Onshore investors are counting on Beijing for a significant liquidity injection and other essential reforms.
The global liquidity drain and other factors have contributed to the sell-off in the Chinese bond market.
The IMF believes that foreign investors do not have sufficient derivative instruments to hedge against risks.
China’s rapidly growing mainland bond market of $15tn is one of the most promising markets for pension funds and other institutional investors. Nevertheless, trading risk, low liquidity, a thicket of legal problems and a flat market are some of the significant issues that the Chinese sovereign debt market needs to address.
In the Chinese bond market, there have been many regulatory restrictions that allow domestic commercial banks to hold bonds until maturity. This reduces liquidity in the secondary market, resulting in high trading costs.
The International Monetary Fund has pointed out that the Chinese bond market needs significant reforms to be a suitable place for foreign investors.
William Xin, Head of Fixed Income Department at Eastspring China, the Asian asset manager, said
“With the exception of government and bank bonds, liquidity in other market segments remains low. However, this will improve over time as the market grows in breadth and depth”.
Calls for reforms meet with resistance
The Chinese government bond issues a wide range of important maturities, unlike the US government bonds, which focus on specific maturities, such as ten and thirty-year bonds, to support price discovery in the US fixed income markets and increase liquidity.
Chinese bonds lack liquidity and are more vulnerable to negative shocks as turnover depends solely on whether the Chinese central bank relaxes or tightens monetary policy.
The Chinese bond market is much lower than the international markets, but it is expected to rise, but it is not yet clear how far it will go. However, the government’s support for an implausibly low default rate will raise further questions about how determined Beijing is to avoid implicit guarantees and whether credit risks are correctly priced.
Bond ratings are a major issue, as most bond ratings outside China have a more realistic view on potential defaults. Local credit rating agencies rate China’s government bonds and most corporate bonds at AA or AAA, which is not really the case, as most Chinese bonds pay for positive ratings themselves. Nevertheless, the IMF says,
“China’s rating industry must rebuild its credibility.
Another resistance from foreign investors is whether they can exit the bond market without any restrictions, according to the IMF.
Further roadblocks on the tax
Taxes complicate matters even more. The Chinese government declared a three-year exemption from withholding tax and value added tax (VAT) on interest income from onshore bonds issued by foreign investors in 2018.
However, investors still do not know what fixed income the tax exemption applies to. The tax regulations have proven to be intransparent, which has led to uncertainties in the calculation of tax calculations among foreign investors. Investors still do not know whether the tax exemption will be extended.
However, none of these difficulties have deterred foreign investors, investment banks and even asset managers from promoting the Chinese bond market. But China must reform its bond market to become trustworthy….