading is estimated on a gross basis b E~erprise stock trading includes offiially recognized cemers only. Source: State Council Securities Committee, circular dated Augur 1994.

Appendix Table A3.2 China: Securities Trading on the Shanghai Exchange in 1994 (January 1994 to January 1995) (Turnover,Y million)

Equities Treasury Bonds

A Shares B Shares Spot Repurchase Futures Funds Total

Source: Shanghai Securitia Exchange: M o r ~ h l y M a r k Stuturicc.

Appendix Table A3.3 China: Securities Trading by Region Trading Value ( 1 992) (Y million)

Treasuly Rills

-- 8,661.6

2,053.8

364.6

248.2

246.2

4,430.4

2,289.1

4,350.1

507.4

266.7

1,138.4

1,374.2

22,366.0

13,540.7

2,253.8

2,690.0

662.1

2,083.6

1,632.8

581.5

559.2

940.6

1,507.4

2,955.6

19,997.2

1,477.2

1,318.5

1,802.4

6.5

247.2

3.2

323.2

1,660.4

968.8

105.6

511.5

396.1

1,152.0 207.1

90.0

100.4 186.1

108,257.4

National lnveslmenl

Corporation Bonds

Local Ente~prise

Bonds

Financial Bonds

Enterprise Large-sum Stocks Time-

De sit c e r t i g e s

-

Beijing

Tianjin

Hebei

Shanxi

Inner Mongolia

Liaoning

Shenyang

Dalian

Jilin

Changchun

Heilongjiang

Harbin

Shanghai

Jiangsu

Nanjing

Zhejiang

Ningbo

Anhui

Fujian

Xiarnen

Jiangxi

Shandong

Qingdao

Henan

Hubei

Wuhan

Hunan

Guangdong

Guangzhou

Shenzhen

Guangxi

Hainan

Sichuan

Chengdu

Chongqing

Guizhou

Yunnan

Tibet

Shaanxi

Xian

Gansu

Qinghai

Ningxia

Xinjiang

Total

Compiled Source: Compiledjrom he Almannr: of China's Banking and finance (/99.3), /'eopl~:s Publishing Company, Beiing.

AppendixTable A3.4 Monthly Transaction Volume in the Interbank Market (Y billion)

Year Month State Banks' % Other Banksb' % Non-bankc d 9'0 All Financial Financial

Institutions Institutions

Total 1990 3,120.96 Total 1991 5,14-4.48

1992 January February March April

May June

July August September

October November December

Total 1992

1993 January February March April

May June

July August

September October

November December

Total 1993

1994 January Fe bruary

March April

May June

July August September October

Total 1994.'

Notes: a State B a n b include Indwtrml and Commercial Bank of China, Agricultural Bank of China, Bank of China, People's Construction Bank o f Chinn.

Bank o/Communication.s and CITIC Indllcrrinl Bank. b Other Banks include non-state-owned commercial banks and regional banks c Data on Other Banks and Non-bankfinancial instirutions available from 1993. d Non-bankJnancia1 institu~ions include rural and urban co-operative credit agencies, rrast and investment companies and accountin~firmr. e January to October only Source: SEEC, 1995.

AppendixTable A3.5 Assets of Financial Institutions Engaged in the Interbank Market (Y billion)

Year Quarter State Bank Assets

1990 Q1 1,626.62

42 1,697.94 43 1,754.13 44 1,998.20

Total 1990 7,076.90

1991 Q1 2,028.58 42 2,093.53 Q3 2,229.06 44 2,479.10

Total 1991 8,830.27

1992 Q1 2,494.51

42 2,657.51 43 2,750.21 Q4 3,000.86

Total 1992 10,903.09

1993 Q1 3,009.85

Q2 2,975.65 Q3 3,044.44 44 3,498.02

Total 1993 12,527.97

1994 Q1 3,495.72

Q2 3,741.94 Q3 4,307.06

Total 1994b 24,072.69

% Other Bank % Non-bank Assets Financial

Institutions Assets

Notes: a TotuL for 1990-1992 include o d y State Bank Assets Md Nan-bank Financd lmtituiioru w e b . b January-September only. Source: SEEC, 1995.

