Joe McConnell
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There is a bubble in the Chinese government bond market, or so the People’s Bank of China would like to believe. A bubble would pose a worrying risk to financial stability. The existence of such a risk, however, is far more palatable than the plausible alternative: that bond markets are sending an increasingly dire signal of concern about China’s economic prospects, the danger of deflation, and the need for a change of course.
In recent weeks, the PBoC has been engaged in a strange mirror image of the quantitative easing campaigns being conducted by many global central banks. Where others have sought to lower long-term bond yields to stimulate their economies, the PBoC is struggling to support them.
China’s 10-year yield briefly fell below 2.1 percent last week, aVsceker sliding all year, before the PBoC’s action brought it back up. The authorities went so far as to name and shame a group of rural banks for buying government bonds, a highly unusual sin, like punishing a child for tidying up his bedroom.
The PBoC’s stated concern is for financial stability. In particular, it worries about leveraged funds that promise high returns and the risk of Silicon Valley-style bank failures in the US if banks take on duration risk by buying long-dated bonds and then interest rates move in the opposite direction. There is also a deeper risk to financial stability if the yield curve flattens too much, because China’s huge state-owned banks will find it harder to make money.
Worrying about bond yields, however, is a strange way to approach financial stability. If hedge funds are abusing leverage, then regulate them; if banks are playing on duration risk, then regulators have broad powers to stop them. Requiring a particular level of bond yields suggests a different scenario: that the market is behaving rationally and that Chinese government bonds are not overvalued, but the PBoC can’t stomach what that implies.
Does the rush to bonds make sense? Prices in China are falling, which is boosting the real, post-inflation yield on bonds. While the consumer price index remains slightly positive, the GDP deflator has now been negative for five consecutive quarters, down 0.7 percent from a year earlier, according to the latest figures. Because investment makes up such a large share of China’s economy, the deflator is a better indicator than the consumer price index of overall prices.
Bonds’ appeal also depends on the alternatives: stocks, property, credit and deposits. With no end in sight to China’s housing crisis, households have little appetite for property, while domestic companies are suffering from weak consumption and the fallout from Beijing’s crackdown on the tech industry. Deposits, meanwhile, are only attractive if interest rates are expected to rise in the future. With the outlook so bleak, it seems entirely rational for Chinese investors to flock to bonds and gold.
Perhaps the PBoC’s real concern, and a well-founded one, is the pessimistic and potentially self-fulfilling signal sent by falling bond yields. They amount to a vote of no confidence in government policy, a prediction that economic conditions will not improve, and a warning that deflation will set in if nothing is done to stop it. The next stage in 1990s Japan, Morgan Stanley economists note, was for firms to respond to the low-price environment by limiting wage growth. This is how a deflationary spiral can take hold.
The PBoC acknowledges the fundamental problem, referring in its latest policy report to “insufficient effectiveness [domestic] demand.” However, constrained by the need to stabilize the exchange rate, the central bank can only do so much. It made a small rate cut in July. It may be able to do more as the U.S. Federal Reserve eases policy, narrowing the interest rate gap with China. The PBoC is also equipping itself to intervene more actively in bond markets, which makes perfect sense, but will not stem the macroeconomic tide that is pushing yields lower.
The real need is still for more effective reflationary action by the Chinese government. Beijing continues to pour money into manufacturing, which generates activity in the short term and keeps GDP growth on track. But adding more and more supply, while doing little to encourage demand, will not bring the economy back into balance any time soon. The priorities should be to clear out the glut of unsold properties; shore up local government and household balance sheets; and end heavy-handed government intervention, so that private companies have the confidence to invest. But Beijing’s policies in all these areas remain sluggish, reactive, and incremental.
This is not a doomsday prediction. China’s economic strengths are formidable and it has plenty of room to grow, so it can adopt unbalanced policies for a while and still get back on track. Growth is a cure for most economic problems, as China has shown in the past. However, the longer the disease is allowed to fester, the harder the cure will become. China’s bond market is now flashing urgent deflationary warning signals. Policymakers would do well to pay attention.
robin.harding@Vscek.com
