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China Faces Risks Amid Bond Market Bubble

Currently, there is a tendency in China, in which money flows rush into government bonds, the consequences of which are circumstances such as a sharp increase in the price index of these emission securities and a simultaneous drop in their yields to a level corresponding to a record low.

China Faces Risks Amid Bond Market Bubble

The mentioned state of affairs in the Asian country is to a certain extent natural. This thesis is explained by the fact that investors are currently interested in finding an alternative direction of financial contributions against the background of a deep crisis in the Chinese real estate sector. The specified crisis turned out to be much longer than the preliminary expectations for the dynamic of the corresponding process in the early stages of its implementation. The present state of affairs in the Chinese real estate sector may become fundamental as a factor impacting the subsequent situation in this area. There is also currently a problem of stock volatility in the Asian country.

On Monday, July 1, the yield on China’s onshore 10-year government bonds, which are a kind of benchmark for a wide range of interest rates, was fixed at 2.18%. The mentioned figure is the lowest since 2002. Also, currently in China, yields on 20-year and 30-year bonds are fixed at levels that are close to becoming what can be described as a negative record. In this case, it means approaching historical lows.

Bond yields, or the yields offered to investors for holding emission securities, are on a downward trajectory, continuing to move accordingly in the corresponding direction as prices rise.

Lowering the cost of borrowing is positive news and an appropriate solution within the framework of such a configuration of economic reality when in the relevant space there is a tendency for uneven recovery associated with various difficulties and obstacles after the collapse in the real estate market, insufficient intensity of consumer activity in the context of expenses and a low level of business confidence in the prospects of the future. At the same time, a sharp rise in bond prices has provoked widespread fears of a so-called bubble in the securities market. The corresponding concerns are also characteristic of some Chinese policymakers. Representatives of the leadership of the Asian country in this case are alarmed by the realistic risk of a repeat of the crisis, such as the collapse of the Silicon Valley Bank (SVB) last year.

Since April, the People’s Bank of China has issued more than 10 separate warnings that the bond bubble could burst. In the relevant context, the financial regulator of the Asian country pays special attention to the fact that the potential implementation of a negative scenario will become a factor of destructive impact on the economic recovery process, which even in more favorable conditions does not demonstrate stability and is characterized by unevenness. The People’s Bank of China also warns that the materialization of the risk that the mentioned bubble will burst will become a source of destabilization of the situation in financial markets.

Currently, the financial regulator of the Asian country borrows bonds. This practice is extremely rare for the People’s Bank of China. Currently, this financial institution holds bonds for $209.14 billion. The mentioned figure is equivalent to about 5% of treasury bonds in circulation and 1.4% of all Chinese bonds worth $14.6 trillion held by entities.

The People’s Bank of China borrows debt securities to sell them to tamp down prices.

The governor of the central bank of the Asian country, Pan Gongsheng, said at a financial forum in Shanghai last month that the negative experience of SVB has formed an understanding that it is necessary to observe and assess the situation in the financial market from a macroprudential point of view. He also stated the need to pay close attention to the discrepancy between maturities and the risks of interest rate changes associated with large holdings of medium- and long-term bonds placed by some non-banking entities. The list of the mentioned entities includes insurance companies, investment funds, and other financial firms.

SVB is the largest bank in the United States that has ended its existence under the irreversible collapse scenario since the global financial crisis of 2008. The reason that the history of this lender ended in bankruptcy is that the financial institution invested billions of dollars in US government bonds. Such practices in the past have generally been justified decisions that fall into the category of constructive strategies. At the same time, the configuration of economic reality that has been observed in the United States over the past few years is not evidence for the expediency of investing in government bonds. Such a strategy ceased to be promising and constructive in the context of the specifics of modernity after the Federal Reserve System began implementing the concept of tightening monetary policy in March 2022, providing for an increase in interest rates. These actions of the financial regulator of the United States are aimed at combating inflation. As part of efforts to curb the intensity of the process of increasing the cost of goods and services, the US central bank raised the cost of borrowing a total of 11 times from March 2022 to January of the current year. The Fed is in no hurry to ease monetary policy so far. There is a kind of consensus among officials of the central bank of the United States, according to which the mentioned actions should be started only when there are signs of a steady movement of the inflationary process toward the target of 2%. It is worth noting that in March 2022, the Fed raised the cost of borrowing for the first time since 2018.

Against the background of the specified tightening of the monetary policy of the financial regulator of the United States, the prices of bonds held by SVB showed a drop which turned out to be tragic for the lender. The mentioned process worsened the financial situation of the bank, effectively making its continued existence impossible.

Currently, in China, politicians are afraid of repeating the SVB experience. In this case, the potential implementation of a negative scenario will not be an event affecting the state of affairs within only the banking sector, but a kind of stress for the entire space of the world’s second-largest economy. The corresponding configuration of economic reality is still a hypothetical probability, but it may become an objective fact of the material plane if the Chinese bond frenzy goes unchecked. The prices of the Asian country’s debt securities have been on a trajectory of rapid growth since the beginning of the current year. This tendency is because investors choose in favor of bonds against the background of very high uncertainty of economic prospects. There are also fewer loans being taken out by businesses in the Asian country at the moment. Against the background of the corresponding tendency, banks have to park excess cash somewhere.

Larry Hu, chief China economist for Macquarie Group, says that the low level of demand for credits in the Asian country is due to the problematic situation in the local real estate sector. Against the background of the corresponding realities, as the expert notes, financial institutions have to buy more bonds, since money is trapped in the interbank market.