Appendix Table A4.1 Sovereign Rating - SelectedDeveloping Countries Sovereign Foreign Currency Debt ( 1 994)

Moodys Standard and Poors

Investment Grade

Chile

China

Colombia

Cyprus

Czech Republic

Greece

Indonesia

Korea, Rep. of

Malaysia

Malta

Portugal

South Africa

Thailand

Below Investment Grade

Argentina

Brazil

Hungary

India

Mexico

Philippines

Slovakia

Trinidad & Tobago

Turkey

Uruguay

Venezuela

Baa2

A3

Bal

n.a.

Baa2

Baa3

Baa3

A1

A2

A2

A1

Baa3

A2

B1

B2

Bal

Ba2

Ba2

Ba3

n.a.

Ba2

Ba3

Ba 1

Ba2

BBB+ (1)

BBB (2)

BBB- (2)

AA- (1) BBB+ (2)

BBB- (1)

BBB- (2)

A+ (3)

A (2)

A (1)

AA- (1)

BB (2)

A- (1)

BB- (2)

n.a.

BB+ (1)

BB+ (1)

BB+ (2)

BB- (1)

BB- (1)

n.a.

B+ (1) BB+ (1)

B+ (3)

Notes: ( I ) Stable outlook (2) Positive outlook (3) Negative ou~look Source: World Bank

AppendixTable A4.2 Credit Ratings of Chinese Borrowers

Announcement date Issuer Full Name Listing Ratings

-- Standard and Poors Moodys

10-Apr-89 26- Jun-91 29-Oct-91 26-Mar-92 28-Jul-93 09-Sep-93 15-Nov-93 02-Feb-94 10-Mar-94 10-Mar-94 19-Oct-94 17-NOV-94

No~es: TO: Tokyo LX: Luxembourg

LN: London UQ: Unquoted NY: New York SI: Singapore H: Hong Kong Source: World Bank.

Bank of China Bank of China CITIC CITIC CITIC People's Republic of China GITIC People's Republic of China Bank of China Bank of China CITIC Bank of Communications

TO A3 TO Baal

UQ Baal LX Baal

UQ BBB Baal LN A3

UQ BBB Baal LX SI H BBB A3

UQ BBB UQ BBB NY BBB

BBB

AppendixTable A4.3 China. Overseas Bond Issuing Institutions ( 1 985-94) (US$ million)

Institutions 1985 1986 1987 1988 1989 1990 1991 1993 1994 - 1992

Issuer Amt % Amt % Amt % Amt % Amt % Amt % Amt % Anit % Amt % Amt % ( U S eq.1 ( U S w.) (US eq.) ( U S eq.) (US8 eq.) ( U S eq.)(US5 eq.) ( U S eq.) (US5 eq.) (US8 eq.)

LTICS ClTlC 307.94 37.5 388.11 32.9 381.34 34.8 113.59 13.7 113.6 44.1 390.82 28.8 680.74 23.9 200.00 5.8

SlTICO 123.53 10.5 120.07 14.5 273.48 20.2 70.00 2.5

GlTlC 128.87 10.9 50.00 4.6 156.95 19.0 119.81 8.8 300.00 10.5

lTlC

Dalian

lTlC

Shandong

ITIC

Shenzhon

lTlC

Slrbtotd 307.94 37.5 702.10 59.5 431.35 39.4 472.98 57.2

Banks BOC 512.79 62.5 477.09 40.5 499.27 45.6 227.93 27.6 151.38 100 144.08 55.9 270.50 20.0 457.36 16.0 825.97 23.9

