Government Regulation, Transaction Networks, and Local Government Bond Pricing

Abstract

Market-based pricing of bonds is not only a necessary component of deepening the reform of bond market institutions and mechanisms but also the foundation for strengthening the benchmark pricing function of the bond market, optimizing macroeconomic control transmission mechanisms, and promoting high-quality economic development. The linkage between primary and secondary bond markets is regarded as an important indicator of market-based and rational bond pricing. However, the current level of marketization in the issuance pricing mechanism of China’s bond market remains inadequate, particularly in the credit bond sector, where there is a notable price disconnect between the primary and secondary markets. Therefore, exploring the linkage between primary and secondary bond markets is crucial. However, the relationship between bond issuance pricing and transaction prices poses challenges for this exploration. Issuance interest rates often reference market transaction yields, which, combined with the issuance process preceding trading, can influence subsequent transactions.

On August 14, 2018, the “inverted interest rate” phenomenon in China’s local government bond market attracted widespread attention. To address this issue, the Ministry of Finance implemented window guidance measures and increased the minimum limit for local government bond issuance interest rates (the “floor price”). This exogenous and unpredictable policy change presented an important opportunity to study the causality between issuance interest rates in the primary bond market and transaction yields in the secondary market.

This study finds that issuance pricing restrictions simultaneously increase local government bond issuance interest rates and transaction yields, creating a relatively sustained and stable linkage effect between the primary and secondary markets. Heterogeneity analysis reveals that pricing restrictions on local government bonds have a more significant impact on bonds issued in central and western regions and short-term local bonds, while their impact on bonds issued in eastern regions and long-term local bonds is relatively smaller. Mechanism analysis indicates that issuance pricing restrictions promote fairer bond issuance prices, enhance secondary market activity, result in a “large world” characteristic of trading networks, reduce risks, and ultimately improve delivery net prices and transaction yields.

The study contributes in the following two aspects. Firstly, it expands the research literature on the “inverted interest rate” phenomenon. Existing studies primarily analyze the causes of this phenomenon, whereas this study builds upon that foundation to focus on the governance effects, ultimately converging on the issue of market-based bond pricing. Secondly, it empirically tests the linkage effects and interaction mechanisms between pricing in the primary and secondary markets for local government bonds. This helps to uncover the “black box” regarding how issuance pricing in the primary bond market influences trading prices in the secondary market.

The research results present a vivid practical case of the organic combination of an effective market and a proactive government, providing valuable insights for policymakers. These findings provide strong empirical support and scientific evidence for building a market-based local financial system based on effective government regulation and promoting the formation of a risk-matched, market-based, and reasonable local government bond pricing mechanism.