Chinese government bonds have become a hotspot for investors seeking a safer alternative to the country’s troubled real estate market and volatile stock market. This surge in demand has driven bond prices up and yields to historic lows.
The yield on China’s onshore 10-year government bond, a key benchmark, hit a record low of 2.18% on Monday, the lowest since records began in 2002. Yields on 20-year and 30-year bonds are similarly at historic lows. Bond yields decrease as prices rise, reflecting increased demand.
While lower borrowing costs are generally beneficial for an economy struggling with a property market crash, weak consumer spending, and low business confidence, the rapid rise in bond prices is causing concern. Chinese policymakers are anxious about a potential bond market bubble, reminiscent of the collapse of Silicon Valley Bank (SVB) last year.
The People’s Bank of China (PBOC) has issued over 10 warnings since April about the risk of a bond bubble bursting, which could destabilize financial markets and hinder the economy’s recovery. In an unprecedented move, the PBOC is now borrowing bonds to sell them and curb the price surge.
“SVB in the United States has taught us that the central bank needs to observe and evaluate the situation of the financial market from a macro-prudential perspective,” PBOC Governor Pan Gongsheng said at a financial forum in Shanghai. He emphasized the need to monitor maturity mismatch and interest rate risks, particularly in non-bank entities like insurance companies and investment funds.
The collapse of SVB was partly due to its substantial investments in US government bonds, which lost value when the Federal Reserve raised interest rates to control inflation. Policymakers in China fear a similar scenario could unfold if the bond frenzy continues unchecked.
Larry Hu, chief China economist for Macquarie Group, noted that weak credit demand due to property woes is pushing banks to buy more bonds, trapping money in the interbank market. The deflationary outlook for the economy has also driven investors towards long-term sovereign bonds.
Beijing is particularly concerned that a sudden shift from deflation to reflation could cause bond prices to drop and yields to rise, potentially leading to significant losses for financial institutions heavily invested in long-term government bonds.
In the first half of this year, financial institutions, mainly regional banks, made net purchases of sovereign bonds amounting to 1.55 trillion yuan ($210 billion), a 61% increase from the previous year, according to Zheshang Securities.
Official interest rates in China are low, following recent cuts by the PBOC aimed at supporting the economy. Persistent deflationary pressures have resulted in lower-than-expected consumer price increases and declining factory prices for 20 consecutive months.
Ken Cheung, director of foreign exchange strategy at Mizuho Securities in Hong Kong, warned that low government bond yields could harm the economy by reinforcing expectations for aggressive interest rate cuts and weak growth, thus exacerbating a “deflation mindset.”
The PBOC’s decision to intervene in the bond market by borrowing government bonds to sell is intended to maintain market stability and prevent an SVB-style crisis. This move, a first in history, underscores the central bank’s determination to cool the bond market frenzy and avoid financial instability.
Chinese state media, such as the Securities Times, have also raised alarms about the risks of a bond market bubble, drawing parallels to SVB and Japan’s Norinchukin Bank, which suffered losses due to over-reliance on bond investments.
“The bubble formed by the rush of funds into the bond market is accumulating interest rate risks,” the Securities Times warned. The PBOC’s intervention aims to address these risks by selling bonds to lift yields and prevent an unsustainable bubble from forming.
The rapid decline in Chinese bond yields poses broader economic risks, including the potential to drive capital outflows and put pressure on the yuan. In April, China saw the highest level of capital outflows since January 2016, largely due to the widening interest rate gap between the US and China.
The PBOC’s efforts to stabilize the bond market reflect its commitment to maintaining financial stability and supporting the country’s economic recovery in the face of multiple challenges.