Critics of the Chinese bond market have long complained that it should be more like Wall Street. Western investors, global regulators and even the IMF and World Bank assume that debt markets everywhere need to provide easy liquidity and the kinds of short-term “repo” (repurchase agreement) borrowing and derivatives that Americans use to finance and hedge their investments.
But this gospel of structural reform overstates the suitability of the US model for China and the rest of the world. According to a book edited by IMF staff, the Chinese bond market, the third largest in the world, unfairly shackles foreigners. They cannot do many things western investors take for granted, including borrowing against them via repo markets and betting that prices will fall. Nor can they count on local banks to make markets or serve as counterparties on bond futures.
Instead, the Chinese market’s structures work in favour of local institutions, which largely use bonds as collateral to finance interbank lending via their own version of the repo market. Trading in that market is 20 times higher than in the bond market. Instead of trading bonds, China “collateralises” them to fuel short-term borrowing.
If Beijing is serious about making the renminbi an international currency, and building resilient market-based finance, the advice goes, it needs to take urgent steps towards the US model.
Allow foreign investors free access to repo and derivative markets. Reform the repo market to give lenders legal rights over collateral, so they can reuse it or liquidate it when counterparties default. Require investors to revalue their bonds when the markets move. And encourage more local banks to become market-makers. The international community wants China to make its banks more sensitive to the daily dynamics of bond markets. They say it will improve liquidity and market discipline.
If Beijing listened, perhaps as a compromise in the trade war with the US, it would be like pouring petrol on a fire. Instability becomes explosive faster through the US model, which amplifies both gains and losses when markets are volatile. The 2016 Sealand Securities scandal is instructive. Sealand shook Chinese bond markets by refusing to honour repo-like agreements that, it claimed, its employees had forged. Chinese regulators forced Sealand’s counterparties to agree to share the losses. This contained the bond market sell-off.
Had China’s repo markets been more like the US, regulators would have found it more difficult to prevent Sealand from triggering a crisis like the one triggered by the failure of Lehman Brothers. Sealand’s counterparties would have been legally required to liquidate the bonds they held as collateral. The sell-off would have shown up on other banks’ balance sheets and spread through the reuse of bond collateral. Investment vehicles that can meet redemption pressures via interbank repo borrowing would have had to sell bonds. Instead, Chinese bond markets are designed to allow trading fluctuations without firesales. Regulators there learnt from the June 2013 interbank liquidity squeeze.
China should heed the lessons of Europe’s 1990s deregulation, known as the Big Bang, when finance ministers in the UK and Germany were seduced by the liquidity promises of the US model. But Lehman’s 2008 failure demonstrated the “liquidity paradox” of US-style markets — it disappears when it is most needed. Post-crisis regulation has done little to solve this problem.
Emerging countries have something else to worry about: adopting the American model would tie them closer into the global cycle that moves institutional money around the world in reaction to US monetary policy. Remaking bond markets in the US image would lead to fickle portfolio flows without monetary policy autonomy. The spectre of Asian-type currency crises would return.
The writer is professor of economics and macro-finance at the University of the West of England