ROCOM 125.66 15.2 70.00 5.2 100.00 3.5 123.08 3.6

PCBC 150.00 11.1 220.00 7.7 143.68 4.2

lCBC 138.10 4.8

ClB 100.00 3.5

Suhtoial 512.79 62.5 477.09 40.5 499.27 45.6 353.59 42.8 151.38 100 144.08 55.9 490.50 36.2 1015.45 35.6 1092.73 31.7

Sovereign PRC 164.43 15.0 588.10 20.6 1607.90 46.6

Debt

Enterprise China 23.48 0.8

Debt Textile

Total 820.7 100 1179.2 100 1095.1 100 826.6 100 151.4 100 0 0 257.7 100 1355.5 100 2852.3 100 3451.9 100

Notes: ITICs = Investmenf and Truf Corporarwns CITIC = China Inuestmem and Truf Corporarion SITICO= Shanghai International Trwt and Inwfmenf Corporarion GITlC = Guangdong Internarional Trwf and Invesfment Corporaion BOC = Bank of China BOCOM= Bank of Communications PCBC = People's Construction Bank of China ICBC = lndwtrial and Commercial Bank of China CIB = China Inuesfment Bank China Teztile = China Teztile Machinery Stock Ltd

Appendix Table A5. I China: Structure Of Securities Regulation

I State Council I

Final Approval of New Exchanges and Overseas Listings

I

of Markets

licensing securities companies regulating debt securities of financial institutions, investment funds and central enter- 1 1 prise bonds 1

development plans public offering quo-

* approval of some debt securities and central enterprise bonds

regulating government securities licensing and regulating aCCOUnQntS

1 company law /

........ - r National Companies

securities companies supervision (but not licensing)

4 Accountants

.................................................................. Local Companies

regional enterprise bonds bonds issued by regional

enterprise companies

Shanghai ~henzhen 1 I 'Y7 Source: Intema(wnal Secuririec Conslllroncy.

E N D N O T E S

Chapter 1 1 The Industrial and Commercial Bank of China (ICBC), the People's Construction Bank of China (PCBC), the Bank of China (BOC) and the

Agricultural bank of China (ABC) 2 Of which the largest are the Bank of Communications (BOCOM) Md the CITIC Industrial Bank. 3 As well as some enterprises. Securities companies, however, as a special category of NBFI, are not allowed to borrow on the interbank market although

rhey cnn lend surplus f u d . 4 There are problem of def;nition in arriving at a precise ratio, which are pointed out in the notes to Appendirc Table A1.3. Earlier, treasury b o d for

investment ezpenditures were earmarked, but this practice faded after 1987, particularly for 'key project construction', so that the separation of the part of treasury bond issues used for investment presented here is an upper limit.

5 There have been two cases where enterprises have directly issued (convertible) b o d overseas (in Sweden and Switzerland, respectively). The authorization for such issues was apparently granted at a local level, and the appropriateness of this procedure it now being questioned.

Chapter 2 1 Capital market liquidity increased markedy following the legalization of inter-regional trading in October 1990 and rhe subsequent development of

STAQS and the Shanghai stock ezchange. 2 Thus National Construction Bondc were intended tofinance infastructure andstate enterprise investment in general, while Key National Consrruction

Bondc were targeted toward priority national projects. 3 For ezample, Fiscal Bondc were also intended to raise f u d for capital construction projects, but were issued mlusivelx and on a man&ory basis,

to banks and otherfinancial institutions. 4 The SEEC at the time assumed the role of a coordinating association for the securities institutions of China, in the absence of a national oversighc

body. Later that year the PBC and local finance bureaus also organized an 'underwriting syndicate'for a further Y 4 billion of treasury b o d . Moreover, this underwriting by b a r k may have been closer to administrative placement, de facto.

5 The organization of the underwriting syndicate however seem to have precluded some of the benej2t.s of underwriting, such as permbring underwriters to offer bids for prices, commission, or term, and as such was semi-administrative. Even the underwriting projections were f a d by the Ministry of Finance.