Moreover, Larry Hu says that the deflationary outlook for the world’s second-largest economy was realized by investors, which is why they began to flock to long-term sovereign bonds.

To a certain extent, the SVB experience has already been repeated in China, but not in its most negative configuration. In this case, it is implied that in an Asian country, financial institutions have invested significant amounts in long-term government bonds. As a result of these actions, banks have found themselves in a very vulnerable position in terms of sensitivity to sudden changes in interest rates. Beijing is concerned about the risk of a scenario involving the bond bubble bursting. If the corresponding fears materialize, prices will fall and yields will rise, against which banks will face large losses.

Larry Hu says that Chinese policymakers are concerned about the risk of a change in the cost of borrowing, the probability of which will increase dramatically as soon as the dominant tendency in the space of the world’s second-largest economy shifts from deflation to reflation.

Zheshang Securities, a state-controlled brokerage company, based on an analysis of data from the Asian country’s financial regulator, found that in the first half of the current year, the net volume of purchases of sovereign bonds by banks, mainly regional lenders, amounted to 1.55 trillion yuan ($210 billion). This indicator exceeded the figure by 61% over the same period last year.

Currently, interest rates in China are low. Over the past few years, the financial regulator of the Asian country has been making decisions indicating a move in a direction that is the opposite of the strategy of tight monetary policy. In June, the People’s Bank of China kept the one-year interest rate on loans at the same level of 2.5%. The strategy of the Asian country’s financial regulator is aimed at supporting the world’s second-largest economy.

There is currently deflationary pressure in China. In May, consumer prices in the Asian country showed an increase that turned out to be lower than preliminary expectations regarding the dynamic of this indicator. At the same time, factory prices showed a decrease in the specified month. This tendency has been observed for 20 months in a row.

Larry Hu says that as soon as the dynamic of external demand slows down, Beijing will be forced to strengthen stimulus measures to achieve the goal of economic growth. In March, the authorities of the Asian country set the corresponding figure at 5%. Many experts are convinced that this goal is realistic. For example, analytics from the International Monetary Fund predict that the world’s second-largest economy will grow by 5% in the current year.

Larry Hu suggests that against the background of rising bond yields, investors will again pay attention to riskier stocks. Also, within the framework of the corresponding scenario, an increase in demand for credits will be recorded with the maximum probability. In this case, financial institutions will reduce their holdings of government debt. Larry Hu says that the implementation of the corresponding scenario will trigger the reverse development of the so-called bond bull market. According to the expert, about 4,000 small and medium-sized banks in the Asian country will be particularly vulnerable to the risk of changes in the cost of borrowing.

Amid growing concern, this week the People’s Bank of China announced its intention to directly intervene in the bond market to cool the frenzy for the first time in history. Relevant information about the plans of the financial regulator was published by the state media of the Asian country.

The People’s Bank of China will borrow government bonds from traders on the open market. Then the financial regulator of the Asian country will sell the mentioned securities in a bid to depress prices and boost yields. The People’s Bank of China has made the appropriate decision after careful observation and assessment and is aimed at maintaining the sound operation of the bond market.

The state media of the Asian country also state concern. This week, journalists warned about the risks of a bubble in the bond market. In the relevant context, they mention SVB and a Japanese bank, whose holdings in government debts of the United States and Europe have lost value amid rising yields.

The Asian country’s state media notes that the bubble formed as a result of the influx of funds into the bond market increases the risks of interest rate changes. In this context, journalists draw attention to the fact that the reason for the bankruptcy of SVB and the huge losses of the Japanese Norinchukin Bank were the risks of the mentioned category associated with over-reliance on investments in bonds.

Numerous verbal warnings failed to become a factor restraining the rapid rise in bond prices. Against this background, the People’s Bank of China was forced to announce an intervention in the market.

Zhang Jiqiang, chief fixed-income analyst at Huatai Securities, says that the mentioned decision by the Asian country’s financial regulator demonstrates the determination to reduce growth rates by selling bonds and lifting yields. The expert also said that the People’s Bank of China wants to avoid an SVB-style crisis.

However, it is worth noting that the rapid decline in bond yields generates significant risks for the world’s second-largest economy. Ken Cheung, director of foreign exchange strategy at Mizuho Securities in Hong Kong, says that in the context of the current conditions, the low yield of government debt securities does more harm than good for the Asian country’s economic system. According to the expert, low yields may reinforce market expectations regarding aggressive interest rate cutting by the People’s Bank of China and weak growth, exacerbating the generation of the concept of a so-called deflationary mindset.

The frenzy in the bond market may become an obstacle to the implementation of the efforts of the Asian country’s financial regulator to stimulate economic activity and increase the money supply. The mentioned frenzy stimulates capital inflows into debt securities, rather than into riskier assets, including stocks, property, and investments of other categories that drive economic growth.

Also, lower yields on Chinese government bonds may increase the spread in interest rates between the Asian country and the United States. The full-scale implementation of this scenario will provoke an outflow of money from the world’s second-largest economy and increase pressure on the yuan.

Larry Hu says that capital outflows from China in April reached the highest level since January 2016. The expert says that this state of affairs is largely due to the yield gap between the Asian country and the United States. In this context, Larry Hu noted that the People’s Bank of China does not want interest rate cuts to be too fast.

Serhii Mikhailov

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Serhii’s track record of study and work spans six years at the Faculty of Philology and eight years in the media, during which he has developed a deep understanding of various aspects of the industry and honed his writing skills; his areas of expertise include fintech, payments, cryptocurrency, and financial services, and he is constantly keeping a close eye on the latest developments and innovations in these fields, as he believes that they will have a significant impact on the future direction of the economy as a whole.