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

BEIJING — China’s latest efforts to curb a bond market surge reveal greater concerns among authorities about financial stability, analysts said.

Slow economic growth and tight capital controls have concentrated domestic funds in China’s government bond market, one of the largest in the world. Bloomberg reported on Monday, citing sources, that regulators had told commercial banks in Jiangxi province not to pay for purchases of government bonds.

Futures showed Chinese 10-year government bond prices fell to their lowest level in nearly a month on Monday before recovering modestly, Wind Information data showed. Prices move inversely to yields.

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

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

The yield on China’s 10-year government bond has risen sharply in recent days after falling all year to a record low in early August, according to 2010 Wind Information data.

At around 2.2%, the Chinese 10-year yield remains well below the US 10-year Treasury yield of nearly 4% or more. The gap reflects how the US Federal Reserve has kept interest rates high while the People’s Bank of China has cut rates in the face of tepid domestic demand.

“The issue is not what it shows (about a weak economy),” Garcia-Herrero said, but “what it means for financial stability.”

“They (Silicon Valley Bank) have in mind, so what does this mean, corrections in sovereign bond yields having a big impact on your sovereign balance sheet,” she continued, adding that “the potential problem is worse than SVB and that’s why” you are very anxious.”

Silicon Valley Bank collapsed in March 2023 in one of the largest US bank failures in recent memory. The company’s struggles have largely been blamed on changes in capital allocation due to the Fed’s aggressive rate hikes.

PBoC Governor Pan Gongsheng said in a speech in June that central banks must learn from the Silicon Valley Bank incident to “promptly correct and block the build-up of financial market risks.” He called for special attention to be paid to the “maturity mismatch and interest rate risk of some non-banks holding a large number of medium and long-term bonds.” That’s what CNBC’s translation of his Chinese shows.

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

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

“We do not believe that the intention of the PBOC’s bond market intervention was to create higher interest rates, but to guide banks and non-bank financial institutions to lend to the real economy rather than park funds in bond investments,” Zeng said.

Stability has long been important to Chinese regulators. Even as yields are expected to decline, the speed of price increases raises concerns.

That’s particularly a problem for Chinese insurance companies that have parked much of their assets in the bond market — after guaranteeing fixed rates of return for life insurance and other products, said Edmund Goh, head of revenue. fixed lines from China to Abrdn.

This contrasts with how in other countries, insurance companies can sell products whose profits can change based on market conditions and additional investment, he said.

“With bond yields falling rapidly, this would affect the capital adequacy of insurance companies. It’s a huge part of the financial system,” Goh added, estimating it could require “trillions” of yuan to hedge. One trillion yuan is about 140 billion USD.

“If bond yields come down more slowly, it’s really going to give the insurance industry some breathing room.”

Insurance companies and institutional investors have flocked to China’s bond market, partly because of a lack of investment options in the country. The housing market crashed, while the stock market struggled to recover from multi-year lows.

These factors make the PBoC’s intervention in the bond market far more significant than Beijing’s other interventions, including in foreign exchange, Natixis’ Garcia-Herrero said. “It’s very dangerous what they’re doing because the losses could be massive.”

“Basically, I’m worried it’s going to get out of hand,” she said. “This happens because there are no other investment alternatives. Gold or sovereign bonds, that’s all. A country the size of China, with only these two options, you cannot avoid a bubble. The solution does not exist. unless open the capital account.”

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

China has followed a state-dominated economic model with gradual efforts to introduce more market forces over the past few decades. This state-led model has led many investors in the past to believe that Beijing will step in to stem losses no matter what.

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

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

Beijing has publicly expressed concern about the speed of its bond purchases, which has driven yields down rapidly.

In July, PBoC-affiliated Financial News criticized the rush to buy Chinese government bonds as “shortening” the economy. The outlet later watered down the headline to say such actions were a “disruption,” 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 typically fluctuated within 20 basis points around the medium-term lending facility, one of the PBoC’s benchmark interest rates . But this year the yield has reached 30 basis points below the MLF, he said, indicating the build-up of interest rate risk.

The potential for gains has fueled demand for the bonds, after such purchases already outstripped supply earlier this year, he said. The PBoC has repeatedly warned of risks as it seeks to maintain financial stability by addressing a lack of bond supply.

However, the low yields also reflect expectations of slower growth.

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

Loan data released late Tuesday showed new yuan loans classified as “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 to channel market forces into 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. “Corporate bond market reforms, in particular, could facilitate Beijing’s pursuit of more efficient economic growth that attracts less long-term debt.”