China’s new bubble has sent tremors through Beijing

For most of this year, yields on China’s longer-term sovereign bonds have been falling, prompting a series of increasingly unusual, even desperate, interventions by the country’s central bank to arrest the declines.

At face value, that might appear odd. The People’s Bank of China has been cutting its policy rates to try to stimulate growth in a sluggish economy, so why would it try to push bond yields up?

Xi Jinping is grappling with a number of threats to China’s economy. Credit: AP

It appears they are worried that a bubble has been forming within the bond market that could lead to financial instability and the risk of an event that could create similar circumstances and losses to those that precipitated the regional banking crisis in the US last year.

The PBOC has effectively thrown the kitchen sink at the market in its efforts to arrest the slide in yields, which has seen the yield on 10-year government debt fall from 2.74 per cent a year ago to a historic low of 2.12 per cent this month. The bonds traded on a yield of 2.18 per cent earlier this week.

The central bank’s efforts to stabilise the yields have ranged from interventions in the market to warnings to smaller banks to stop buying bonds, bans on buying and cancellations of trades, investigations of banks, fines, stress tests and instructions to brokers to pull back on their trading. Some smaller banks have been accused of market manipulation and new bond funds have been told to steer clear of longer-dated securities.

State-owned banks have been selling bonds to try to drive their prices down and yields up – there is an inverse relationship between bond prices and their yields.

The PBOC has also borrowed a massive hoard of bonds from the major banks, signalling it will sell them to produce that same outcome of falling prices and rising yields if it is forced to.

Its fears clearly relate to the potential for a banking and insurance crisis if, for whatever reason, there was an abrupt reversal of the trends within the market and bond prices suddenly fell and yields surged.

Banks, probably the smaller regional banks, would be left with major mark-to-market losses and capital shortfalls.

That would be akin to what occurred in the US and which caused a number of smaller banks, including the high-profile Silicon Valley Bank, to fail. Silicon Valley was the biggest bank failure in the US since the global financial crisis in 2008.

Chinese insurers, which offer fixed returns, would also have their capital adequacy stressed.

The risk the authorities perceive in the bond market is, therefore, a threat to systemic stability that could produce a major domestic financial crisis.

In recent weeks, volumes of trading in longer-dated bonds have collapsed to a fraction of their levels at the start of this month after the authorities began warning of “illegal” speculative trading.

It would not be in China’s interest for bond market activity to simply dry up completely – that would itself have very significant implications for bank and systemic stability, given the key role that bond markets play within financial systems.

The PBOC is fighting a battle it can’t win in the market unless it, and the economic policymakers in Beijing, can find a way to win in the real economy.

It might appear a paradox that the authorities are striving to drive up bond yields even as the PBOC has been reducing its policy rates – although those are short term – in a bid to stimulate lending and economic activity.

However, this paradox highlights the source of the problem.

The collapse of China’s property market – the implosion of an earlier bubble – in which prices continue to fall, has had a chilling effect on consumer and business confidence and China’s economic growth, and particularly activity within the domestic economy, which has essentially stalled.

That’s been reflected in a flat-lining inflation rate, factory gate prices that have been falling for nearly two years and fears of deflation.

Consumers are wary and risk-averse, their spending is weak and, where once their savings might have gone into the property market, they are now hoarding them.

With China’s businesses also cautious, demand for credit is low. Last month bank borrowers repaid more than China’s banks lent for the first time in nearly two decades. There is a lot of liquidity swirling around the system and few options for it to find a safe place to rest.

The property market, until it has clearly stabilised, is not one of them and may not be for some years, given the surplus of housing stock and a declining population.

China’s stock market, which has fallen for the past three years, is down another 3.7 per cent year-to-date.

That leaves the obvious haven – for households, businesses and banks – of the government bond market. The liquidity has to go somewhere and, if China’s banks are to cope with the inflows of deposits from households and businesses against the backdrop of weak demand for credit, the bond market is the only place to which they can safely turn.

China’s property meltdown continues to reverberate through the country’s economy. Credit: Bloomberg

The banks could try to reduce the flow of funds they are receiving by lowering their deposit rates, but that wouldn’t address the liquidity sloshing around but simply shift it somewhere else.

The risk for the PBOC and Beijing is that if they crack down too severely on the flow of funds into the banks and then into the longer-dated bonds, they will divert that liquidity into higher-risk assets and effectively force the bubble in the bond market into other asset classes.

Banks would obviously prefer to lend rather than put their excess liquidity into low-returning bonds, so the solution to the conundrum facing the authorities is obvious. They need to aggressively stimulate economic growth and the demand for credit to divert liquidity into more productive and less systemically challenging areas.

Beijing has, however, consistently rejected pressure to embark on large-scale stimulus to try to boost consumption, instead concentrating on an export-led growth strategy under which exports have grown to the extent that they are sparking pushback from those economies on the receiving end.

Yet even though the volume of those exports might have grown, their value hasn’t kept pace. That seems to be a function of depressed domestic demand and consequent over-capacity within China’s factories.

The PBOC is fighting a battle it can’t win in the market unless it, and the economic policymakers in Beijing, can find a way to win in the real economy. It is fighting a symptom of the underlying problem – slowing growth in the real economy – rather than the cause.

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