Bond Market in China
The China’s bond market did not grow as fast as the stock market, but from 1998 to 2003 it had an annual growth rate of 11.7% in terms of newly issued bonds, while total outstanding bonds reached RMB 1,933.61 billion (or US$233 billion). The second largest component of the bond market is called “policy financial bonds”. These bonds are issued by “policy banks,” which belong to the Treasury Department, and the proceeds of bond issuance are invested in certain industries (e.g., infrastructure, similar to municipal bonds in the U.S.). Compared to government-issued bonds, the size of the corporate bond market is minuscule: In terms of the amount of outstanding bonds at the end of 2001, the corporate bond market is less than one-fifteenth of the size of the government bond market.
In fact, the under-development of the bond market, especially the corporate bond market, relative to that of the stock markets, is rather common among Asian countries. Second, consistent with previous evidence, the size of all four components of China’s financial markets are small relative to other regions and countries, including bank loans made to the Hybrid Sector (private sector) in China (other countries). Moreover, the most under-developed component of China’s financial markets is the corporate bond market (labeled “private” bond market).
Perhaps the most important reason for the imbalance among different financial markets lies in investors and markets’ ability to “price” the risk of investing in stocks and bonds as well as the possibility of being compensated by the risk and uncertainty of investing in these (corporate) securities. On the other hand, the development of the bank loans market does not rely on sophisticated institutions, because banks have the expertise (based on their long-term relationship with firms) to evaluate even opaque and risky firms. In order to price bonds (or assign the proper interest rate), investors must have accurate estimates of the probability of default and recovery rate in the case of default. These probabilities are not available without a sound accounting/auditing system and high-quality bond-rating agencies. Another important fact is that during a firm’s default, the conflict of interest between the firm’s bondholders and stockholders usually favor stockholders, because managers of the firm work on behalf of stockholders. This is true even in countries with strong protection of creditor rights. In emerging economies, creditor rights protection is much worse and the courts are not efficient, all of which imply that the recovery rate for bondholders during default will be very low. Finally, the lack of institutional investors makes matters worse, in that these investors are better at monitoring firms’ managers than dispersed (small) bondholders.
On the other hand, we already mentioned that stock markets in emerging countries, such as in China, are not efficient in that prices do not necessarily reflect fundamentals of firms. So why are investors willing to take the chance of investing in stocks? One reason is the stock market’s ability to provide a better arena than the bond market in fulfilling investors’ motive of speculation, since stock prices fluctuate more than bond prices (when firms are not in financial distress), and there is no limit on the upside of holding stock as stockholders own the residual claim of the firm’s assets. Thus, investors believe, despite the large amount of risk, that they can be compensated by the possibility of a “lottery-like” winning payoff.
The lack of a well functioning bond market reduces the overall efficiency of the financial markets, which is detrimental to the economy. In the absence of an efficient bond market, the economy will lack a market-determined term structure of interest rates that accurately reflects the opportunity cost of funds at each maturity. The deficiencies in the term structure of interest rates consequently hamper the development of derivatives markets that enable firms and investors to manage risk, as well as the effectiveness of the government’s macroeconomic policies. Therefore, it is imperative that China should develop its bond markets in the near future along with its legal system and related institutions.
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