China's Government Bond Market
Takeshi Jingu

I.

Introduction: the significance of CGBs to China's recent
economic policy

China has arrived at the critical juncture of trying to move away from its traditionalmode of economic development. The government led by President Hu Jintao has been
attempting to change the approach to economic development over the past several
years, and a focus on scientific development underpins the new approach. China's
17th Communist Party Congress (held 15-21 October 2007) proposed placing apriority on scientific development in all facets, and this is expected to encouragechange in China's approach to economic development.
The new proposal addresses the growing harm resulting from China's emphasis onachieving uniform nationwide economic development, i.e., the negatives of an
economic development approach favoring GDP expansion, which include risingincome disparity and damage to the environment. It does so by (1) placing a greaterpriority on protecting the environment and farmland by distinguishing between thoseregions where development should be promoted and those regions where development
should be restricted or prohibited1, and, in parallel with this, (2) attempting to achieve
greater equality among citizens in the level of public services (including drinking
water, compulsory education, and health care) that they receive. In fact, the criteria forevaluating government officials were changed in 2006 to include protection of theenvironment, thereby reducing the bias toward GDP growth.
President Hu Jintao's report to the 17th CCP Congress, in referring to fiscal andfinancial reforms, proposed raising the level, both in absolute and percentage terms, oftransfer payments from the central government to local governments, and also
proposed improvements to the financing systems of provincial and lower-level local
governments, as a way to achieve greater equality in the public services received. The
basic plan, in other words, is to rely on income transfers from the central government
to raise the standard of living in those regions where unfavorable conditions orenvironmental considerations preclude economic development. Even amid attempts toincrease government revenue and streamline government spending by improving
fiscal systems and strengthening tax collection2, there is likely to be an increase in
1

2

24

Under the 11th 5-year plan (2006-2010), national land at the municipality and county levelis classified into the following types of regions: priority development, moderate
development, restricted development, and prohibited development.
Jingu and Ri (2007)

Nomura Capital Market Review Vol.11 No.1

demand for government spending in light of the large potential demand for public
services in those rural areas that have lagged thus far in economic development.
Although this differs from the traditional approach in which regional economies reliedon projects funded by CGBs, we expect CGBs to play an important role as a source offunding to create greater equality in public services.
Meanwhile, one problem currently plaguing China's economy is excess liquidity.
The management of monetary policy is becoming increasingly difficult for the PBC,
which has constantly had to absorb liquidity from the market in order to keep it fromgrowing excessively. One reason for this difficulty is a shortage of treasury bills
available for use in open market operations3.
The fundamental cause of this excess liquidity is China's currency regime, and we
expect to see a widening of the trading band of the yuan's exchange rate. With demand
for forward currency contracts and other tools for hedging risk expected to increase
further, market participants are regularly pointing out the need for China to have astable domestic yield curve. In addition, for open market operations to flexibly
respond to capital inflows, it is essential that financial markets have depth. The needfor further development of the CGB market is evident from this perspective, as well.

II. The history of the CGB market's development
1. From 1981 to 1997
In this section, we take a brief look back at the development of China's government
bond market that began in the 1980s, concentrating on those aspects relevant to thecurrent problems facing the CGB market 4 . In 1981, China resumed issuance ofgovernment bonds after roughly a 20-year hiatus, primarily to address a shortfall in
funding for national construction projects. Issuance was done through administrative
allotment, and trading CGBs on the secondary market was not allowed. There was nosecondary market for CGBs in the beginning because of this, although the trading of
CGBs was tried on a trial basis in Shanghai and six other cities in 1988, after which
trading was allowed nationwide in the early 1990s. Stock exchanges were opened inboth Shanghai and Shenzhen in 1990, when CGB trading was also allowed, causing
the nexus of CGB trading to move to the stock exchanges. Subsequently, sparked by amajor scandal involving illegal short selling of CGBs in 19955, off-exchange bondtrading was ended, and in 1997 the banks were pulled out of the exchanges, and began
conducting their bond trading in the interbank market, where they have done so since
then.

