1. 1 The Chinese Government Bond Market: Opportunities and Challenges S. Ghon Rhee, Ph.D. K. J. Luke Distinguished Professor of Finance Executive Director Asia-Pacific Financial Markets Research Center University of Hawai ‘ i Presentation at US Central Intelligence Agency March 26, 2004 Asia-Pacific Financial Markets Research Center, University of Hawaii

2. 2 Size of China’s Economy GDP 2002 GDP 2002 ( $ Billion) GDP per Capita ( $ Billion) GDP per Capita Japan3,986 $31,300 China 1,237 980 Korea 503 10,560 Taiwan 289 12,500 Indonesia 180 810 Hong Kong 163 23,700 Thailand 126* 1,990* Malaysia 95 3,870 Singapore 90 20,900 Philippines 76 980 * Estimates Asia-Pacific Financial Markets Research Center, University of Hawaii

3. 3 Asian Stock Market Performance 1995 – 2000 2001 2002 2003 China20.32% -24.70% -18.79%10.05% China20.32% -24.70% -18.79%10.05% Hong Kong10.19 -28.10 -20.0129.95 Hong Kong10.19 -28.10 -20.0129.95 Indonesia-2.01 -6.01 8.06 48.75 Indonesia-2.01 -6.01 8.06 48.75 Japan-5.97 -39.67 -20.6121.87 Japan-5.97 -39.67 -20.6121.87 Korea -11.85 31.82 -10.0225.61 Korea -11.85 31.82 -10.0225.61 Malaysia-5.95 2.39 -7.4220.57 Malaysia-5.95 2.39 -7.4220.57 Philippines -10.38 -24.64 -13.71 34.80 Philippines -10.38 -24.64 -13.71 34.80 Singapore-2.51 -17.12 -19.12 27.44 Singapore-2.51 -17.12 -19.12 27.44 Taiwan-6.78 15.72 -22.0627.99 Taiwan-6.78 15.72 -22.0627.99 Thailand -27.00 12.11 15.9777.29 Thailand -27.00 12.11 15.9777.29 USA 17.24 -7.36 -18.3522.57 USA 17.24 -7.36 -18.3522.57 Asia-Pacific Financial Markets Research Center, University of Hawaii

4. 4 Foreign Exchange Reserves of Major Asian Economies Asia-Pacific Financial Markets Research Center, University of Hawaii

5. 5 Foreign Holdings of US Treasury Securities Asia-Pacific Financial Markets Research Center, University of Hawaii

6. 6 Corporate Bonds Outstanding: RMB 50 billion (2003) Equivalent to less than 1% of GDP Quick Summary: Bond Market Asia-Pacific Financial Markets Research Center, University of Hawaii

7. 7 T-Bonds Issued in 2003 Unit: Billion RMB Unit: Billion RMB Assigned Issue Assigned Issue TypeSecondary Market Amount Book-Entry 377.88 Bonds Inter-Bank Market 335.50 Exchange Market 42.38 Savings BondsOTC Market 250.46 Total628.34 Asia-Pacific Financial Markets Research Center, University of Hawaii

8. 8 Idiosyncratic Features of the CGB Market (I) 1.Fragmented Regulatory Structure of Government Bond Markets a. Dual Supervisory Structure of Primary Market a. Dual Supervisory Structure of Primary Market T-Bonds and E-Bonds: MOF F-Bonds:PBOC b. Tripartite Structure of Secondary Market Inter-Bank Market:PBOC Over-the-Counter (OTC) Market:PBOC Exchange Market:CSRC C. Meaning of the OTC Market in China? Asia-Pacific Financial Markets Research Center, University of Hawaii

9. 9 Idiosyncratic Features of the CGB Market (II) 2.Secondary Markets: Money Market rather than Bond Market Trading:10% Spot Transactions 90% REPO Transactions Inter-bank Market: REPOs are bond collateral loans among banks Exchange Market: REPOs are short-term loans among securities companies Asia-Pacific Financial Markets Research Center, University of Hawaii

10. 10 Trading Value of Government Bonds (1996-2003) Asia-Pacific Financial Markets Research Center, University of Hawaii

11. 11 Idiosyncratic Features of the CGB Market (III) 3.Missing Links in the Market a. T-Bills: Money Market in China has been developed without T-Bills Maturity Structure of Bonds Issued in 2001 Maturity Structure of Bonds Issued in 2001 2 years: 4% of total issues 3 years: 34%5 years: 21% 7 years: 14%10 years: 16% 15 years: 3%20 years: 8% b. Interest Rate Risk Hedging Instruments Bond Futures: Banned in 1995 Short-term Interest Rate Futures: Not Available No Short Sales Asia-Pacific Financial Markets Research Center, University of Hawaii

12. 12 T-Bonds (Book-entry) and F-Bonds Issued in 2003 Maturity Structure of T-Bonds (Book-entry) and F-Bonds Issued in 2003ItemT-Bond(Book-entry)F-Bond Bond issued (Billion RMB) 377.88452.0 Weighted Average Maturity (yr) 7.275.42 Weighted Average Int Rate(%) 2.862.87 Maturity(count) ≤1yr210 2-10yr712 ≥10yr412 Par Value Billion RMB ≤1yr35.5120.0 2-10yr252.0152.0 ≥10yr90.38180.0 Asia-Pacific Financial Markets Research Center, University of Hawaii

