China’s bond market intervention highlights financial stability concerns

BEIJING – Analysts say China’s latest efforts to curb a bond market boom highlight broader concerns among officials about financial stability.

Slow economic growth and tight capital controls have led domestic funds to concentrate in China’s government bond market, one of the world’s largest. Regulators have told commercial banks in Jiangxi province not to settle purchases of government bonds, Bloomberg reported on Monday, citing sources.

Prices of 10-year Chinese government bonds in futures trading fell to a nearly one-month low on Monday, but later recovered slightly, according to Wind Information data. Prices move in the opposite direction of yields.

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

He pointed out that unlike electronic trading of bonds by retail investors or asset managers in Europe, banks and insurance companies hold government bonds, meaning they suffer nominal losses if prices fluctuate significantly.

The yield on 10-year Chinese government bonds has surged sharply in recent days, after hitting a record low throughout the year in early August, according to 2010 data from Wind Information.

At around 2.2%, the Chinese 10-year yield is much lower than the US 10-year Treasury yield, which is around 4% or more. This difference reflects how the US Federal Reserve has kept interest rates high while the People’s Bank of China has been lowering rates in the face of weak 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 that means a correction in sovereign bond yields will have a big impact on your sovereign balance sheet,” he said, adding that “the potential problem is even worse than SVB and that’s why they are very worried.”

Silicon Valley Bank collapsed in March 2023, one of the biggest US bank failures in recent times. The company’s struggles were primarily attributed to a shift in capital allocation due to aggressive rate hikes by the Fed.

PBOC Governor Pan Gongsheng said in a speech in June that central banks need to learn from the Silicon Valley Bank incident to “promptly correct and prevent the accumulation of financial market risks.” He called for special attention to “the maturity mismatch and interest rate risks of some non-bank entities holding a large number of medium- and long-term bonds,” according to a CNBC translation of his Chinese-language speech.

Zerlina Zeng, head of Asia debt strategy at CreditSites, said the PBOC has stepped up intervention in the government bond market, from increasing regulatory scrutiny of bond market trading to providing guidance to state-owned banks on how to sell Chinese government bonds.

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

“We don’t think the PBOC’s bond market intervention was aimed at pushing higher interest rates, but rather at guiding banks and non-bank financial institutions to increase lending to the real economy instead of putting funds into bond investments,” Zeng said.

Stability has long been important to Chinese regulators. Even though yields are expected to come down, the pace of price increases is a concern.

This is particularly an issue for Chinese insurers, which have put most of their assets into the bond market after having to guarantee fixed return rates for life insurance and other products, said Edmund Goh, head of China fixed income at Aberdeen.

He said this is unlike other countries where insurance companies sell products whose returns may change depending on market conditions and additional investments.

“The rapid fall in bond yields will affect the capital adequacy of insurance companies. This is a big part of the financial system,” Goh said, estimating that a “trillion” yuan may be needed to cover it. One trillion yuan is about US$140 billion.

“If bond yields decline at a slower pace, that would provide some relief to the insurance industry.”

Insurers and institutional investors have shunned China’s bond market due to a lack of investment options. The real estate market has plummeted, while the stock market is struggling to recover from multi-year lows.

These factors make the PBOC’s bond market intervention far more important than Beijing’s other interventions, including in foreign exchange, Natixis’ Garcia-Herrero said. “What they’re doing is very dangerous, because the damage could be huge.”

“Basically, I am just worried that this will get out of control,” he said. “This is happening because there are no other options for investment. Gold or sovereign bonds, that’s it. In a country the size of China, with only these two options, there is no way to avoid a bubble. Unless you open the capital account, there is no solution.”

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

China has adopted a state-run economic model over the past few decades, with gradual efforts to incorporate more market forces. This state-led model has led many investors in the past to believe that Beijing will step in to prevent deficits no matter what.

Aberdeen’s Goh said news of the local bank cancelling the bond settlement “came as a shock to most people” and “reflects the desperation of the Chinese government.”

But Goh said he did not think it was enough to affect foreign investor confidence. He expected the PBOC to intervene in the bond market in some form.

Beijing has publicly expressed concern over the pace of bond purchases, which has led to a sharp reduction in bond yields.

In July, the PBOC-affiliated “Financial News” criticized the Chinese government’s bond-buying spree, describing it as “shorting” the economy. According to CNBC’s translation of the Chinese outlet, the outlet later lightened the headline, saying such actions are “disturbing.”

Chang Le, fixed-income senior strategist at ChinaAMC, pointed out that the Chinese 10-year yield has usually fluctuated in a 20 basis-point range around the medium-term lending facility, one of the PBOC’s benchmark interest rates. But this year, the yield reached 30 basis points below the MLF, he said, which reflects the accumulation of interest rate risk.

The prospect of gains has boosted demand for bonds, he said, while such purchases far outstripped supply earlier this year. The PBOC has repeatedly warned of risks while trying to maintain financial stability by tackling a bond supply shortage.

However, lower yields also reflect expectations of slower growth.

“I think bad loan growth is one of the reasons why bond yields have come down,” Goh said. If smaller banks “can find good quality borrowers, I’m sure they will lend them money.”

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

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

“Measures that enhance market diversity and discipline can help reinforce the PBOC’s periodic actions,” Chang said. “Reforms in the corporate bond market, in particular, can facilitate Beijing’s pursuit of more efficient economic growth, leading to less borrowing in the long term.”