3
4

5

Jingu (2007)
This section is based on data from Cao (2006), He and Gao (2007), and various editionsof the "Zhongguo Guozhai Shichang Nianbao" (Annual Report on China National Debt
Markets) (in Chinese).
Trading in CGB futures was suspended in May 1995. In August 1995, restrictions wereplaced on off-exchange bond trading, including a prohibition of off-exchange repo trading.

China's Government Bond Market 25

China experimented with an underwriting system for CGB issuance in 1991, andthen created a primary dealer system in 1993. Since 1996, all tradable CGBs havebeen issued through an auction system. Although initially there were a number ofdifferent types of CGBs issued, in 1994 issuance began for certificate bonds (alsocalled savings bonds or voucher form T-bills: non-tradable securities sold toindividuals and corporations through bank and post office branches) and book-entry
bonds (primarily sold to institutional investors; tradable on the interbank market andon stock exchanges), and those two forms have comprised the bulk of issuance sincethen6. As will be explained later in this report, 1994 was the year that CGB issuancebegan to grow. Within the interbank government bond market, interest rates were
deregulated for the secondary market (cash bonds and repos) in 1997 and for theissuance market in 1999.

2. From 1998
As the volume of CGB issuance increases, and as the number of market
participants grows, the negative ramifications of the CGB market being split amongstock exchanges, the interbank market, and the over-the-counter (OTC) market (forcertificate bonds) are starting to become more apparent. Although the authorities were
initially cautious because of the market turmoil in the mid-1990s, from 1998 until
2001 they authorized interbank market participation for insurance companies,
agricultural credit institutions, fund management (mutual fund) companies, securities
firms, finance companies, and leasing companies. In addition, a market maker system
was established in April 2001 to increase liquidity, and in April 2002 participation in
the interbank market was changed from a system requiring approval to one requiring
only registration7.
Investors were thus allowed to participate in multiple markets, while in 2002 bookentry CGBs were introduced to the over-the-counter market, allowing the same namebook-entry CGB to be issued on three different markets at the same time. Since 2005,
all book-entry CGBs have been issued simultaneously in either two (stock exchanges
and the interbank market) or all three markets. In December 2003, the government
published rules on managing the transfer of CGB holdings between markets byinstitutions participating in the three markets. In 2006, approximately 87% (in value
terms) of cash bond and repo trades were made on the interbank market.
On the issuance side, the government began announcing its CGB issuance plans in
2000, and gradually began increasing the regularity of issuance around 2003. The
maturity profile of CGB issuance ranges from 3-month bills on the short end of thecurve to 30-year bonds on the long end. In 2003, the government imposed a greaterobligation on underwriting syndicate members by establishing minimum bid amounts.
In the area of financial innovations, several new trading methods have been
6

7

26

For more on the diverse types of CGBs issued in the past, see Nomura Institute for
Capital Markets Research (2007). Book-entry CGBs were later made eligible for OTC
sales by the banks (explained later).
As of end-2006, 6,439 institutions (including 4,450 corporations) participated in theinterbank market.

Nomura Capital Market Review Vol.11 No.1

introduced, including buy-sell (or buyout) repos in 2004, bond forward trading in
2005, and bond borrowing and lending in 2006.

3. Fiscal policy and CGB issuance
We look next at fiscal policy and CGB issuance from the macroeconomic
perspective.
Following the introduction of the open-door policy in 1978, the Chinese
government did not explicitly use fiscal policy as a primary means of macroeconomic
control until 19938. Macroeconomic control policies were instituted in June 1993 in
response to the economic overheating that occurred in the early 1990s. These policies
included strict controls on government deficits, along with the reduction of tax
incentives. In 1994, rather than cover government deficits with loans from the central
bank, as was done previously, the government began raising funds by issuing CGBs,
and this sparked an increase in CGB issuance (Figure 1).

