Illustration: Luo Xuan/GT

China's bond market has been bumpy since the beginning of the year. Bond defaults have long been seen by many investors as isolated events that only occurred in private lending or Internet finance platforms. However, since the beginning of the year, defaults have spread from small and medium-sized firms to large ones, from private firms to State-owned enterprises (SOEs) and from sectors burdened with overcapacity such as steel, nonferrous metal and coal to other sectors, with the trend continuing to escalate.

How should we assess the risks in China's bond market? How should regulators guide the development of the market? And how should investors balance the gains and risks? These questions have become a common concern.

First, we must note that even if defaults are on the rise, the development of China's bond market, especially development of the credit market, is vital to the country's financial reform as well as China's drive to establish a multi-layered capital market. It could also allow the financial sector to serve the real economy and make it easier and cheaper for private firms to get loans. 

With the development of the bond market, capital can be invested in the best area or sector at a proper cost. The country's progress in liberalizing its bond market could support its efforts to liberalize the interest rate market, open up the capital account and promote the global role of the yuan. In addition, development of the bond market could help promote the development of the country's stock market and corporate governance, as well as offering more investment channels and options to Chinese investors.  

Therefore, China should not give up on efforts to liberalize the bond market because of the fear of default risks. There is more to lose than gain if we doubt the necessity and relevance of a more developed bond market.

Furthermore, defaults are not necessarily a dreadful thing - in fact they are essential for the sound development of the bond market.

The financial market is ultimately a market full of risks. And the greatest risk in the bond market is that of default. Once a bond default occurs, investors not only end up being unable to recoup their investment but also face the loss of the principal. Defaults and bankruptcies are rare occurrences in China but they have a significant impact on investors, so the market already sees it as vital to assess and predict default risks. All the models that attempt to predict default risk are based on the assessment of the limited number of defaults that have occurred previously. The fact that defaults have been so rare in China until recently has made Chinese investors insensitive to the risks. This situation deprives those investors who are risk savvy of an opportunity to observe and study the default and credit risks in China's bond market.           

Although defaults have increased in the domestic market recently, the actual default rate in China is still low compared with international levels. Besides, bond subscriptions by Chinese investors usually involve large values, so these investors should have developed a certain degree of risk tolerance. Unless defaults and investment losses occur, investors can hardly have the chance of developing a better understanding of risks, let alone the opportunity to develop their risk management skills. Therefore, the level of debts held by either SOEs or private firms should be determined by their business performance, and if they miss the payment deadline they should be allowed to default. Otherwise, China's bond market cannot live up to the role it should be able to shoulder.

Allowing defaults to happen can help the market do a better job of setting prices based on risks and avoid risk mispricing. Only if bond issuers are allowed to default without implicit protection from the government can China's bond market develop soundly and help the Chinese economy successfully shift to a more sustainable growth model.

The author is professor and deputy dean of the Shanghai Advanced Institute of Finance at Shanghai Jiao Tong University. bizopinion@globaltimes.com.cn
Newspaper headline: Defaults a sign of growing maturity in bond market