The Same Pricing Restrictions, Different Trading Returns: Evidence From China's Interbank Bond Market

Abstract

AbstractEffective government regulation of the financial market depends on whether the public interest theory of regulation is established in a market with a relatively high degree of marketization. This study employs the price floor regulation implemented in the Chinese local government bond primary market on August 14, 2018, as a quasi-natural experiment. Utilizing spot trading order flow data from the interbank bond market, we conduct a comparative analysis of the differential responses of bond issuances by different fiscal entities, explore the impact of primary market price floor regulation on secondary market trading, and validate the regulatory mechanisms at play. Our findings indicate that, first, price floor regulations in the primary market effectively rectify pricing distortions for local government bonds with differing levels of fiscal strength. Bonds from high-fiscal-strength local governments, which exhibit greater levels of distortion, experienced a significant increase in the secondary market trading yield rates, whereas those from low-fiscal-strength local governments showed no significant change. Second, price floor regulation in the primary market significantly enhances the liquidity of local government bonds and has a notable impact on the trading yield rates of bonds from high-fiscal-strength local governments. Lastly, primary market price floor regulation substantially broadened the number of trading entities for local government bonds and produced increased trading activity, while the bond trading network exhibited "large-world" characteristics, exclusively elevating the trading yield rates for bonds from high-fiscal-strength local governments. Grounded in the perspective of fiscal demarcations of local governments, this study sheds light on the "black box" of how primary market price floor regulation impacts secondary markets, confirming the interconnectivity between primary and secondary bond markets.