How China fine-tunes bond values to spark economy

In times of economic pressure, granting collateral value to bonds can slash borrowing costs and fuel a surge in economic activity

Featured faculty: Wu Xian
Written by Putro Harnowo

Against all odds, China managed to rack up record-breaking exports last year with a US$1.2 trillion surplus. It was quite unprecedented, given the US mounting tariffs for months. The tension eventually calmed following the October truce, but a bigger problem is brewing closer to home. The world factory has experienced sustained deflation since 2023.

In contrast to inflation, deflation is a broad decline in the prices of goods and services. While it is not always harmful, deflation may spiral into weak consumer spending, lower business profits, and increased unemployment. The government has committed to stimulating domestic consumption by lowering benchmark interest rates to encourage spending.

“When deflation happens, the government normally wants to boost the economy by lowering the interest rate to raise the inflation rate mildly. However, at some point, the interest rate will hit the floor and cannot be lowered further,” says Wu Xian, Assistant Professor of Finance at the Chinese University of Hong Kong (CUHK) Business School.

To shift away from heavy reliance on traditional interest rate adjustments, the central bank can utilise unconventional monetary policy tools. For instance, the People’s Bank of China, between 2013 and 2014, injected liquidity into the banking system by allowing certain bonds to serve as collateral for commercial banks to borrow. This tool is called collateral-based monetary policy or collateral framework.

“Collateral framework is not unique to China. It has also been adopted widely across the world, for example, the Federal Reserve’s term asset-backed securities loan facility and the European Central Bank’s long-term refinancing operations. However, its impacts were hard to measure,” Professor Wu adds. “There’s a lot of endogeneity in economics, so we couldn’t tell whether the change in markets is due to this policy or other factors, like bond characteristics or the unobservable economic shocks.”

A study by Professor Wu titled Collateral-based monetary policy: evidence from China, in collaboration with Fang Hanming of the University of Pennsylvania and Wang Yongqin of Fudan University, is the first ever to measure the causal positive effects of the collateral framework on the real economy.

Professor Wu and her collaborators find that the collateral framework significantly decreases the bond spread, or the yield gap between a corporate bond and a safer government bond, and provides companies with more capital to invest and pursue other business activities. This tool also has broader and long-term effects. For instance, follow-up studies show that a collateral framework targeting green bonds can stimulate more investments in green initiatives.

Lessons learned from Chinese bonds

China’s central bank provides lending programmes for commercial banks based on loan terms, including the standing lending facility or short-term liquidity operation for immediate cash, the medium-term lending facility with three to 12-month terms, and the pledged supplementary lending with three to five-year term loans to support specific sectors.

To obtain these loans, banks need to put down securities as collateral. Since 2013, the central bank has accepted treasury and local government bonds, as well as AAA-rated corporate bonds, as collateral. This framework was extended in June 2018 to include AA and AA+ rated corporate bonds. While AAA bonds are more secure, an AA rating offers a slightly higher yield for a marginally higher risk profile.

Interestingly, many Chinese bonds are traded on two venues, despite having the same fundamentals. Bonds listed in the interbank market for qualified institutional investors are also available on major exchanges, such as the Shanghai and Shenzhen exchanges, for non-bank financial institutions and retail investors.

Only bonds in the interbank market are eligible as collateral, since the interbank market is regulated by the central bank. Professor Wu and the team use these bonds as the treatment group and the same bonds in the exchange market as the control group. “This allows us to establish a causal relationship between the collateral framework and bond prices, which is not possible in other financial markets.”

The team examines daily bond trading from January to September 2018 and finds that the collateral framework increased the value of eligible bonds. Before the collateral expansion, banks could use the AA and AA+ rated corporate bonds to borrow from other financial institutions in the repo market. The repo market participants don’t lend money based on the full value of the bonds but reduce them by a few per cent.

“Companies can borrow at a lower cost as long as they can issue at least AA or AA+ rated bonds. This allows the central bank to support and ease funding to the real economy.”

Professor Wu Xian

Being included in the collateral framework trims such reduction by three per cent, boosting the collateral value and the prices of these bonds. It reduced the spreads of the newly eligible bonds by 37–53 basis points, equivalently, 10–15 per cent of the average spread in the secondary interbank market, where previously issued bonds are traded among qualified institutional investors.

This effect can further pass through to newly issued bonds in the primary market and allows bond issuers to secure a lower borrowing cost. It reduces the spread of the eligible bonds in the primary market by about 35-56 basis points. This means the bond issuers can borrow at a cheaper rate than before.

“Companies can borrow at a lower cost as long as they can issue at least AA or AA+ rated bonds. This allows the central bank to support and ease funding to the real economy,” Professor Wu adds.

Wider effect in the market

After 1 June 2018, issuing new eligible bonds is cheaper in the interbank market than in the exchange market. Firms can take advantage of this policy and choose the best market to issue bonds. Eligible bonds are more likely to be issued in the interbank market than the exchange market.

By the end of 2018, the People’s Bank of China’s lending facilities totalled more than eight trillion Chinese yuan, about 25 per cent of the monetary base.

“Collateral framework is crucial when interest rates are low,” Professor Wu adds. “This way, the central bank can conduct policy expansion by allowing commercial banks to borrow more and lend to other institutions and businesses.”

The 2018 collateral framework also made the People’s Bank of China one of the first central banks to specifically target green bonds. While her study doesn’t explore the impact on green finance, Professor Wu sees that follow-up studies have shown that green firms received more loans because of this framework.

Furthermore, as the interbank and exchange markets coexist with a shared bond structure, Professor Wu plans to understand more deeply whether this arrangement is efficient. Her next study looks into which type of assets should be traded in the decentralised interbank market, which holds 86 to 90 per cent of all Chinese bonds.

“There’s some benefit to keeping both markets, as each has its own strengths,” she adds. “A centralised market is more transparent, but you can find dealers to trade in large quantities in the decentralised exchange markets. How to design these markets is an interesting direction to explore in the future.”