China’s central bank moves to dampen bond frenzy

As China’s economy slows, national regulators are keeping a wary eye out for any financial instabilities that may lead to a crisis. The latest concern is the $4 trillion bond market, which is seeing increased activity as investors look for a safe haven from the damaged real estate market and volatile shares.

Yields on 10-year government bonds touched 21.8% on July 1, the lowest since records began in 2002, while yields on 20-year and 30-year bonds were also at historic lows.^[1] While a rally in bond investment is to be expected in the economic climate in China, the size of the spike is worrying the central bank.

Early in the month, the People’s Bank of China (PBoC) said it would “borrow sovereign bonds from primary traders in the open market in the near future” in order to “maintain the stable operation of the bond market”.^[2] The central bank has been worried since April that a bond frenzy could lead to a crisis similar to the collapse of Silicon Valley Bank in the US last year.

“If a large amount of funds are locked in long-term bonds with low yields, and if the cost of the liability increases significantly, the funds will be caught into a passive situation of sizeable drawdowns from a sharp repricing,” a PBoC official told the state-owned Financial News in April.

“This is exactly what caused the liquidity crisis of . . . Silicon Valley Bank last year.”^[3]

A hedge fund fix

As July has progressed, PBoC has moved from warnings to action. It has announced deals with several institutions to borrow several hundred billion renminbi of long-dated bonds that it can sell into the market to try to satisfy demand. The PBoC has also said it will continue to borrow and sell the bonds on an open-ended and unsecured basis.^[4]

The move is a surprising new direction for the PBoC, which has long avoided any form of quantitative easing in its monetary policy. Indeed, central bank governor Pan Gongsheng was keen to emphasise that the new tool does not mean that the PBoC is in the business of quantitative easing.

“Including government bond buying and selling into the monetary policy toolbox doesn’t mean we’ll do quantitative easing,” he said at a banking forum. “It is meant to be a channel for base money injection and a tool for liquidity management.”^[5]

The PBoC policy is certainly different from when central banks like the US Federal Reserve and the Bank of England bought bonds to push yields down when their economies were struggling in the traditional sense of quantitative easing. The PBoC is planning to short sell bonds in a hedge-fund type move, first borrowing them and then selling them onto the market at the right time to try to increase yields.^[6]

Insiders have said that PBoC has started surveying bond investments held by some regional banks, looking into the banks' balance, leverage ratio, duration, and holding structure across different bond categories.^[7]

The threat of ‘Japanification’

But although it’s a bold initiative, there are underlying problems due to the lack of investment choices in China that could continue to stagnate its economy. Real estate prices are still falling, the stock market is shaky and regulators have kept a tight hold on alternative investments. Market observers see conditions that could lead to a “Japanification” in China.^[8]

Japanification, or a balance sheet recession, is where an economy deflates, experiencing low or no growth, falling asset prices and financial stress over a significant period following a stretch of high debt among households, companies and governments, similar to Japan’s experience in the 1990s.

China’s current downturn has some factors in common with 90s Japan - an ageing population, an imbalance in debt holdings and a real estate decline. But there are also significant differences. Analysis from JPMorgan^[9] and Goldman Sachs^[10] point out ways in which China’s position is more precarious - more rapid ageing, a worse global economic backdrop, and a potentially more pronounced real estate downturn. But also ways in which it is in a better position - a much lower urbanisation ratio, a larger domestic market, stronger government control of assets and liabilities and a stock market that’s volatile rather than collapsing.

No two economic crises are ever quite the same, so whether the threat is a Silicon-Valley-Bank-style liquidity crisis or Japanification, China’s economic woes remain a major geopolitical risk for the global economy and global trade. Investors, governments and financial services firms need to keep a close eye on developments to adjust their own strategies.

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