Hong Kong
CNN
—
Investors have been flocking to Chinese government bonds, sending bond prices soaring and yields to record lows, as they seek safer alternatives to the country’s battered property market and volatile stock prices.
The yield on China’s 10-year onshore government bonds, a benchmark for broader interest rates, hit 2.18% on Monday, the lowest since records began in 2002. Yields on 20- and 30-year bonds are also hovering near record lows. Bond yields, or the return that holding a bond offers investors, fall as prices rise.
Lower borrowing costs are welcome for an economy struggling to recover from plummeting real estate prices, sluggish consumer spending and declining business confidence.But the sudden moves in bonds have stoked talk of a bubble and sparked a serious crisis. Chinese policymakers are nervous, fearing a crisis similar to last year’s collapse of Silicon Valley Bank (SVB).
The People’s Bank of China (PBOC) has issued more than 10 warnings since April about the risks of a bond bubble bursting, destabilizing financial markets and derailing China’s uneven economic recovery. Now the Chinese government is doing something unprecedented: borrowing and selling bonds to keep prices down.
“The U.S. central bank has taught us that central banks need to observe and assess the situation in financial markets from a macroprudential perspective,” Pan Gongsheng, governor of the People’s Bank of China, said at a financial forum in Shanghai late last month.
“Currently, close attention needs to be paid to maturity mismatch and interest rate risks associated with large holdings of medium- to long-term bonds by some non-bank institutions,” the central bank governor added. These institutions include insurance companies, investment funds and other financial institutions.
SVB was the largest U.S. bank failure since the global financial crisis, and its roots lie in the bank’s billions of dollars invested in U.S. government bonds. What seemed like a safe bet went awry when the Federal Reserve began raising interest rates to curb inflation. The prices of the bonds SVB held fell, and its finances took a hit.
Chinese policymakers worry that if the bond frenzy is not curbed, there is a risk of a similar crisis in the world’s second-largest economy. China’s government bond prices have soared since the start of the year as investors flock to the bonds amid an uncertain economic outlook. Corporate borrowing has also fallen, leaving banks with more cash to park.
“The real estate problem is weakening demand for credit, which is pooling money in the interbank market and forcing banks to buy more bonds,” said Larry Hu, chief China economist at Macquarie Group.
He added that a “deflationary outlook” for the economy has also taken hold among investors, leading them to flock to longer-term government bonds.
Like SVB, Chinese financial institutions have large investments in long-term government bonds, making them vulnerable to sudden fluctuations in interest rates.
Beijing is concerned If the bond bubble bursts, causing prices to fall and yields to rise, lenders could suffer big losses.
“Policymakers are concerned about interest rate risk, which will rise if the mainstream view shifts from deflation to reflation,” Macquarie’s Foo said.
According to an analysis of central bank data by state securities firm Zheshang Securities, net purchases of Treasury bonds by financial institutions, mainly local banks, totaled 1.55 trillion yuan ($210 billion) in the first half of this year, up 61 percent from the same period last year.
China’s official interest rates are low after the People’s Bank of China cut them in recent years to support the economy. Deflationary pressures continue, with consumer price inflation falling less than expected in May and factory prices falling for the 20th consecutive month.
But “if external demand slows, Beijing will have to step up stimulus to achieve its (economic) targets.” “Growth targets can be achieved,” Hu said.
If that happens, bond yields will rise as investors again flock to riskier stocks, while demand for credit will rise, leading banks to lend more and reduce their holdings of government bonds, which would reverse the bond bull market, Hu said.
He added that the country’s “approximately 4,000 small and medium-sized banks” will be particularly vulnerable to interest rate risk.
Growing concerns prompted the People’s Bank of China to say it would intervene directly in the bond market on Monday to quell the frenzy. for State media said it was the “first time in history.”
Central banks borrow government bonds from open market traders and then sell them to drive down prices and increase yields.
The People’s Bank of China said the decision was made after “careful observation and evaluation” and added that it aimed to “maintain the healthy operation of the bond market.”
Chinese state media has also sounded the alarm. The state-run Securities Times warned on Tuesday about the risks of a bond market bubble, pointing to the examples of SVB and Japanese banks whose holdings of U.S. and European government bonds have lost value as yields rise.
“The bubbles formed by capital inflows into the bond market are accumulating interest rate risk,” Securities Times said in an editorial. “The ‘triggers’ for SVB’s collapse and Japan’s Norinchukin Bank’s massive losses were all interest rate risk caused by excessive reliance on bond investments.”
Numerous verbal warnings have failed to stem the rise in bond prices, prompting market intervention this week.
Zhang Jiqiang, chief bond analyst at Huatai Securities, said Monday’s move “demonstrates the PBOC’s determination” to tame the stock market rally by selling bonds and raising yields.
“Central banks want to avoid a crisis like SVB,” he said.
The sharp decline in Chinese government bond yields also poses major risks to the economy.
“As things stand, lower government bond yields will do more harm than good for the economy,” said Ken Cheung, director of foreign exchange strategy at Mizuho Securities in Hong Kong.
That’s because market expectations of aggressive interest rate cuts by the People’s Bank of China and slower growth could worsen the formation of a “deflationary mindset,” he said.
Moreover, the bond market frenzy could work against the People’s Bank of China’s efforts. It encourages capital to flow into the bond market rather than into riskier assets such as stocks, real estate, and other investments that stimulate economic growth, stimulating economic activity and increasing the money supply.
Falling Chinese government bond yields could widen the interest rate gap between the United States and China, potentially leading to capital outflows from the world’s second-largest economy and putting pressure on the yuan.
“China’s capital outflows in April hit the highest level since January 2016, mainly due to the widening U.S.-China yield gap,” Hu said. “So the PBOC does not want interest rates to fall too quickly.”
