CHINA has been actively promoting the bond market as an alternative fund-raising channel to the banking system and equity sales. Regulators this year have allowed small businesses to do private bond placements, and have expanded the array of bonds in which insurers can invest.

The value of bonds, including government and corporate bonds, issued in the second quarter amounted to nearly 2 trillion yuan (US$315.5 billion), a 30 percent increase from the first three months of the year, central bank data showed.

The bond market is playing a greater role in capital allocation and risk management, People's Bank of China governor Zhou Xiaochuan said last month. But still, the government is being urged to expand deregulation of bond issuance and trading. Several speakers at an August forum organized by China Chengxin Group, a local ratings agency co-owned by Moody's Investors Services, spoke to this issue. Here are some of their comments.

Bonds to boost incomes and ease rate distortion

A sound bond market is essential for increasing domestic consumption, lifting China's financial status and solving domestic financial distortions.

China has been promoting domestic consumption to replace investment as a driver of economic growth, but so far the efforts seem to have been in vain. The Chinese people have not yet accumulated enough wealth, and it's useless to try to boost their consumption by increasing money supply. Most people have access to extra earnings only through salary increases, bank deposits and investment in the stock market. The bond market urgently needs management professionals to create wealth for the ordinary people.

Shanghai is aiming to become a leading global financial center by 2020, but this will not happen if the bond markets remain fragmented and under the jurisdiction of different regulatory bodies. Without a prosperous bond market, Shanghai's dream of becoming a global financial center may end up as a joke.

There are two major ways a sound bond market can help the economy. The first is to determine a proper interest rate level. The central bank is starting to liberalize borrowing and lending rates. If that liberalization triggers vicious competition, small and private banks may eventually go bankrupt. The inability to price yields with investment returns will go against market rules and pass on risk to innocent investors. If we lack a bond market to set the base for interest rates, China's interest rate liberation may end in a dead end.

A well-priced bond market can also challenge the monopoly of state-owned banks. When big and small businesses don't have to rely on loans to get funding, banks with poor efficiencies will no longer thrive. It is the bond market, instead of the interest rate liberalization and the opening of private lending markets, that can truly force reforms in the banking system.

Developing a sound bond market requires governments to stop repaying debt on behalf of companies or other issuers. Paying debt with monetary decisions will create a distortion of yields. It is the same as robbing people to pay for something else.

I'd also like to emphasize that the bond market requires sound management.

It would be a mess if the bond market ends up like the stock market, where companies tend to raise funds without regard to corporate responsibilities. A key function of the bond market is to add the specter of bankruptcy pressure over an issuer, forcing issuers to improve asset quality.

Fragmentation hinders progress

China's bond market has developed quickly in recent years, with participation by banks, brokerages, insurers and fund houses. But some problems in the system have hindered full development of the market.

The first is poor regulatory efficiency under different regulators and laws. Even bonds issued by a same company can be subjected to different rules laid down by the central bank, the National Development and Reform Commission or the China Securities Regulatory Commission if the debt is sold in different markets. Fragmented regulations will create blind spots and won't help control risks.

A second problem is the lack of unified standards. Currently China's corporate debt market is comprised of enterprise bonds, corporate bonds, private placement bonds, medium-term notes and short-term financing bonds. Of those, only the issuance of enterprise bonds is under the watch of the country's economic planner. Different bonds are under the regulatory control of different bodies.

A third problem stems from separated trading markets. Nearly 70 percent of bond transactions take place in the interbank market, and the number of bonds available on the exchange market is limited.

The interbank market has strong investors and a huge clearing system, while the exchange market has efficient a pricing mechanism and advanced technology.

But separation of the two systems goes against the international trend of merging and has barred smooth exchange of capital and bond products. The same type of bond is usually valued differently on the two markets, creating different yields for investors.

A fourth problem is a monopoly over bonds by commercial banks. Due to China's high savings rate, banks have become the only major investor in the bond market. The sustainability of the bond market is worrisome. A proper corporate credit system cannot be established if banks are holding huge amounts of bonds. If any deficit occurs, banks will be the utmost victims.

I think we should complete four tasks to improve the bond market.

The first is to unify the interbank and the exchange market in order to develop a coherent bond market.

The second is to open a custody system that merges the businesses of the China Securities Depository and Clearing Corp and the China Central Depository & Clearing Co. That would allow investors to trade bonds with one account wherever they are.

The third is to establish a multi-layer bond market to suit the needs of different issuers and investors. It is also necessary to train more professional investors. Lastly, a unified regulatory framework should be established in due course to streamline and specify responsibilities of regulators.

Local governments need flexibility

Local government debt is an important part of China's bond market, and I think there are several ways to improve and standardize the current system.

After 2008, China has chosen to boost the economy mainly through increasing investment.

One of the controversial options is to expand through state-owned companies and local government financing vehicles. China is now facing another round of economic slowdown, and the solution is still investment. Since state-owned companies are now cautious about expanding debt due to a lack of high quality projects, local government financing vehicles are the main powerhouse.

The fund-raising needs of local governments are huge as their investments and social security expenditures increase and their tax and land revenue bases decrease.

Local governments are often raising funds not by issuing debt but by other back-door channels.

Based on our analysis, the risk of local government debt is still controllable because jurisdictions are just starting to accumulate debt.

State assets can be used to cover debt, and the debt-asset ratio of Chinese local governments is mostly below 45 percent. The local governments are able to take on more debt.

We should not simply assume that the local government debt has become excessive. Nor can we neglect risks.

If local governments are allowed to issue bonds irresponsibly and undertake inefficient projects, the future of bond development will be terrifying.

I have some suggestions.

First, the budget law should be revised as soon as possible to allow local governments to issue bonds by themselves. Approval and review measures can be set up to monitor the magnitude of local government bonds.

Currently the central government is issuing bonds on behalf of local governments. This must change.

Second, a quota should be imposed on the amount of bonds a local government can issue.

Third, governments should be required to compile their balance sheets in a way to improve oversight by their regional people's congresses.

Fourth, rating agencies should play a greater role in the market. Allowing rating agencies to evaluate local government bonds would improve transparency and help keep track of the credit accrued by local governments.