Financial stability concerns prompt China to intervene in its bond market.

• Analysts said that China's recent efforts to curb a bond market rally indicate authorities' concerns about maintaining financial stability.
• Alicia Garcia-Herrero, chief economist for Asia-Pacific at Natixis, stated that the sovereign bond market is "the backbone of the financial sector, even if you run a bank-driven sector" like China or Europe.
• The guarantee of fixed return rates for life insurance and other products has led Chinese insurance companies to park much of their assets in the bond markets, according to Edmund Goh, head of China fixed income at abrdn. This is a major issue for the industry due to rapidly falling yields.

Analysts said that China's efforts to curb a bond market rally indicate broader concerns among authorities about maintaining financial stability.

The concentration of domestic funds in China's government bond market, one of the largest in the world, has been caused by slow economic growth and tight capital controls. According to Bloomberg, commercial banks in Jiangxi province were instructed by regulators not to settle their purchases of government bonds on Monday.

The 10-year Chinese government bond's prices plummeted to their lowest in nearly a month on Monday, before slightly recovering, according to Wind Information data. Prices move inversely to yields.

Alicia Garcia-Herrero, chief economist for Asia-Pacific at Natixis, stated that the sovereign bond market is crucial to the financial sector, even in countries like China or Europe that have bank-driven sectors.

In contrast to retail investors and asset managers in Europe trading government bonds electronically, banks and insurers typically hold them, resulting in nominal losses if prices fluctuate significantly.

Recently, the 10-year Chinese government bond yield has experienced a sudden increase, following a year-long decline that reached a record low in early August, according to Wind Information data from 2010.

Despite being around 2.2%, the Chinese 10-year yield has remained significantly lower than the U.S. 10-year Treasury yield of nearly 4% or higher. This gap reflects the difference in interest rate policies between the two countries, with the U.S. Federal Reserve keeping rates high and the People's Bank of China lowering rates in response to weak domestic demand.

"Garcia-Herrero stated that the issue is not the depiction of a weak economy in the problem, but rather its implications for financial stability."

"They are considering [Silicon Valley Bank] and its potential impact on sovereign balance sheets, with the potential problem being even worse than SVB, which is why they are very concerned."

In March 2023, Silicon Valley Bank failed, becoming one of the largest U.S. bank failures in history. The bank's difficulties were mainly attributed to changes in capital allocation resulting from the Federal Reserve's aggressive rate increases.

In a speech in June, PBoC Governor Pan Gongsheng emphasized the importance of central banks learning from the Silicon Valley Bank incident and taking prompt action to prevent the accumulation of financial market risks. He specifically highlighted the need for attention to the maturity rate mismatch and interest rate risk of non-bank entities holding a large number of medium and long-term bonds.

The PBoC has intensified its intervention in the government bond market, with stricter regulation of bond market trading and instructions for state-owned banks to sell Chinese government bonds, according to Zerlina Zeng, head of Asia credit strategy at CreditSights.

The PBoC aims to "keep a steep yield curve and control risks resulting from the accumulation of long-term CGB bonds by city and rural commercial banks and non-bank financial institutions," she stated.

Zeng stated that the PBOC's bond market intervention was not aimed at increasing interest rates, but rather at directing banks and non-bank financial institutions to lend money to the real economy instead of investing in bonds.

Insurance hole in the 'trillions'

Chinese regulators have long prioritized stability, and while yields are predicted to decline, the rate of price increases remains a cause for concern.

Edmund Goh, head of China fixed income at abrdn, stated that Chinese insurance companies have invested a significant portion of their assets in the bond market, in order to provide fixed return rates for their life insurance and other products.

In contrast to other countries, insurance companies in the US typically offer products with fixed returns that do not depend on market conditions or additional investment, he stated.

The decline in bond yields could affect the capital adequacy of insurance companies, which is a significant part of the financial system. Goh estimated that it could require "trillions" of yuan to cover the potential losses, equivalent to about $140 billion USD.

"If bond yields move lower, it will provide some breathing space to the insurance industry."

Why the bond market?

Due to limited investment options in China, insurance companies and institutional investors have turned to the bond market for investment. However, the real estate market has declined, and the stock market has struggled to regain momentum after multi-year lows.

The bond market intervention by the PBoC is more significant than Beijing's other interventions, including foreign exchange, according to Natixis' Garcia-Herrero. "The consequences could be catastrophic if they continue on this path."

"She expressed concern that the lack of alternative investment options, such as gold or sovereign bonds, would lead to a bubble in the economy of a country the size of China. The only two options available, she believed, made it impossible to avoid a financial crisis. The solution, she believed, was to open the capital account."

The PBoC did not immediately respond to a request for comment.

Beijing has long been known for its state-led economic model, which has gradually allowed for market forces to play a larger role. This has led many investors to believe that the government will intervene to prevent losses.

The cancellation of a bond settlement by a local bank has left many people stunned, indicating the government's desperation, according to abrdn's Goh.

Goh stated that he believed the PBoC should have intervened in the bond market to boost foreign investor confidence.

Beijing's yield woes

The rapid lowering of bond yields due to bond buying has caused Beijing to publicly express concerns.

In July, "Financial News," which is affiliated with the PBoC, criticized the rush to purchase Chinese government bonds as "shorting" the economy. However, the outlet later softened the headline to describe such actions as a "disturbance," according to CNBC's translation of the Chinese outlet.

According to Chang Le, the fixed-income senior strategist at ChinaAMC, the Chinese 10-year yield has typically fluctuated within a 20 basis-point range around the medium-term lending facility (MLF), one of the People's Bank of China's benchmark interest rates. However, this year, the yield fell 30 basis points below the MLF, indicating the accumulation of interest rate risk.

The lack of bond supply has been tackled by the PBoC while trying to maintain financial stability, resulting in an increase in demand for bonds due to the potential for gains.

Low yields, however, also reflect expectations of slower growth.

Goh stated that poor credit growth is likely a contributing factor to lower bond yields. He added that smaller banks would prefer to lend money to good quality borrowers if they could find them.

For the first time since 2005, new yuan loans categorized under "total social financing" decreased in July, as loan data released on Tuesday revealed.

S&P Global Ratings' managing director, Charles Chang, stated that the recent fluctuations in China's domestic bond market highlight the necessity for reforms that direct market forces towards efficient credit allocation.

Beijing's pursuit of more efficient economic growth that incurs less debt over the long term could be facilitated by reforms in the corporate bond market, according to Chang.