6 Primary dealers in China's bond market are defined as follows: they are qualified ro participaiion in the national underwriting syndicate, they have the privilege of dueussing itsuance term with the Ministry of Finance, they will have the privilege of underwriting open market operations and bond repurchme with the PBC, and can set up investment fun& in bondc. They also have the duty of protecting the liquidity of secondary markets and can actively undergo bond trading as commission agents, or on their own account. Underwriting is therefore just one of theirfirncrions.

7 Due to declining competitionjrom equities and real estate, itselfpartly due to the government-imposed delay in the issue of new equities and certain types of non-government debt, as well as the clamp-down on real estate specula.tion.

8 One reason for the 'voluntary' application for quotas may have been the relatively attractive coupon. and hence ease of placement, combined with a small commission or fee.

9 In 1995, Y 20 billion of the year's itsue of Y 150 billion is beingplaced by up to 50financial institutions, operating as primary dealers. The remaining Y 10 billion of thefirst tranche of Y 30 billion gor March 1995) it being placed throughfinancial institutions. These three year bonds cany a 14.5percent coupon with no intation adjustment. Another I00 million, however, of three year treasury bills are being placed through a group offive specialized banks, who will sell these on a retail basis through their local branches. This resembles the Y 70 billion of certi$cates issued in 1994. These b o d are not tradable. The coupon rate is 14.0percent. and they will cany an intation adptment.

10 The present arrangement appears to be based on historical practice associated with the plan cycle. Another reason for lrunpish issues may be a desire to avoid competition between different securities.

11 The central government has a surplus in thefirst half of the year and a de f~ i r in the second half and so the Ministry of finance, considering good debt management practice, would clearly prefer a diyerent sale pattern.

12 Payment of a semi-annual coupon may make rhe debt artractive to more sophisticated investors, but secondary market tradingprices suggest that the payment of an annual coupon on thefive year 1993 treasury bill did not give it enough appeal to overcome investor dislike of long maturities.

13 The data are based on initial placement. Reliable &a on end holders of debt securities is not amilable. The table will understate the proportion of debt sold to householdc in earlier years, as enterprises parced on some of their debt to workers and may overstate the proportion held by individuals in later years to the eztent that: (i) udrwriters have retained treasury bills for their own porrjolios or have sold them to institutions rather than individuals, and (ii) secondary market trading results in a net transjer to institutions.

14 The inflation adjustmem is published on the 20th ofeach momh; adjusted according to the infition adjustmems on the deposit rae, and a price

indez used by the PBC. I n March 1995, the adjustment amounted to 11.87 percent. The PBC in& d$ersfrom the i k prepared by the Stae

Statistical Bureau: the former includes gooh and services while the latter i s based only on goods. Moreover, the PBC in& is not published The

formula used for the inflation adjustments is as follows:

Adjustment =[{(wllwJ-1 } - r x n ] x 100 where

wl = the monthly price index, at time of maturity

wo = the momhly price in&, a time of issue r = annual interest rate

n = years lo maturity

1 5 Bond yields in this study are not lakenfrom Chinese published sources due to methodological problem. All yields have been recalculaed using stan-

dard methodology (see Appendit: B2.1 for details).

16 Bonds issued by provincial TICS did not have the approval of any gmrnment department. They have a maturity of 5 to 20 years and are sold to both

individuals and enterprises.

1 7 There are no specialized depositories for enterprise bonds. They are generally held in paperjorm.

18 I n 1993 there was one prominent case of enterprise bond default; the Great Wall company incident. The bonds had a coupon of 24 percem, which

the enterprise was later unable to honor.

19 Trade in Fiscal Bonds is not permitted, and Special Stare Bonds cannot be listed, and mart of the 1994 and 1995 treasury bill i r s w are not tradable.