Figure 1: CGB issuance amounts(Rmb billions)
1,000
Fiscal deficit

900

CGB issuance
800
700
600
500
400
300
200
100
0
1990

Source:8

1992

1994 1996

1998

2000 2002

2004

2006

Nomura Institute of Capital Markets Research, based on the "Zhongguo Zhengjuan
Qihuo Nianjian" (China Securities and Futures Statistical Yearbook) and CEIC
Data (in Chinese).

"Quan Guo Ganbu Xuexi Peixun Jiaocai" (National Cadre Training Program Course
Materials), 2006 (in Chinese).

China's Government Bond Market 27

A tightening of macroeconomic policy was successful in achieving a soft landing
for the Chinese economy. In 1997, however, the Asian currency crisis erupted, tipping
the Chinese economy into a period of deflation in 1998. To deal with sluggish internaland external demand, falling prices, and rising unemployment, the Chinese
government pursued monetary easing as well as aggressive fiscal policy measures.
1998 was also the year when the PBC stopped setting limits on bank lending, a formof direct control.
These aggressive fiscal policies remained in place from 1998 until 2004. They
included the issuance of long-term construction CGBs to fund the construction of
infrastructure, which totaled Rmb100 billion in 1998, Rmb110 billion in 1999,
Rmb150 billion each in 2000, 2001, and 2002, Rmb140 billion in 2003, and Rmb110
billion in 2004. Thus, following its initial increase in 1994, the amount of CGB
issuance increased further from 1998, as did the government deficit.
Starting in the second half of 2003, it became clear that the economy was gettingstronger and pulling out of deflation, while fears of economic overheating in at least
some industry sectors began to emerge in 2004. Consequently, at end-2004 theaggressive fiscal policies that had been in place for seven years were ended, andChina switched to the more moderate, or "neutral" fiscal policy that remains in place
today.
This more moderate fiscal policy has been characterized by controls on
government deficits, structural adjustments, further reforms, and tax revenue increases
combined with spending reductions 9 . Here, the term structural adjustments meanschanges in the structure of fiscal spending and of projects funded with CGBs, basedon the concepts of scientific development and public service funding outlined in the
introduction. The term "reform" refers to the parallel process of abandoning the oldmodel of economic development dependent on CGB-funded projects, which isessentially the change in approach to economic development referred to in the
introduction. The controls on government deficits led to their reduction, from a peakof Rmb314.96 billion (2.6% of GDP) in 2002 to only Rmb166.25 billion (0.8% ofGDP) in 2006.
China has thus pursued textbook fiscal policies, adopting expansionary policies
during downturns and then returning to neutral policies during times when economic
overheating is a concern. Consequently, it is important to note that China retains
considerable leeway in its fiscal policy, in case the economy sours in a backlash fromthe overheated growth of recent years10.

910"Quan Guo Ganbu Xuexi Peixun Jiaocai" (National Cadre Training Program Course
Materials), 2006 (in Chinese).
Be aware, of course, that there is a hidden, potential deficit over the long term, including
nonperforming loans of financial institutions and social security funding shortfalls.

28

Nomura Capital Market Review Vol.11 No.1

III. Problems with the CGB market
The CGB market has had its regulatory infrastructure developed and also grown insize, making it increasingly important both as a way for the government to raise funds
and as an investment vehicle for investors. But the market also has a number ofproblems, as we describe below.

The first problem relates to the maturity profile of CGBs. Although this maturity
profile has improved relative to before, it is still weighted heavily in the intermediatezone (1-year to 10-year), and has an insufficient amount of treasury bills. Looking at
the amount of CGBs outstanding in the interbank market by remaining maturity, only
11% of the total is short term (a year or less remaining maturity) and 23% is long term
(over 10 years), leaving the bulk of bonds in the intermediate zone (Figure 2). We
think that this small amount of treasury bills also affects the liquidity of the overallmarket. Furthermore, because the PBC does not have sufficient treasury bills withwhich to conduct open market operations, it has recently had to rely on the issuance ofcentral bank bills. An increase in treasury bills is thus also desirable from theperspective of giving the PBC greater flexibility in its open market operations in the
future. Meanwhile, as the amount of investable funds held by the insurance companies
increases, we expect demand for long-term CGBs will also increase.

