Chinese bonds have warned of higher debt supply

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China’s plans to issue billions of dollars in government bonds before the end of the year could burst a “bubble” in the country’s treasury market, people close to the central bank have warned.

The warning comes after frenzied buying that sent 10-year Chinese government bond prices soaring, pushing yields below 2.2 percent and prompting the People’s Bank of China to warn that a sharp reversal could threaten financial stability.

Official data and state media reports indicate that as of July, the government has yet to issue just over half of its planned 2024 quota of local government and special central government ultra-long treasuries, totaling about 2 .68 billion Rmb ($376 billion). still to come.

“When these government and local bond issues, driven by budget requirements, explode at the end of the year, the volume is in the trillions. The possibility of a significant reversal in yields is very high,” said one of the central bank insiders.

China’s economic slowdown has led to increased bond issuance over the past few years.

These include special local government bonds – the proceeds of which are used by lower authorities for projects and investment, and special very long-dated treasury bonds used to help stimulate the economy.

Despite the planned increase in emissions, the dim economic outlook and a weak stock market have led investors, including Chinese banks, to pile into government bonds, leading regulators to worry that the market is in bubble territory. The 10-year yield hit an all-time low of 2.12% this month.

The PBoC said it was concerned about leveraged funds loading up on bonds and the risk of failures similar to US Silicon Valley Bank if banks buy long-dated Treasuries and then interest rates reverse.

“Long-term government bond yields have deviated from a reasonable range and show a trend towards a certain degree of bubbles,” said Xu Zhong, deputy general secretary of the National Association of Financial Market Institutional Investors, this month. organization under the PBoC. the central bank’s newspaper, Financial News.

Finance Ministry data shows that as of July, the government had yet to issue about Rmb2.1 billion of its Rmb3.9 billion quota for a full year of local government special bonds, while state media reported that it had yet to has yet to issue Rmb582bn from a Rmb1bn issue. of ultra-long central government treasuries.

This has created a glut of potential new issues in the government bond market, those close to the central bank have warned.

“Initially, everyone expected government bonds and local government bond (yields) to rise with large-scale issuance,” one of the people close to the central bank said.

But the person said that “various factors” have prevented this show. There was now an “imbalance between supply and demand” that was driving up prices.

However, the “bears” will eventually prevail, the person said, as the finance ministry increased issuance to meet its full quotas for this year.

“When these (new bond issues) break out and the Treasury steps in, with supply and demand (rebalancing), and when it goes short, won’t the market reverse?” said the person close to the central bank. “Can you understand why the central bank has to talk constantly to remind people and guide them to rationally face such high risks?”

Analysts say there is also a greater risk to financial stability if the yield curve flattens too much, as that would put pressure on the ability of China’s state-owned banks to earn profits.

The PBoC is reforming its monetary instrument this year, including setting a new policy benchmark rate and fine-tuning the rate transmission mechanism, exerting more influence on the growing bond market. The move follows a shift in bank liquidity from loans to other assets such as bonds.

But Yang Yewei, a fixed income analyst at Guosen Securities, said the PBoC could face challenges if it adopted yield curve controls similar to those used by the Bank of Japan and the Reserve Bank of Australia over the past decade.

Yang said foreign regulators typically used yield curve controls to cap yields while the PBoC tried to set a floor. “There’s little precedent for this,” Yang said.

In addition, China’s bond market lacked the depth to support such a monetary policy approach, with official data showing it was equivalent to just 65% of national GDP, compared to much higher levels overseas .

Zhu Haibin, chief China economist at JPMorgan, said the PBoC is trying to modernize monetary policy by using interest rates to control credit creation rather than directly controlling the amount of credit. “Sooner or later (monetary policy change) will come,” Zhu said, but added that the transition is still in an experimental stage and will be a long process.

“The challenge is that policy transmission is not yet that smooth. That is why we see the PBoC taking action to control central government bond yield curves – where trading reflects very weak market confidence and rising market risks.”