Posted by: mulrickillion | October 2, 2011

Understanding Chinese Bond Yields and their Role in Monetary Policy

By Nuno Cassola and Nathan Porter

International Monetary Fund (IMF), Working Paper No. 11/225, September 2011 —

Summary: China’s financial prices are informative enough for the PBC to introduce a monetary policy framework centered around interest rates. While bond yields are not fully efficient—reflecting regulation, liquidity, and segmentation—we find they contain considerable information about the state of the economy as well as evidence of an emerging transmission channel: changes in PBC rates influence the structure of Treasury, financial, and corporate bond yield curves, which are then associated with changes in growth and inflation. Coporate spreads are also a leading indicator of growth and inflation. While further liberalization will strengthen both efficiency and transmission, several necessary elements to move towards indirect monetary policy are already in place.

[An excerpt from the Working Paper reads]:

Monetary management in China is increasingly showing signs of tension. The continued reliance on quantitative targets and direct and administrative controls is not only resulting in increased instability in monetary aggregates, but has also increased the incentives for intermediation to move outside the regulated financial sector. The pace of this disintermediation has increased rapidly in recent times to avoid the impact of such quantitative controls (Chu, and others, 2010). While disintermediation may also partly reflect the financial development process, it suggests the need for a transition towards an indirect monetary policy framework. Not only might such a shift result in a more effective management of demand for credit in these circumstances, it could also increase the efficiency of intermediation (Feyzioglu and others, 2009). Such a shift will be most effective if financial prices are efficient and informative signals of economic conditions, and there is an effective transmission mechanism from the chosen policy rate to other financial prices, and ultimately the real economy.

Despite their large size (around ¾ of GDP), Chinese fixed income markets are relatively young, and have for much of their life been highly regulated (ICMA, 2005; Porter and Xu, 2009). Beyond regulation on the issuance of corporate bonds, trading in the bond market remains largely segmented between the exchanges and an (institutional) interbank market, thereby splitting liquidity. Moreover, while wholesale and foreign currency interest rates have been liberalized, the structure of retail interest rates remain regulated, potentially affecting the structure of market determined interest rates (Porter and Xu, 2009). . . .

>>Read the full Working Paper here (wp11225.pdf).

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