Figure 2: CGBs outstanding by maturity date
(Rmb billions)
800
700
600
500
400
300
200
100
0
2008 2010 2012 2014 2016 2018 2020 2022 2024 2026 2028 2030 2032 2034 2036
(Maturity date)

Note:

Source:As of end-November 2006. CGBs outstanding, excluding certificate bonds. The
bonds maturing in 2017 include the special treasury bonds issued in August 2007
to provide funds to the China Investment Corporation, the entity created to manage
China's foreign reserves.
Nomura Institute of Capital Markets Research, based on data from Wind
Information

China's Government Bond Market 29

The second problem relates to certificate bonds. Although the issuance of bookentry bonds is increasing, certificate bonds still account for about one fourth of total
CGB issuance outstanding. These certificate bonds, which are primarily sold toindividuals, have yet to transition to a paperless (electronic) system, and this presents
its own set of problems, both in terms of safety and, on the technological side, thedifficulty of managing the bonds centrally. Specifically, it has been difficult to create asingle system for issuance nationwide, and this has created the problem of someregions not having enough bonds and other regions having bonds left over. To address
this issue, China began issuing paperless government savings bonds in 2006 (more onthese bonds below).
The third problem that has been pointed out is the lack of liquidity. Trading
turnover (trade amount/outstanding amount) in the CGB market was only 0.4x in
January-November 2007, compared with 2.1x for central bank bills and 0.92x forpolicy financial bonds. Contrast this with Japan, where the turnover of cash JGBs wasapproximately 4x in 2007. Out of a total of approximately 80 issues, only 12 had aturnover above 1x in 2007 (versus only 10 in 2006). Even the major issues traded on
both the interbank market and the stock exchanges do not always see trading action ona daily basis11.
One reason for this is the skewed ownership of CGBs. Looking at CGB ownershipby investor type in the interbank market as of November 2007, the commercial banks
owned 58.7% of all CGBs, special members owned 23.0%, and the insurancecompanies owned 5.8% (Figure 3). Special members include the PBC and otherauthorities12, and together with the commercial banks and the insurance companies
own nearly 90% of outstanding CGBs.
Figure 3: Ownership profile of CGBs (in the interbank market)
Total as of end-November 2007:
Rmb3.842 trillion
Insurancecompanies
5.8%

Other
5.1%

Stock
exchanges
7.4%

Specialmembers
23.0%

Source:111230Commercial
banks
58.7%

Nomura Institute of Capital Markets Research, based on data from ChinaBond

Sun (2006)
The PBC, the Ministry of Finance, the policy banks, the China Government Securities
Depository Trust & Clearing Co. Ltd., and the China Securities Depository & Clearing
Corporation, Ltd.

Nomura Capital Market Review Vol.11 No.1

The commercial banks dominate ownership, and it is this lack of a diverse range ofmarket participants that explains the infrequency of trading. In addition, because thecommercial banks prefer to invest in CGBs for purposes of managing risk and theircapital ratio, most of the CGBs in commercial bank portfolios are held to maturity,
and when they are traded it is usually in the form of a repo transaction. The risk fromrising interest rates appears to be concentrated among the commercial banks and theinsurance companies and to make matters worse derivatives aimed at avoiding risk arescarce.
There is still a divide between the interbank market and the stock exchanges. We
have already seen a number of initiatives that address this, including the broadeningof the types of investors who can participate in both markets, the issuance of the same
name on both markets, and the announcement of rules governing trades that straddle
both markets, but commercial banks, which own a large share of CGBs, are still
unable to participate in the stock exchanges.
A fourth problem is the unreliable government bond yield curve, which reflects the
low level of liquidity. A government bond yield curve normally establishes the riskfree interest rate and provides a basis for pricing assets. This instability of thereference yield is a glaring problem for a country, like China, that is transitioning to amarket economy.
Even the short end of the yield curve below 1-year, where transaction volume isrelatively large, is still not very stable13. In the intermediate and long-term portions of
the curve, we have already pointed out the lack of sufficient trading activity in CGBs
and policy financial bonds. There is also a problem with price formation; prices canget distorted, for example, when some institutions raise their volume of trades14. In
this regard, it is conceivable that the lack of sufficient derivative products makes it
difficult to correct these price distortions.