13. 13 Idiosyncratic Features of the CGB Market (IV) 4.Missing Links in the Market-Continued c. Foreign Participation in Primary and Secondary Markets except QFIIs d. Asset-Backed and Mortgage-Backed Securities e. Municipal Bonds e. Municipal Bonds Revenue Source: 1/2 from Municipal Governments Revenue Source: 1/2 from Municipal Governments Expenditures: 2/3 by Municipal Governments Expenditures: 2/3 by Municipal Governments Municipal Bonds may rely on ABS scheme using future cash flow of municipal governments Asia-Pacific Financial Markets Research Center, University of Hawaii

14. 14 Idiosyncratic Features of the CGB Market (V) 5.Benchmark Interest Rates a. Deposit interest rates are serving as benchmark Corporate bond yields should stand at 40% above the deposit interest rates?! b. Why very little differences are observed between savings bonds and book-entry bond yields? Savings Bonds:Syndicated Underwriting Book-Entry Bonds: Uniform Price Auction Method Book-Entry Bonds: Uniform Price Auction Method Asia-Pacific Financial Markets Research Center, University of Hawaii

15. 15 Idiosyncratic Features of the CGB Market (VI) 6.Segmented Secondary Markets a. Yield Differentials between Interbank and Exchange Market are Puzzling b.The only way to block arbitrage transactions are institutional constraints imposed by the Chinese authorities Asia-Pacific Financial Markets Research Center, University of Hawaii

16. 16 ● Interbank Market ◆ Exchange Market Secondary Market Yields: Interbank vs. Exchange Markets Asia-Pacific Financial Markets Research Center, University of Hawaii

17. 17 Recommendation 1: Benchmark Interest Rates Make T-Bond Yields Serve as Benchmark Interest Rates a. Stop MOF’s practice of setting a range of bidding spreads at the primary market auction b. Introduce T-Bills c. Create Balanced Maturity Structure d. Make all T-bond issues fungible Asia-Pacific Financial Markets Research Center, University of Hawaii

18. 18 Recommendation 2: Consolidation of Primary Market Under the current structure, PBOC does not serve as “ears and hands” of MOF. a. Allow PBOC serve as the Fiscal Agent for All Government Bonds b.Regulatory Harmonization and Functional Delineation among PBOC, MOF, and CRSC c.CSRC as the Market Regulator for both Primary and Secondary Markets d.Clearing & Settlement by PBOC: DVP for All Government Bonds d.Regularity of Issue Cycle Asia-Pacific Financial Markets Research Center, University of Hawaii

19. 19 Recommendation 3: Consolidation of Tripartite Secondary Market Mere functional integration cannot achieve consolidation of three markets into a single market a. Interbank market will remain as the money market mainly for PBOC’s open market operations b. Exchange market has limitations because automated trading system can not offer pre-trading negotiations and personal relationships among bond dealers……Korea’s Experience c. Create a “true” OTC market with all types of financial institutions participating Asia-Pacific Financial Markets Research Center, University of Hawaii

20. 20 Korea Stock Exchange’s Experience Unit: $ billion Exchange Market. YearGov’t BondsCorp BondsTotal OTC Market 1997 $0.14 $2.25 $2.39 $82.27 1998 5.42 7.46 12.88 359.17 1999* 248.87 10.32 259.19 658.32 2000 18.58 2.88 21.46 736.36 2001 9.45 1.56 11.01 1,066.44 *KSE Introduced inter-dealer broker system for government bond trading in March 1999 Asia-Pacific Financial Markets Research Center, University of Hawaii

21. 21 Recommendation 4: Infrastructure Building 1.Interest Rate Risk Hedging Instruments Is Repeat of Pre-1995 Bubble Valid Concern ? 2.PBOC-Based C&S System Clearing: Multilateral netting basis Settlement: DVP through PBC-wire system Is China Government Securities Depository Trust & Clearing Co. up to the Task? 3.Introduction of When-Issued Trading Asia-Pacific Financial Markets Research Center, University of Hawaii

22. 22 Recommendation 5: Infrastructure Building 3. Bond Fund 3. Bond Fund a. Institutionalization of Individual Bond Holdings a. Institutionalization of Individual Bond Holdings 4. Inter-Dealer Broker System 4. Inter-Dealer Broker System a. Brings market makers together a. Brings market makers together b. Disseminates to the market via telephone,screen or a combination of the two b. Disseminates to the market via telephone,screen or a combination of the two c. Promote secondary market liquidity, depth, transparency c. Promote secondary market liquidity, depth, transparency Asia-Pacific Financial Markets Research Center, University of Hawaii

23. 23 Recommendation 6: Infrastructure Building 5. Credit Rating Culture Be Promoted 5. Credit Rating Culture Be Promoted 6. Credit Guarantee and Credit Enhancement 6. Credit Guarantee and Credit Enhancement Mechanism are urgently needed for SMEs 7.Fiscal Autonomy for Municipal Governments: 7.Fiscal Autonomy for Municipal Governments: Development of a municipal bond market is an extremely important policy agenda Asia-Pacific Financial Markets Research Center, University of Hawaii

24. Thank You! For Further References, Please visit http://www2.hawaii.edu/~rheesg Asia-Pacific Financial Markets Research Center, University of Hawaii