China’s Bond Bubble: A Looming Financial Crisis?

 

The yield on China’s onshore 10-year government bond dropped to 2.18% on Monday, the lowest since records began in 2002, highlighting an unprecedented surge in demand that is causing significant concern among Beijing's policymakers.

Chinese government bonds have seen an unprecedented surge in demand in recent months, driving their prices up and yields down to historic lows. While at first glance this might appear beneficial in an economy grappling with sluggish consumer spending, a property market in disarray, and weak business confidence, it is causing significant concern among policymakers in Beijing. The parallels with the collapse of Silicon Valley Bank (SVB) in the United States last year are too stark to ignore, prompting the People’s Bank of China (PBOC) to take unprecedented measures to prevent a similar financial disaster.

Simply put, the yield on China’s onshore 10-year government bond, a crucial benchmark for various interest rates, dropped to 2.18% on Monday, the lowest since records began in 2002. Yields on 20-year and 30-year bonds are also hovering near historic lows. This dramatic fall in yields is a direct result of soaring bond prices, as investors flock to government bonds in search of a safe haven amid the volatile stock market and the troubled real estate sector.

While lower borrowing costs could theoretically aid an economy struggling to recover, the sharp rise in bond prices has raised fears of a bubble. The PBOC has issued over 10 warnings since April about the potential risks of a bond market bubble bursting, which could destabilize financial markets and derail China’s economic recovery. This concern has prompted the PBOC to intervene directly in the bond market, an action described by state media as unprecedented.

The collapse of Silicon Valley Bank in 2023 serves as a cautionary tale for China. SVB’s failure, the largest US bank failure since the global financial crisis, was precipitated by its substantial investments in US government bonds. When the Federal Reserve began hiking interest rates to control inflation, the value of these bonds fell, undermining SVB’s financial stability.

China’s financial institutions are similarly exposed. With deflationary pressures driving investors to long-term sovereign bonds, and banks parking excess cash in bonds due to weak credit demand, the risk of a sudden shift in interest rates is significant. If the bond bubble bursts, leading to falling prices and rising yields, Chinese lenders could face substantial losses.

In response to these risks, the PBOC has taken the extraordinary step of borrowing government bonds from traders to sell them in the open market. This intervention aims to depress bond prices and boost yields, thereby cooling the market frenzy. PBOC Governor Pan Gongsheng emphasized the need to monitor and manage interest rate risks and maturity mismatches in the financial market, particularly among non-bank entities like insurance companies and investment funds.

The PBOC’s actions reflect a broader concern about the potential for an SVB-like crisis in China. In the first half of 2024, net purchases of sovereign bonds by financial institutions, primarily regional banks, totaled 1.55 trillion yuan ($210 billion), a 61% increase from the previous year. This significant investment in long-term government bonds makes these institutions vulnerable to sudden interest rate changes, highlighting the urgency of the PBOC’s interventions.

The rapid decline in bond yields poses several risks to the Chinese economy too. According to Ken Cheung, director of foreign exchange strategy at Mizuho Securities in Hong Kong, low government bond yields can exacerbate deflationary expectations and counteract efforts to boost economic activity. This could lead to a "deflation mindset," where businesses and consumers delay spending in anticipation of lower prices in the future, further slowing economic growth. In addition, the bond market frenzy diverts capital from riskier assets such as stocks and real estate, which are crucial for driving economic growth. This misallocation of capital can undermine the PBOC’s efforts to stimulate the economy and increase the money supply.

Moreover, the decline in Chinese government bond yields widens the interest rate spread between the US and China, potentially leading to capital outflows and increased pressure on the yuan. In April 2024, China’s capital outflows reached their highest level since January 2016, largely due to the widening US-China yield gap. Maintaining a balance between supporting economic growth and preventing excessive capital outflows is a delicate task for Chinese policymakers.

The current situation in China’s bond market is reminiscent of Japan’s experience in the late 1990s and early 2000s. During this period, Japan faced prolonged deflation and weak economic growth, leading to a similar rush into government bonds. This resulted in historically low yields and significant challenges for monetary policy. The Japanese government’s extensive bond holdings and the subsequent market volatility offer valuable lessons for China as it navigates its current predicament.

The surge in Chinese government bond prices and the resulting record-low yields are ringing alarm bells in Beijing. The PBOC’s unprecedented market interventions reflect the gravity of the situation and the urgent need to prevent a financial crisis akin to the collapse of Silicon Valley Bank. As China grapples with deflationary pressures, weak credit demand, and a fragile economic recovery, the balance between fostering growth and ensuring financial stability remains precarious. The lessons from global financial history underscore the importance of vigilant and proactive policy measures to navigate these complex challenges.