Loading
“Short essays”Your browser does not support the element. appear to be causing big problems in China’s bond market. Over the past year the term has been used to refer to rumours swirling around financial hubs, which often originate with brief posts on social media that attempt to explain the inner workings of the system. One such rumour claims that the central bank is hunting down speculators who have made “illegal transactions” on the bond market. Another implies the China Financial Futures Exchange, where bond futures are bought and sold, has ratcheted up fees in order to discourage trading.These are works of fiction and should be ignored, warn regulators. But social-media users can hardly be blamed for trying to explain the country’s bond yields: a ten-year government bond now offers 1.65%, just above a record low and down from 2.8% a year ago. In most countries this would be a sign that investors are preparing for a long bout of deflation and stagnation of the sort suffered by Japan in recent decades. Capital Economics, a research house, compares the market’s moves to those in America during the global financial crisis of 2007-09.No short story can capture the forces driving down yields. They first emerged from the devaluation of China’s most important asset, residential property, and are now reverberating through markets more broadly. China’s closed financial system, in which investors are trapped alongside falling valuations, exacerbates the problem.The pressures are most evident at China’s banks, which are among the biggest buyers of government bonds. A large part of the state’s plan for solving the housing crisis is for local governments to buy up a vast quantity of unsold homes. An estimated 32m housing units are ready for purchase; another 49m sit dormant. Accomplishing such a plan requires asset devaluation on a grand scale, with local governments negotiating down the price of these homes. In some cases, prices will have to drop by more than 50%. Only then will local officials be able to shoulder the cost.Falling prices will please first-time homebuyers, but not banks. They use unsold flats and the land reserves of property developers as collateral against loans. Thus a reduction in the value of these assets is a nightmare. Even small changes require them to reassess the quality of loans. A precipitous drop would prompt many to go sour. Not only would this reduce income from loans, it would also require banks to set aside additional money to buffer losses, further squeezing their profits.Property problems are one of many issues putting pressure on banks. In 2015 households hoovered up credit, often in the form of mortgages; they accounted for 43% of the growth in loans that year. At the time, firms and state entities each accounted for 28% of new borrowing. But the picture has changed dramatically since then. Household borrowing collapsed during the covid-19 pandemic and has been slow to recover; it accounted for just 1% of the growth in lending in 2023, according to a survey of more than 230 banks by Jason Bedford, an independent analyst. Indeed, in the first half of last year, new household borrowing appears to have declined.Vanishing demand from households is alarming. So is the fact that businesses are borrowing increasing amounts. Small companies are particularly keen on credit, and they benefit from state-enforced low interest rates—despite growing default risks. Meanwhile, bank deposits, and thus interest payouts, have boomed. As home prices have fallen, people have become less keen on investing in property. And a stockmarket rout in 2023 caused many retail investors to eschew shares. Bank term-deposits, which promise higher yields with restrictions on withdrawals, are now the preferred option for many savers.Such trends are proving unsustainable. China’s central bank was forced to cut deposit rates last year and is expected to do so again soon. As a result, term deposits at state banks now pay out 1.6% a year compared with over 4% five years ago. Net interest margins, the difference between what banks make on loans and pay for deposits, have nevertheless come crashing down. Bank of Shanghai’s margin was just 0.9% in March; Xiamen International Bank’s hit 0.6% in June. Both are creeping to dangerously low levels.With few other safe assets to turn to, banks that are under pressure, as well as insurers and fund managers, have piled into government bonds, driving down yields. Since China’s financial system is not about to open up, allowing money out, yields are almost certain to remain low.The country’s enormous army of amateur traders desperately hopes that the state will boost stockmarket valuations by directly buying shares and aggressively stimulating the economy. Doing so would enable investors of all stripes to return to equity markets, in the process lifting pressure on the bond market. Even if this happens, however, the impact may be muted. Corporate earnings declined for a third consecutive year in 2024, falling by more than they did in 2022, when China was paralysed by lockdowns. Moreover, if the state did somehow manage to manufacture a boom, a widening gap between valuations and company fundamentals would only set the scene for a subsequent crash.Another solution might be to increase the supply of government bonds. There has already been a move in this direction: issuance hit a record high in December, reaching 1.8trn yuan ($250bn). Much of this borrowing was part of a plan to allow local governments to refinance their debt. Any further increase would have to come hand-in-hand with a desire to increase state spending or cut taxes. Although it is still unclear what the government’s plans are on this front, a finance minister did say on January 10th that China’s fiscal policy would be “highly active” this year.A surefire way to take pressure off the bond market would be to relax capital controls, not least because Chinese demand for overseas investments is extremely high. Yet the more China’s economic outlook deteriorates, the more difficult it will be to do this. Above all else, ministers want to avoid a situation in which capital flees the country. That is why the government is in fact more likely to tighten, rather than loosen, controls this year—regardless of how low bond yields fall.
