China bond bulls warned over bumper debt supply

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China’s plans to issue billions of dollars of 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 follows frenzied buying that has driven up the prices of Chinese 10-year central government bonds, pushing yields below 2.2 per cent and leading the People’s Bank of China to caution that a sudden reversal could threaten financial stability.

Official data and state media reports indicate that as of July, the government had yet to issue just over half of its planned 2024 quota of local government and special central government ultra-long treasuries, with a total of about Rmb2.68tn ($376bn) still to come.

“When these government and local government bond issuances, driven by budgetary requirements, explode at the end of the year, it’s trillions in volume. The possibility of a significant reversal in yields is very high,” one of the people close to the central bank said.

China’s economic slowdown has led to increasing bond issuance in the past few years.

These include special local government bonds — whose proceeds are used by lower authorities for projects and investments, and ultra-long dated special treasury bonds used to help stimulate the economy.

Despite the planned increased issuance, the subdued economic outlook and weak stock market have led investors, including Chinese banks, to pile into government bonds, leading to concerns among regulators that the market is in bubble territory. The 10-year yield hit an all-time closing low of 2.12 per cent this month.

The PBoC has said it is concerned about leveraged investment funds loading up with the bonds and the risk of failures similar to Silicon Valley Bank in the US, if banks buy treasuries with long maturities and then interest rates reverse.

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

Ministry of Finance data shows that as of July, the government had yet to issue about Rmb2.1tn of its Rmb3.9tn full-year quota of special local government bonds, while state media reported it still had yet to issue Rmb582bn of a Rmb1tn issuance of ultra-long central government treasuries.

This has created an overhang of potential new issuance in the government bond market, the people close to the central bank warned.

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

But the person said “various factors” had impeded this issuance. Now there was a “supply-demand imbalance” that was driving up prices.

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

“When these [new bond issues] erupt and the Ministry of Finance comes in, with supply and demand [rebalancing], and when the big short comes in, won’t the market reverse?” the person close to the central bank said. “Can you understand why the central bank needs to constantly speak out to remind people and guide them to rationally face such big risks?”

Analysts say there is also a deeper risk to financial stability if the yield curve flattens too much because that would put pressure on China’s state banks’ ability to earn profits.

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

But Yang Yewei, a fixed-income analyst at Guosen Securities, said the PBoC might face challenges if it adopted yield curve control similar to that used by the Bank of Japan and the Reserve Bank of Australia in the past decade.

Yang said foreign regulators usually used yield curve control to cap yields while the PBoC was trying to set a floor. “There’s little precedent for that,” Yang said.

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

Zhu Haibin, chief China economist with JPMorgan, said the PBoC was attempting to modernise monetary policy by using interest rates to control credit creation rather than directly controlling the quantity of credit. “Sooner or later [the shift in monetary policy] will come,” Zhu said, but added the transition was still at an experimental stage and would be a long process.

“The challenge is that the policy transmission is still not that smooth. That’s why we see the PBoC is taking actions to control the central government bond yield curves — in which the trades are reflecting very weak market confidence and growing market risks.”