IV. Recent trends
Over the past several years, the government has implemented a variety of measures
to address these problems, which we look at below.
First, in 2006 the government changed its approach to managing debt, abandoning
the method, in use since 1981, of managing the amount of CGB issuance each year,and going instead to a system of managing the amount of CGBs outstanding. Thisapproach made it easier to regularly issue rollover treasury bills, and also created abasis for increasing the issuance of treasury bills, which are needed to conductmonetary policy. There has been a steady increase in the level of information
disclosure on CGB issuance since 2000. The FY2007 CGB issuance plan, which gives
quarterly auction dates for 1-year, 3-year, 7-year, and 10-year book-entry CGBs, wasannounced on 27 January 2007. Actual issuance is now largely according to plan,
13
14

Jingu (2007)
Sun (2006)

China's Government Bond Market 31

making it considerably easier to predict CGB issuance now relative to several years
ago (Figure 4).

Figure 4: CGB issuance (maturities of 1yr to 10yr)
Qtr ofissuance
Q1

Q2

Q3

Q4

Note:
Source:Years tomaturity
1yr
3yr
5yr
7yr
10yr
1yr
3yr
5yr
7yr
10yr
1yr
3yr
5yr
7yr
10yr
1yr
3yr
5yr
7yr
10yr

2003

2004

2005

2006

2007

As of end-November 2007. A shaded area means issuance.
Nomura Institute of Capital Markets Research, based on the China Government
Bond Almanac and data from ChinaBond.

Second was the issuance of special treasury bonds in 2007. These special treasury
bonds are issued by the Ministry of Finance to raise funds for the China Investment
Corporation (CIC), the corporation that manages China's foreign-exchange reserves,and although improving the CGB market was not the specific purpose of theirissuance, they bear mentioning based on their importance to conducting monetary
policy. Special treasury issuance totaled Rmb1.55 trillion, all in 2007. Out of thisamount, Rmb200 billion was issued directly to the market across several tranches,
while the remaining Rmb1.35 trillion was purchased by the PBC after passing throughthe Agricultural Bank of China15. Of the Rmb1.35 trillion, Rmb600 billion was issuedin August and the remaining Rmb750 billion was issued in December. In regards tomonetary policy, this Rmb1.35 trillion in special treasury bonds is now available to
the PBC for use in open market operations. The Rmb200 billion issued directly to themarket served to absorb liquidity from the market at the time of issuance.
Third is the introduction of paperless savings bonds in 2006. The purpose was toimprove the safety and centralize the management of certificate bonds, and the15

Jingu (2007)

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Nomura Capital Market Review Vol.11 No.1