Chapter 3

I There was an apparent reversal of this trend in early 1995, when bond trading seemingly exceeded trading in equities foudold (Appendix Table A3.2).

However the escalation in bond trading was almost entirely in the bond fuures market, due an incidem of speculation on one specijic security.

Liguidity in the underlying spot market for bonds &o rose as a consequence, b~ by a much more limited extent.

2 Thefirst bond faures contract in China was put on the market on December 26, 1992. Ajier a year's ezperimentation and amendmem to trading

sales, it began real operation at the end of 1993.

.P Speculation on the inflaion indexaion of a treasury bond led to the recent tremendous increa~e in fuures trading on the Shanghai exchange, which

as shown in Table 3.1 had rapidly outstripped spot trading by January 1995. On February 23rd. 1995, the volume of fuures trading on the bond

market way nearly USdlOO billion in a single day. Traders who had taken illicit short positions dejnulted, leading to widespread disorder and tem-

porary market closure. The implicaions appear to be t h a in China's presem inflaionary environment, indez-linking, with a lock of transparency in

the redemptwn amount. may not be advisable, and also, t h a trading in derivatives requires tighter regulation ar well as supervision. Tighter regu-

lations were drawn up rapidly ajier the incident, with the publication of a 'ftegulaion on Bond Fuures Trading,' within days of the incident.

4 By the end of 1994, bond trading volumes on Shanghai were reported to be 300 times their 1993 levels.

5 Treasury bill holders can obtain short term liquidity against their porlfolios via the growing market in repurcha~e agreemeu.

6 I n the early clnys of the market most trading was by individu& and, while i n d i v i d d may still be relaively more signgiant as clients of theprovin-

cia1 trading centers, on the major exchanges where most turnover occurs it is institutions which domime. For example, most of the bonds in the depos-

itory of the Shanghai Central Clearing Corporatwn (a strong indicaor of availability to trade) belong to TICS, investmem companies, banks and

enterprises. Of the institutions. TlCs are reported to be the most active traders. Banks and insurance companies have become more active from 1994

since previous restrictions on their holdings were removed ajier June 1993.

7 Ending in repos is conducted at the two major exchanges, Wuhan and STAQS. BU trading practices can range greatly due to the lack of unqonn

national conventions or rules. In Shanghai, repo terms gofrom 7, 14 and 28 to 91 days, and bidding is on yield ratios. Wuhan has te rm of 1. 2,

3, 6 and 9 months. On STAQS, both tens andprices are negotiated between dealers.

8 Internal trans/ers are complicaed by the weak payments system and discouraged by the PBC's branch-kvel reserve requirements A further faetor which

geographically segmeno the interbank market is intervention by local 0ffiiaI.s in reaction to the uneven r a e of developmem across China. 0 f i ck . l~

in some provinces try to place restrictions on the ouflow of funds from their areas towards others which may promise higher returns. The market is

usually organized by provincial branches of PBC which can further encourage transactions to remain within a particular area.

Y The interest rate ceiling is set with rejerence to deposit rates. I n 1994, the ceiling (which also applied to repos) war 1.098 (moahly rate) percem.

Loans to banks cannot meed 40 days, and to NBFls, 7 days. I n practice, longer maturities are achieved through roll-overs, and the lending ceiling

has also been circumvented. Average ~ u r d y prior to 1994 is estimaed, de faeto, to have exceeded a year, in the absence of administraive inter-

vention. The central bank had repeatedly issued regulations to limit t ens , usually to little avail.

I 0 The PBC is ezamining the w e of open market operaions as a mechanism for implementing monetarypolicy. Two technical requirements for open mar-

ket operations to work are that barks hold a porr/olio of treacury bills and that the interbank market is an eff~cient channel for distributing system-

wide liquidity.

I I See Appendix B2.1 for details of yield calculations.

12 A benchmark issue is an issue which provides a reliable indicator of the market yield for a given maurity due to good secondary market liquidity.

