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| China's Government Bond Yield Curve: An Affine Model and Term Transmission Mechanism |
| ZHANG Chengsi, XU Shuo, HE Qizhi
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School of Finance, Renmin University of China;
School of Statistics, Zhejiang Gongshang University |
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Abstract In the price-based monetary policy framework, the government bond yield curve plays a crucial role in transmitting short-term policy rates to long-term market rates, which is vital for the effectiveness of monetary policy. The smooth transmission of the term structure of government bond yields is of particular importance for the monetary policy transmission mechanism.
This paper first reviews the literature of relevant international and Chinese studies. The phenomenon of poor term transmission, where short-term policy rate changes do not effectively propagate to long-term rates, has been observed in both developed and developing economies. For instance, between 2004 and 2006, the United States experienced the “Greenspan Conundrum”. A similar phenomenon of imperfect term transmission also occurred in China, particularly during the period from 2011 to 2014, when the People's Bank of China raised short-term policy rates, but long-term yields failed to follow suit, leading to what has been referred to as the “Chinese Greenspan Conundrum”. While some studies have attempted to explain this phenomenon by factors such as macroeconomic uncertainty and financial market volatility, there has been a lack of systematic research into its causes.
To address this gap, this paper constructs a macro-financial affine model, which incorporates three latent factors and two macroeconomic factors (inflation and output). The model is estimated using data on short-term and medium-to-long-term (3 months, 1 year, 3 years, 5 years, 7 years, and 8 years) government bond yields from April 2006 to September 2024, along with relevant macroeconomic data. Parameters of the model are estimated using the minimum chi-square estimation method (MCSE), and the fit error sequence is evaluated both within and outside the sample to assess the model's explanatory power. The study finds that while the term transmission of government bond yields is generally smooth in most periods, in certain specific periods, the transmission efficiency of short-term interest rate to long-term interest rate decreases significantly. Through decomposition of the fitting errors, it is shown that the volatility of the term premium, rather than market expectations of short-term rates, plays a significant role in explaining long-term yield fluctuations.
Further empirical analysis explores the causes of poor term transmission, incorporating factors such as macroeconomic uncertainty and financial market volatility. The results indicate that bond market volatility has a significant effect on long-term yields, with higher market risk leading to an increase in long-term rates. Additionally, output uncertainty also influences long-term yields, with greater uncertainty tending to push long-term yields higher. However, while these factors explain part of the transmission disruptions, they do not fully account for the anomalies observed during the periods of poor transmission in 2011-2012 and 2013-2014. This suggests that financial structural factors, in addition to macroeconomic and market volatility factors, play a critical role in explaining these disruptions.
The paper delves into the financial structural factors influencing term transmission of the yield curve through a comprehensive set of financial structure indicators, covering macro, market, and micro levels. At the macro level, leverage ratios and the structure of social financing are found to be key factors. The study shows that higher leverage in the non-financial sector increases bond demand, pushing up long-term yields, while higher leverage in the financial sector tends to lower long-term yields by enhancing credit supply. At the market level, the expansion of the bond market relative to the stock market promotes term transmission, and improving the liquidity of the bond market also helps to enhance the pricing power of the market. At the micro level, issues such as an imbalanced government bond issuance structure and the high proportion of financial bonds and the freezing of high-quality assets by the pledge repo transaction mechanism have been identified as significant causes of poor transmission.
Based on these findings, the paper proposes several policy recommendations: (1) optimizing the issuance structure of government bonds by increasing the issuance of medium-and short-term bonds, and reducing the imbalance in the maturity structure; (2) improving bond market liquidity by reforming the repurchase transaction mechanism and reducing the adverse effects of asset freezing; (3) expanding the size of the bond market and enhancing the role of the direct financing market to further improve market efficiency. Additionally, strengthening financial market regulation, enhancing market transparency and reducing the impact of abnormal market fluctuations on term transmission are essential measures to improve the transmission efficiency.
Future research could extend this study by using a longer time span of data and incorporating more comprehensive financial structure variables. Moreover, drawing on international experiences and examining the applicability of financial market deepening and structural adjustments in other countries will provide valuable insights for promoting China's bond market and term transmission mechanism and improving the efficiency of yield curve maturity transmission. This will not only help optimize China's monetary policy framework but also contribute to reforming the financial system.
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Received: 29 April 2024
Published: 02 January 2025
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