Development of the Chinese Money Market and Its Critical Issues for Future Development - Essay Example

The development of the Chinese money market and its critical issues for future development Introduction China has been undergoing changes in the money market and interest rate regimes, ever since the beginning of reforms period in the late 70s. Since then, there has been a growing emphasis on development of short-term nationally integrated money markets. The rationale behind this liberalization regime was to improve effectiveness of the money markets; make the capital markets more robust for them to effectively provide liquidities and fund for portfolios; and also to render operations in the foreign exchange market more vibrant (Mehran, Quintyn, and Laurens, 1996). Considering the recent developments in the money market in China, it can be said that varieties of market transaction have improved, the transaction scale has expanded and the market membership has also widened (Neftci and Ménager-Xu, 2007). However, in relation to other countries of the world, development of the Chinese money market requires further restructuring. There are various components in the money market of China, namely the interbank market that conducts the lending and borrowing; repurchase market; and securities market. The operation of the money market is extremely crucial for financial sector reforms, operation of the commercial banks and smooth functioning of the monetary policy of the central bank. Nevertheless, bureaucratic controls on the interest rates of deposits and loans are still dominant, which renders the impact on other financial markets less powerful due to changes in the interest rates. It is also crucial for appropriate functioning of the fiscal policy (Neftci and Ménager-Xu, 2007). The purpose of this essay is to discuss the development of various sub-segments of the Chinese money markets in the latest decade as well as to highlight crucial market issues. Some recommendations are also provided that can guide the course of future development of the money market with relevance to the policy implication. Importance of the topic Effective functioning of the monetary policy is dependent on creation of a vibrant money market. The money market forms a medium, where the central bank of an economy comes in contact with the entire financial system as well as determines the cost and availability of credit required by the financial institutions for proper functioning. As the Chinese economy is undergoing a number of reforms with the passage of time, number of members in the money markets is also rising. The once concentrated money markets have now expanded to include not only state-owned commercial banks and joint stock commercial banks, but also the local banks, foreign funded banks, financial companies, cooperatives and fund management companies. The following chart shows the rise in number of institutions in the financial markets. (Source: Neftci and Ménager-Xu, 2007) As the number of institutions under ambit of the money market is growing, overall economic development of the nation is largely dependent on buoyant performance of these institutions. This topic has provided a comprehensive view on enhancement of all sectors in the money market of China. This can be useful to understand the current scenario in the money market of China, which affects decision making of the overall financial system. The various limitations and possible sources of improvement are discussed in the essay. Interbank market This is one of the core components of the money market. This market is characterized by short-term lending and borrowing between the financial institutions by means of credit, with or without collateral. In the initial years, this was not a very popular tool for managing reserves due to lack of other financial instruments in the monetary and capital markets. The most common practice then was lending and borrowing in order to match the surplus or deficit in the medium and long-term funds. It was during 1993 that lending and borrowing between the financial institutions had come under pressure due a rise in the number of borrowing of non-financial institutions like, investment companies and trust of the commercial banks (Duo, 2000). During this time, in order to avoid the credit ceiling management, interbank lending and borrowing became popular. Since the introduction of reforms in the monetary market in China, two major changes have been experienced in the interbank market. The first major change has been to specify all members that are eligible to conduct trading in this market and they can conduct trading only through electronic trading system. The second major change is that the central bank has reduced maturity limit and lending limit of the financial institutions. These changes are in line with advancement of other developing countries and the rationale behind this is to restrain over-borrowing and prevent long-term financing through short-term financing. It is a common consensus among the scholars that liberalization of the interbank market rate is a good initiation point for liberalization of the interest rates (Park and Sehrt, 1999). The functioning of the interbank market is impeded by inefficient payment system of the central bank. This is because interest rates on excess reserves ratio of the commercial banks are high, which is why these banks do not intend to reduce the excess reserves ratio (Imam, 2004). There is also a dilemma regarding incorporation of the securities companies within pursuit of the interbank operations. On one hand, there is high demand on part of the securities companies; but, if these institutions are included, then the interbank offered rates will no longer reflect the interaction between demand and supply of deposit reserves of the financial institutions. They would also include fluctuations of the capital market, thereby reducing effectiveness of the monetary policy. In 2009, value of the interbank bond market was 3033.91 billion Yuan, implying rapid growth of this market (Deutsche Bundesbank, 2014). Bond Repo Market  In financial literature, bond repurchasing refers