Opinion | China’s overheated government bond market is the least of its worries
Who said China’s financial markets were in turmoil? Since January last year, the yield on the country’s benchmark 10-year government bond – which moves inversely to prices – has fallen from 3 per cent to 2.1 per cent, its lowest level since Bloomberg began tracking data on the market in 2002.
The rally in Chinese sovereign debt, which Nikko Asset Management dubs “the quieter China trade”, has been driven in part by a surge in investment in the country’s bonds. Since the start of this year, overseas investors have piled into short-term bank debt, increasing their holdings of onshore bonds in the interbank market to a record high, according to data from Bloomberg.
However, the more salient trend is domestic investors’ stampede into fixed-income products because of the lack of stable alternative assets amid a long-running bear market in stocks and a crisis in the property sector. The assets of Chinese bond mutual funds surged to a record 6.5 trillion yuan (US$907 billion) in May, up a staggering 40 per cent in the past year.
Chinese policymakers are worried that the fierce rally in the bond market, after the 10-year yield stood at 4 per cent in early 2018, has gone too far. The People’s Bank of China (PBOC) has warned of a bubble that could burst in a similar manner to the one that brought down Silicon Valley Bank in the United States last year. The regional lender suffered crippling losses on its large holdings of US Treasury bonds when interest rates rose sharply.
The fear of so-called duration risk – the sensitivity of bonds to changes in borrowing costs – has compelled Chinese regulators to exert more control over the bond market. Rural banks in Jiangxi province were recently told not to settle their latest purchases of government debt and several brokerages have reduced their trading of bonds, while some of the largest state banks have been asked to keep records of the buyers of the sovereign debt they sold in the hope of deterring speculators.
13:04
What does it mean for the world when Chinese consumers tighten their belts?
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However, while Beijing has legitimate concerns about financial stability, its efforts to take the heat out of the bond market are misguided, ineffective and disingenuous. First, the plunge in bond yields reflects the weakness of China’s economy and the inadequacy of the policy response. Last month, bank loans shrank for the first time since July 2005 as households and businesses continued to retrench and pay down debt.
China’s economy is struggling to stabilise. A key gauge of services activity that includes the retail industry was on the verge of contraction last month for the first time since the end of 2023. The country is suffering its longest period of deflation since 1999, fuelling concerns about a Japanese-style “balance sheet recession”. In a report on August 1, Bank of America said that “the baton of deflation” has been “well and truly handed off from Japan to China”.
While Beijing might not like the bleak signal low bond yields are sending about the prospects for growth, it cannot defy economic gravity. The longer China’s structural weaknesses persist, the greater the downward pressure on yields. Rather than fretting about an overheated bond market, policymakers should come up with a credible plan to secure the delivery of pre-sold but uncompleted homes and introduce more forceful measures to stimulate domestic demand.
Second, the PBOC’s efforts to put a floor under bond yields run counter to its dovish policy stance. Although China’s central bank is constrained by its need to keep the yuan stable and limit capital outflows, the scope for further monetary easing will increase once the US Federal Reserve starts to reduce interest rates, which is almost certain to happen next month. The results of Bank of America’s latest Asia Fund Manager survey on August 14 showed that 85 per cent of respondents expected additional easing in China, keeping yields pinned down.
Third, Beijing meddles in the government debt market at its peril. China needs a safe, strong and predictable bond market given its plans to ramp up issuance of long-term debt to fund its stimulus and investment programmes. Unlike volatile stocks, sovereign bonds are a crucial market for policymakers, especially given the severe strains on local government finances and the crisis in the housing market.
Moreover, China’s government debt market has a number of attributes that appeal to foreign investors. The most important one is that China is less exposed to the global financial cycle, with the country’s monetary policy operating largely independently from that of the United States. This has helped the country’s debt market outperform its US counterpart since 2021. “Chinese bonds are an asset class that provides good diversification opportunities within a global portfolio,” Nikko Asset Management notes.
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Why investors can expect more market volatility after recent global stock sell-off
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The relatively low correlation between the world’s two biggest bond markets, coupled with pervasive deflationary forces in China, make a sharp and sustained sell-off in Chinese sovereign debt highly unlikely. Interest rate risk is less of a concern than credit risk or the threat of borrowers defaulting on their loans. The International Monetary Fund warned earlier this month that institutions with large exposures to the property and local government financing vehicle sectors were particularly at risk.
If there is a worrying message emanating from China’s government debt market, it is not the threat to financial stability but the risk of a more severe and prolonged economic downturn.