Such an issue facilitates debt issuance byproviding an indicator against which to price new issues. Benchmark i s s w of different maturities help to

define the yield curve.

13 rhe volume of debt issued today is in principle suffiient.

14 AS injat ion rates continue to rise in 1995, the government i.v continuing its attemp& to curb credit growth and has further raised interert raes (PBC

lending to./inancial institutions) early this year. Yet bond trading volumes are high and bond prices have risen further, ie, yields have ~robnbly fall- en further.

15 A Technical Assistance program under the IMF is investigating these ism in detail.

Chapter 4

I Internationalfinancing activities by developing country borrowers are being increasingly dominated by securitized arrangemeno, such as bonds, o~

opposed to loans. This reflects in part the increase in securitization in global capital markets. Dewloping countries raised $53 billion (gross) through

bond issues in imernational capital markets in 1993, more than twice the amoum raised in 1992. Low interest rates, particularly dollar rates, and

improved creditworthiness in many developing country borrowers contributed to that surge.

2 Looking at major new issues, dollar bond maturities srrerchedfrom seven years in November 1992, for the People; Consrrucrion Bank of China, to 10

years in July 1993, for a CITlC Yankee issue, and lo 20 years in March 1994, for rhe Bank of China.

3 An adzquare ser of comparable dara,for each year and counrry, in rerrns of currency of issue and maruriry does nor exisr, and the table b therefore

based on a specijii bond type, rheJloating rate bond, for m e d i m and long bonds.

4 A recenr srudy suggesrs r h a the price of developing counrry new bond issues is srrongly affected by macroeconnmic performance (Jun and Mahajan;

1994). Four dererminanrs of bond risk premia are sratisrically signijicant in this srudy: resemsldebt ratio (-); variance of reserva (+); i nh r ion rares (+); and real CDP growth rates (-).

5 Since China's overseas bond issua are not traded on rhe exchanges, but are rraded largely over the counrer berween major internarional invesrors, rhe

meosuremenr of rhe true de~eriorarion in rhese term is d~fficult. 6 A1 rhis Lime, Moody's rated Argenrina, Brazil and Mexico, as well as Venezuela, T u r k , Pakisran and Hungary, below investment grade. Chile,

Colombia, Indin and Indonesia were investment grade bur below China. However, three Asian emerging economies enjoyed higher ratings; Korea

(Al), as well as Malaysia and Thailand (A2). (Appendiz Table A4.2)

7 Although Chinese authorities claim rhat a substantid part of the proceedsfrom overseas bond issues are used,for domestic infrostruc~ure projects, Q is

dtficult to assess the extent to which this occurs (since each bond issue efectively ‘bundles's number of loans to infrasrructure projects), or ifs effec-

tive cost to thefrnal borrower.

Chaprer 5 1 The legalframework for thejnancial system in China has generally talcen rhe form of regulations, of which there are now more than 250. Legislation

in China can be classijied into regulations promulgated by, in descending order of importance; ( i) the National People's Congress; ( i i ) the State

Council and its ministries; and ( i i i ) provincial and municipal authori~ies. As a rule, the National People's Congress enacts laws which are general

in nature. Authoriries at a lower level in the hierarchy will, following the same principle, issue more specijic rules and regulations, whichfrt the context of the local environment. Provisions issued by the lower level authoritier are more specijli in application and rend ro have a more limited sphere

of inJluence. The interlocking rules and regulations though opaque ar fust glance, are not hapharard. Appendiz Table A5.1 illustrates the structure

of securities regulation in China. 2 The SCSC consists of 14 represenratives from relevant government departmerus, including the Ministry of Finance (MOF), the Slate Planning

Commission (SPC), the Ministry of Foreign Trade and Economic Co-operation (MOFIEC) and rhe Slate Commission for Restructuring the Economic

System (SCRES). The Chairman of rhe SCSC is the Vice Premier for economic affairs (Zhu Rongii).