to the promise made by the seller to purchase a security from the buyer at an agreed price on a future date. It was only in 1991 that bond repurchase was introduced in China. Initially, it was mainly used by non-financial institutions for the purpose of borrowing from the commercial banks (Marcia, 1989). The People’s Bank of China had introduced this instrument as a tool to prevent the flow of bank funds in the stock market. It was expected that the commercial banks would refrain from trading in the stock exchange and carry out repurchase trading only in the interbank bond market (Cassola and Porter, 2011). Since the introduction of this tool, it has gained wide popularity and the trading volume of bond repo market is quite higher than the borrowing and lending. The primary reason that can be attributed for this trend is that this option is safer than borrowing as interest rates involved in repurchase is more stable compared to borrowing. The rise in popularity of the repo trading can be largely attributed to preference of the banks to depend on this for the short-term financing. The central bank has also used bond repo as an instrument in the monetary policy. As recorded in 2003, number of members in the bond repurchase market and the interbank markets had risen to 740 (Imam, 2004). Bond market Interbank bond market is crucial for development of the bond repurchase markets. In case of China, it has been observed that recent developments that had taken place in the bond markets have been decisive for advancement in entire functioning of the monetary market. There are mainly two types of bonds that are issued by China, namely the T-bonds (treasury bonds) and the PRF bonds (policy related financial bonds). Though corporate bonds had been introduced, yet their share is relatively small compared to other types (Anon, 2013). The main investors in the T-bonds and PRF bonds are the commercial banks and other financial institutions. Since their inception, there have been quite a few notable changes in the bond market. In the initial period of 1997, these bonds were allocated to banks by the central banks based on their proportion of increased deposits. The rates of interest and amount were also predetermined by the central bank. However, since 2000, Ministry of Finance had begun to distribute T-bonds by inviting tenders on the bond market. Similarly, allocation of PBF bonds was taken up by the State Development Bank by the way of inviting tenders and other means (Scott and Ho, 2004). The recent trend shows that price of the bonds and the interest rates, which were initially the prerogative of the government, were to be developed under influence of the free market forces as Chinese economy is liberalizing its financial markets. It is important to estimate contribution of the bond market in overall functioning of the monetary market. The proper functioning of the bond market is important for superior performance of the monetary policy as well as smooth functioning of the commercial banks. The interbank bond market has provided the chance to commercial banks to manage their asset composition in scheduled time (Yang and Xingyun, 2002). This in turn has provided the opportunity to bring down excess reserves of commercial banks held with the central bank. As proportion of bond assets in the total assets increases, deposit-loan ratio of the banks reduces; this in turn improves quality of assets of the banks. Additionally, the yield curve has shown a slightly upward trend in the interbank market, which has maturity of over five years (Bai, Fleming and Horan, 2013). (Source: Bai, Fleming and Horan, 2013) The research has shown that this type of a trend can be a useful reference for the central banks, while predicting the inflation rates and pricing the financial products. There are few challenges that are faced in the bond markets of China; the most persistent one being dearth of investors in the interbank bond markets other than the financial institutions. Non-financial institutions and individual investors are kept away from this market; so, problems of liquidity often arise in this market (Huang and Zhu, 2007.). Open market operations Out of all instruments required for conducting the monetary policy, open market operations are most crucial for the central bank as this involves buying and selling of securities for own account of the bank (Central Bank of the Republic of Republic of China, 2014). Open market operations become very important for sterilization operation of the central banks so as to insulate themselves from the foreign exchange market. With passage of time, correlation between the OMO and the interbank rates as well as the OMO and the repurchase rates has strengthened. This hammers on importance of the interbank lending and the repurchase rates in open market operations. The major problem of China is that interest rates on deposits and loans of the commercial banks are still subject to central bank control. This makes money market instruments less important in relation to assets possessed by the commercial banks. It is for this reason that changes in short-term rates of interest in the monetary market are unable to influence that of loans and deposits in China (Wilson, 1996). The recent trends in the Chinese money market have shown that Chinese central bank has relied on open market operations for the purpose of sterilization. The central bank of China uses obverse repurchases of OMO to control excess liquidity since 2004. The time frame of the repurchase operations ranges from 7 to 182 days (Barth, Tatom and Yago, 2009). Commercial Bills Commercial Bills form a cheaper source of financing compared to bank loans, when they are issued by large and reputed companies in the market. These papers are akin to the bill of exchange in the financial markets. It has been observed in China that commercial paper forms a cheaper source of financing because of regulation of interest rates on the loans. Presently, policy of the Central Bank has been to promote the use of commercial paper via bills of exchange as a financial tool. China had experienced a rapid development of the commercial