China’s intervention in the bond market reveals concerns about financial stability

BEIJING – China’s latest efforts to stem the bond market rally reveal broader concerns among authorities about financial stability, analysts said.

Slow economic growth and strict capital controls have concentrated domestic funds in China’s government bond market, one of the largest in the world. Bloomberg reported this on Monday based on sources regulators told commercial banks in Jiangxi province not to complete their purchases of government bonds.

Futures showed prices for China’s 10-year government bond fell to the lowest level in almost a month on Monday before recovering modestly, according to data from Wind Information. Prices move inversely to interest rates.

“The government bond market is the backbone of the financial sector, even if you run a bank-driven sector like China [or] Europe,” said Alicia Garcia-Herrero, chief economist for Asia Pacific at Natixis.

She pointed out that, unlike electronic bond trading by private investors or asset managers in Europe, banks and insurers tend to hold government bonds, which entail nominal losses if prices fluctuate significantly.

Yields on Chinese 10-year government bonds have risen abruptly in recent days after falling all year to a record low in early August, Wind Information data dating back to 2010 shows.

At around 2.2%, the Chinese ten-year yield remains much lower than the US ten-year yield of almost 4% or higher. The difference reflects how the U.S. Federal Reserve has kept interest rates high while the People’s Bank of China has cut rates due to tepid domestic demand.

‘The problem is not what it shows [about a weak economy]Garcia-Herrero said, but “what it means for financial stability.”

“They have [Silicon Valley Bank] in mind, so what that means, corrections in government bond yields have a major impact on your government balance sheets,” she continued, adding that “the potential problem is bigger than that of the SVB and that is why they are very concerned. ‘

Silicon Valley Bank collapsed in March 2023 in one of the largest US bank failures in recent times. The company’s problems were largely due to shifts in capital allocation due to aggressive rate hikes by the Fed.

PBoC Governor Pan Gongsheng said in a statement speech in June that central banks must learn from the Silicon Valley Bank incident to “immediately correct and block the accumulation of risks in financial markets.” He called for special attention to be paid to the “duration mismatch and interest rate risk of some non-bank entities holding a large number of medium and long-term bonds.” This is evident from a translation of his Chinese by CNBC.

Zerlina Zeng, head of Asia credit strategy, CreditSights, noted that the PBoC has increased intervention in the government bond market, from increased supervision of bond market trading to guidelines for state-owned banks to sell Chinese government bonds.

The PBoC has sought to “maintain a steep yield curve and manage the risks arising from the concentrated holdings of long-term CGB bonds by urban and rural commercial banks and non-bank financial institutions,” it said in a statement .

‘We do not believe that the PBOC’s intervention in the bond market was intended to achieve higher interest rates, but to guide banks and non-bank financial institutions in providing credit to the real economy, rather than parking money in bond investments ‘, Zeng said. .

Stability has long been important to Chinese regulators. Even if interest rates are expected to fall, the speed of price increases remains worrying.

That’s a particular problem for Chinese insurance companies that have parked much of their assets in the bond market – after guaranteeing fixed returns on life insurance and other products, said Edmund Goh, head of China Fixed Income at Abrdn.

That contrasts with how insurance companies in other countries may sell products whose returns can change depending on market conditions and additional investments, he said.

“With the rapid fall in bond yields, it would affect the capital adequacy of insurance companies. It is a big part of the financial system,” Goh added, estimating it could require “trillions” of yuan. One trillion yuan is approximately $140 billion USD.

“If bond yields fall more slowly, that will really give the insurance industry some breathing room.”

Insurance companies and institutional investors have rushed into China’s bond market, partly due to a lack of investment opportunities in the country. The real estate market has collapsed, while the stock market is struggling to recover from multi-year lows.

These factors make the PBoC’s intervention in the bond market much more consequential than Beijing’s other interventions, including on the foreign exchange front, Natixis’ Garcia-Herrero said. “It is very dangerous what they are doing because the losses can be enormous.”

“I’m actually just worried that it’s going to get out of hand,” she said. ‘This happens because there [are] no other investment alternatives. Gold or government bonds, that’s all. For a country as big as China, with only these two options, there’s no way to avoid a bubble. The solution is not there unless you open the capital account.”

The PBoC did not immediately respond to a request for comment.

China has pursued a state-dominated economic model, with gradual attempts to introduce more market forces in recent decades. This state-led model has led many investors in the past to believe that Beijing will step in anyway to limit losses.

The news that a local bank canceled a bond settlement “came as a shock to most people” and “shows the desperation on the part of the Chinese government,” said Abrdn’s Goh.

But Goh said he didn’t think this was enough to shake the confidence of foreign investors. He had expected the PBoC to intervene in the bond market in some way.

Beijing has publicly expressed concerns about the pace of bond buying, which has caused interest rates to fall rapidly.

In July, the PBoC-affiliated ‘Financial News’ criticized the hurry to buy Chinese government bonds as a short position in the economy. The outlet later watered down the headline to say such actions were a ‘disturbance’ according to CNBC’s translation of the Chinese outlet.

Chang Le, senior fixed income strategist at ChinaAMC, pointed out that China’s 10-year yield has generally fluctuated within a range of 20 basis points around the medium-term lending facility, one of the PBoC’s key interest rates. But this year, rates were 30 basis points below the MLF, he said, indicating the accumulation of interest rate risk.

The potential for gains has boosted demand for bonds after these purchases already outpaced supply earlier this year, he said. The PBoC has repeatedly warned of risks while trying to maintain financial stability by addressing the lack of bond supply.

However, low interest rates also reflect expectations of slower growth.

“I think poor credit growth is one of the reasons why bond yields have fallen,” Goh said. If smaller banks “could find good quality borrowers, I’m sure they would prefer to lend to them.”

Lending data released late Tuesday showed that new yuan loans falling under the “total social financing” category fell in July for the first time since 2005.

“The latest volatility in China’s domestic bond market underlines the need for reforms that channel market forces toward efficient credit allocation,” said Charles Chang, managing director at S&P Global Ratings.

“Measures that increase market diversity and discipline can help strengthen the PBOC’s periodic actions,” Chang added. “Reforms in the corporate bond market in particular could facilitate Beijing’s push for more efficient economic growth, which entails less debt in the long run.”