3 There is an inrerlocking arrangement of senior oflcids between rhe SCSC and the CSRC which facildates coordination eg the Chairman of rhe CSRC

is also thefrrst Deputy Director of the SCSC. The Vice Chairman of the SCSC is common to the CSRC.

4 Thus at preseru, the Shanghai Securities Commission is clearly not a branch of rhe CSRC. The draft narional securities law envisages regionalpres-

ences of the national body and d would be open ro these municipal bodies to take on such responsibilities.

5 An example is the PBC's periodic regda~iom concerning the money market. An issue of concern for some years har been the tendency of iruerbank

loans to lengthen in maturity. Thus in 1986, the PBC issued a regdation in which the term could be sertled between rhe twoparties; in 1987 the PBC

limited the term of loans to less than four month; in 1988, rhe PBC reirerated that borrowing should be used o& for short, rather than long lermc; in March 1990 the PBC limited the term to generally one, and not exceeding four, monrh. I n February 1992, the term w a limited to one month, and

most recenrly, in June 1993, the loans were limited to daily transaction in principle, not exceeding 7 days. 6 Financial derivatives are under the jurisdic~ion of CSRC (Faures Depar~ment), bur bond marker trade surveillance is under the PBC. Oversea deriv-

atives activities by Chinese entities are usually conjned to exchanges acceprable to the CSRC, such as the CBOE and clearing members of the exchanges.

7 The proper relationship be~ween banking and securities broking is a contenrious issue and the rrend today in many developed countries is towards

'unimrsal banking'. However the US Glass-Steagal Act still seeks to keep the traditional banking operations of deposit taking and loan separate from

all securities business, although lhere have been calls for the removal of this restriction, which has been seen os a competitive disadvantage in rhe

international context. I n Japan, which was based on the US model, a recent change hac allowed banks to set up securiries brokers as separate, whol-

ly-owned subsidiaries. A detailed treatment of this subject is beyond the scope of thepreseru study.

R E F E R E N C E S

Almanac of China's Banking and Finance (1993). People's China Publishing House. Beijing. People's Republic of China.

Bei Duoguang, Koontz, Arden, Lu, Lewis Xiangqian (1992) "The Emerging Securities Market in the PRC." China Economic Review, Vol 3, No 2, 149-172.

Bi, Keqian, (1993) The Credit Markets in China, Columbia Journal of World Business. Fall. 77-95

Bowles, Paul and White, Gordon (1992). "The Dilemmas of Market Socialism: Capital Market Reform in China - Part I: Bonds". Journal of Development Studies. Vol28, No 3, April. 363-385

Bowles, Paul and White, Gordon (1992). "The Dilemmas of Market Socialism: Capital Market Reform in China - Part 11: Shares." The Journal of Development Studies. Vol. 28, No. 4 July. 575-594

Hong Kong Stock Exchange (1993) The China Bond Market. August. Research & Planning Department, Mimeo, Confidential.

International Monetary Fund (1991). "CHINA: Issues in Developing Government Securities Markets: Domestic Public Debt Manangement and Monetary Policy Techniques." Two volumes (Confidential).

International Monetary Fund (1994). "International Capital Markets: Developments, Prospects, and Key Policy Issues." May.

SEEC (1995) "China's Bond Markets." Mimeo. Beijing. March.

Shenzhen Stock Exchange (1994). "Shenzhen Stock Exchange: An Overview". Mimeo, Shenzhen.

Spencer, Michael, (1994) The Role of Capital Markets in Financing Chinese Enterprises. Mimeo, IME

State Council Securities Committee (1994) Circular on Securities Statistics and Regulations. Beijing, China. August.

Yi-Chen Zhang and Yu Da, (1994) 'China's Emerging Securities Market'. Columbia Journal of World Business, Vol XXIX, Summer. 113-121.

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