paper compared to the corporate bonds. This is because business enterprises had to acquire permission of regulatory authorities in order to issue debentures, which do not exist in case of bills of exchange. Most of the enterprises in China use this tool for short-term financing. Although these can be used only in case of short-term financing, most of the enterprises still fulfil the purpose by issuing these in a recurring fashion. There are certain hurdles in the commercial bill market development due to the policies in China. The commercial bills need to be accepted by the banks before being circulated in the market. Another major problem in smooth development of the commercial bills is that authentication of these papers involves physical movement of the same and this consumes a considerable amount of time (Wadsworth, 2013). Evaluation of the present condition It has been observed that Chinese financial markets have gone through a lot of changes since implementation of the reforms. Over the time, China has liberalized its bond markets, which have made it easy for investors to access the Chinese bond market. Even during the financial crisis, performance in the money market of China was relatively better compared to its Western counterparts. Over the last five years, foreign investors have flocked to China for the better returns offered by bonds in money market of China. The only problem in this scenario is that corporate bonds account for only 8% in the total market share of bonds (Zhen, 2013). It can be said that the bond market in China is an integral part of the money market, which significantly contributes to the growth of Chinese economy. The money market helps in financing loans of the government at a low cost; is responsible for accumulating capital for organizations at a cheaper rate than bank loans; and promotes overall development. Recommendations: Future issues to be considered On analysis of the present scenario in Chinese financial market, it appears that there are certain areas that can be developed for efficient functioning of the money market. Firstly, proportion of financing by indirect means is much higher compared to that by direct means. This kind of a financing structure impedes optimal resource allocation and raises possibility of a financial risk. The reorganizing of the financial structure will, therefore, be crucial for development of this market (Su, 2005.). Secondly, although the recent years have been marked with a surge in trading in interbank bond markets, there are still few changes that need to be adapted for proper transmission of the monetary policy through functioning of the bond market. The present challenges pertain to diversification of financial products and trading instruments, along with improvement in accessing liquidity by the financial institutions. The variety of bonds in the Chinese market is also limited, which restrains scope of this market and the concept of brokers and market-makers are also not considered seriously in China. Experiences of other countries show that brokers and market developers have played a crucial role in activation of the market. (OECD, 2002). Thirdly, there are ample chances of improvement for the bond repurchase market of China. The repurchase market in the developed countries performs more functions than simply managing liquidity of the financial institution. China can come up with ways to improve product offerings of the bond repurchase market. Fourthly, China should also allow trading between financial and non-financial institutions so as to improve the situation of liquidity in financial markets. For the same purpose, outside investors should also be allowed to participate in the trading process. Fifthly, China needs to consider development of the credit rating agencies to improve functioning of the commercial bills infrastructure. Due to lack of proper credit rating agencies, commercial banks have to step in and vet the bills before they can be circulated in the markets. In this regard, it can be stated that enhancing transparency within organizations and improving their accounting standards are equally necessary. Finally, relaxing controls of the government is essential for raising efficiency of the money markets. It has been found out that short-term interest rates in the money market are unable to influence that of the commercial banks. Loosening the control of interest rates on deposits and loans of the commercial banks will be imperative for future developments of the money market. Conclusion This essay has discussed in details the evolution of money market in China and several issues it faces that possibly impede its development. The various sub-segments in the money market have been discussed in details, namely the interbank market, the bond repo market, the bond market, the open market operations and the commercial bills. This essay has mainly focused on the money market after introduction of the reforms in China. It can be said that changes in the money market in China is relatively new and it was only in the last twenty years that China has considered opening up its money market. The current trend has shown growth in volumes of trade in the money market as well as in number of members there (Rose, 2003). People’s Bank of China has been using indirect means to regulate the money market in the recent years. Though the country is slowly embracing the liberalization of its money market, yet there are certain factors that are slowing down the process. The problems that has been identified in China relates to excessive control by the government in issuing securities in money market and control of the interest rates for loans and deposits. A few recommendations have been suggested based on the analysis of the present scenario. Few of the major recommendations are diversification of financial products, development of proper credit rating agencies and relaxing controls of the government to make the money market function in a better way. The financing structure of the interbank bond market also needs to be restructured. Reference List Anonymous, 2013. 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