electronic book-entry approach will enable such centralized management. The
differences between the electronic savings bonds and certificate bonds are: (1) the
certificate bonds are underwritten by a syndicate (as of 2007, comprising 39
commercial banks and the national postal savings system), whereas the electronicsavings bonds are sold by agents (initially seven banks); and (2) the certificate bonds
are issued to society at large, and can be purchased by corporations as well as
individuals, whereas the electronic savings bonds are sold only to individuals16. For
the time being, both certificate bonds and electronic savings bonds will be issued, andboth will be nontradable government bonds for use as savings by individuals.
A fourth measure has been the introduction of new financial products for theinterbank market, beginning with buy-sell repos in 2004. In contrast with a generalcollateral repo, a funding transaction using bonds as collateral, in a buy-sell repo, thebondholder sells the bond to the fund provider, and then repurchases the bond after agiven period. Because ownership of the bond resides with the fund provider during
the period of the repo, a buy/sellback repo can be used for bond procurement andshort sales.
Bond forward transactions (with a period no longer than 365 days) were introduced
in 2005, and then rules covering bond borrowing and lending were announced in 2006.
Bond loans are a mechanism to enable the borrowing of bonds with collateral, withthe aim of increasing overall market liquidity and providing short-sale capability. The
lending period is up to 365 days, at a lending fee agreed upon by both parties.
The amount of buy-sell repos in 2007 (January-November) totaled Rmb659.7
billion, more than double the amount in all of 2006, but only about 1.6% of theamount of general collateral repos, which totaled roughly Rmb40.5 trillion in the first
11 months of 2007. The amount of bond forward transactions in 2007 (JanuaryNovember) totaled Rmb227.3 billion, an increase of 3.5x over the full year 2006,
although still a fairly low number when considering that the amount of bonds
outstanding in the interbank market totaled approximately Rmb10 trillion in
November 200717.
Fifth were the improvements made to the market maker system. The market makersystem was initially introduced in 2001, but in January 2007, the People's Bank of
China issued the "Administrative Rules on Market Makers in the Interbank Bond
Market." These rules loosened the requirements that had to be met to participate as amarket maker. Specifically, the new rules eliminated the requirements for market
makers to meet hurdles regarding bond sales volume and to be qualified as a primary
dealer for open market operations. It also eased the requirement for applying for
qualification, from ranking in the top 20 companies in cash bond trading volume
during the year preceding application, to ranking in the top 80 companies. The rules
16

17

Although the underwriting approach is being used for both book-entry CGBs andcertificate bonds, issuance terms are determined at auction for book-entry CGBs but
decided by the authorities (the Ministry of Finance and the PBC) for certificate bonds.
Yields for electronic bonds are also set by the authorities. Neither certificate bonds nor
electronic bonds are tradable.
These facts and statistics refer to the interbank market overall, and include bankdebentures and other bonds outside of CGBs.

China's Government Bond Market 33

also strengthened the hand of market makers with certain incentives, including (1)more favorable treatment and fee structures in the issuance market and in bondborrowing and lending, and (2) priority in becoming qualified as a member ofunderwriting syndicates for CGBs and policy financial bonds and as a primary dealer
for open market operations. As of November 2007, however, these incentives had not
resulted in any change in the number of market makers.
Future improvements in the CGB market could conceivably include changes in the
CGB ownership profile, improvements in market infrastructure, and the introductionof financial innovations.
As the main institutional investors in securities markets, namely fund managementcompanies and the insurance companies, experience growth in the amount of funds
that they have available to invest, we expect to see a change in the CGB ownershipprofile, which is now heavily weighted toward the commercial banks. This is anotherreason why fostering a base of institutional investors is important.
Regarding the market segmentation problem, although it is now possible to engage
in transactions that straddle the interbank market and the stock exchanges, the investor
category with the highest ownership of CGBs, the commercial banks, are not allowed
to trade their CGB holdings on stock exchanges. Although the relative size of thestock exchanges is getting smaller, solving the problem of pricing differences between
the two markets may require allowing the commercial banks to participate in the CGB
markets operated by the stock exchanges.
With respect to financial innovations, a number of new methods of trading havebeen introduced, but the volume of those trades remains small. We see a need toincrease the trading volume of those new products already introduced, as well as toconsider reopening the market for CGB futures, which has been closed since 1995,
mostly from the standpoint of providing investors a way to hedge their positions.
To achieve a higher level of market liquidity and a more stable yield curve, it isessential to pursue comprehensive market reforms.
Lastly, it is important to note that in practical terms, the CGB market can play animportant role in both monetary policy and fiscal policy. For example, both theamount and issuing method of the special treasury bonds issued in 2007 have had an
impact on the conduct of monetary policy. If over the long term, an increase in theliquidity of the CGB market helps to stabilize the benchmark yield and make open
market operations more effective, it should in turn increase the effectiveness of the
PBC's indirect macroeconomic controls, which depend on the interest ratetransmission mechanism. We expect cooperation between the Ministry of Finance and
the PBC to become even more important to the CGB market's operation in the future.

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Nomura Capital Market Review Vol.11 No.1

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China's Government Bond Market 35