China's Bond Market Intervention Reveals Financial Stability Concerns

BEIJING – China's recent efforts to stem the rise of its bond market reveal broader concerns among authorities about financial stability, analysts said.

Slowing economic growth and strict capital controls have concentrated domestic money in China’s government bond market, one of the world’s largest. Regulators have told commercial banks in Jiangxi province not to settle their purchases of government bonds, Bloomberg reported on Monday, citing people familiar with the matter.

Chinese 10-year government bond futures fell to their lowest in nearly a month on Monday before recovering modestly, according to data from Wind Information. Prices are moving in the opposite direction to yields.

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

She noted that in contrast to electronic trading of bonds by individual investors or asset managers in Europe, banks and insurance companies tend to hold government bonds, which means nominal losses if prices fluctuate significantly.

The yield on China's 10-year government bonds has risen surprisingly in recent days, after falling all year to a record low in early August, according to Wind Information data going back to 2010.

At around 2.2%, the yield on China’s 10-year Treasury bonds remains well below the yield on 10-year U.S. Treasuries, which is hovering around 4% or higher. The gap reflects how the U.S. 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 problem is not what it shows (about a weak economy),” Garcia Herrero said, but “what it means for financial stability.”

“They are thinking about Silicon Valley Bank, so that means that corrections in sovereign bond yields will have a significant impact on the sovereign balance sheet,” she continued, adding that “the potential problem is worse than Silicon Valley Bank and that is why they are very concerned.”

Silicon Valley Bank collapsed in March 2023 in one of the largest U.S. bank failures in recent times. The company’s travails were largely blamed on shifts in capital allocation due to aggressive interest rate hikes by the Federal Reserve.

In a speech in June, People’s Bank of China Governor Pan Gongsheng said central banks need to learn from the Silicon Valley Bank incident, “immediately correct and stop the accumulation of financial market risks.” He called for special attention to “the mismatch of maturity rates and interest rate risks of some non-bank entities holding a large number of medium- and long-term bonds,” according to a translation by CNBC China.

The People's Bank of China has increased its intervention in the government bond market, from increasing regulatory scrutiny of bond market trading to directing state-owned banks to sell Chinese government bonds, noted Zerlina Zeng, head of credit strategy in Asia at CreditSights.

The People's Bank of China seeks to “maintain a steep yield curve and manage risks arising from concentrated holdings of long-term central government bonds by urban and rural commercial banks and non-bank financial institutions,” it said in a statement.

“We do not believe that the goal of the People's Bank of China's intervention in the bond market was to engineer higher interest rates, but rather to guide banks and non-bank financial institutions to expand credit to the real economy rather than depositing funds in bond investments,” Zeng said.

Stability has been paramount for Chinese regulators, and even if yields are expected to move lower, the speed of price rises is a concern.

This is a particular problem for Chinese insurers, which have put much of their assets into the bond market — after securing fixed rates of return on life insurance and other products, said Edmund Goh, head of fixed income in China at Aberdeen.

This contrasts with the way insurers in other countries are able to sell products whose returns can fluctuate depending on market conditions and additional investment, he added.

“With bond yields falling rapidly, it will impact the capital adequacy of insurance companies. It’s a huge part of the financial system,” Guo added, estimating that it could take “trillions” of yuan to cover it. A trillion yuan is equivalent to about $140 billion.

“If bond yields fall more slowly, it will really give the insurance industry some breathing room.”

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

These factors make the People’s Bank of China’s intervention in the bond market more significant than Beijing’s other interventions, including in the foreign exchange market, said Garcia Herrero of Natixis. “What they are doing is very dangerous because the losses could be huge,” he added.

“Basically, I’m worried that things could get out of hand,” she said. “This is happening because there are no other investment alternatives. Gold or sovereign bonds, that’s the only option. In a country the size of China, with only those two options, there’s no way to avoid a bubble. The solution is not there unless you open up the capital account.”

The People's Bank of China 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 the losses, whatever the outcome.

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

But Goh said he did not think the move would be enough to dent foreign investor confidence. He expected the People's Bank of China to intervene in the bond market in some form.

Beijing has publicly expressed concerns about the speed of bond buying, which has sent yields falling rapidly.

In July, the Financial News, a newspaper affiliated with the People’s Bank of China, criticized the rush to buy Chinese government bonds, calling it “short selling” the economy. The newspaper later softened its headline to say such moves were “troubling,” according to a CNBC translation of the Chinese paper.

Yields on China’s 10-year bonds typically fluctuate in the 20 basis points range around the medium-term lending facility, one of the People’s Bank of China’s benchmark interest rates, said Zhang Li, chief fixed income strategist at ChinaAMC. But this year, the yield has been 30 basis points below the medium-term lending facility, he said, indicating a buildup of interest rate risk.

The potential for gains has driven demand for bonds higher, he said, after buying already outstripped supply earlier this year. The People’s Bank of China has repeatedly warned of the risks as it tries to maintain financial stability by addressing a shortage of bonds.

However, low yields also reflect expectations of slowing growth.

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

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

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

“Measures that enhance market diversity and discipline could help bolster the People’s Bank of China’s proactive measures,” Zhang added. “Reforms in the corporate bond market, in particular, could facilitate Beijing’s drive for more efficient economic growth that results in lower long-term debt.”