Chinese lenders face a significant challenge: They are unable to lend enough.

• Government bonds have become increasingly popular among Chinese commercial banks due to Beijing's stimulus measures failing to boost consumer loan demand.
• The People's Bank of China released data showing that total new yuan loans in the 11 months through to November 2024 decreased by more than 20% to 17.1 trillion yuan ($2.33 trillion) compared to the previous year.
• Since December, Chinese sovereign bonds have experienced a significant surge in demand, resulting in yields reaching record lows this month.

Chinese commercial banks have a huge problem.

Despite Beijing's stimulus efforts, loan growth has slowed down in China, as both consumers and businesses remain pessimistic about the economy's future prospects.

So what do banks do with their cash? Buy government bonds.

Since December, Chinese sovereign bonds have experienced a significant surge in demand, resulting in 10-year yields reaching record lows this month, decreasing by approximately 34 basis points, according to LSEG data.

According to Edmund Goh, investment director of fixed income at abrdn in Singapore, weak consumer and business loan demand has caused capital to flow into the sovereign bonds market.

The largest issue onshore is the absence of assets to invest," he stated, while "there are no indications that China can break out of deflation at present.

The total new yuan loans in the 11 months through November 2024 decreased by more than 20% to 17.1 trillion yuan ($2.33 trillion) compared to the same period in the previous year, according to data from the People's Bank of China. In November, the new bank lending amounted to 580 billion yuan, which was significantly lower than the 1.09 trillion yuan lent in the same month of the previous year.

Despite the stimulus measures announced by Chinese authorities since September, the loan demand has not increased significantly, as the economy is still struggling to meet its full-year growth target of "around 5%."

The world's second-largest economy is predicted to experience slower growth of 4.5% this year, with credit demand in December expected to decrease even more from November, according to Goldman Sachs.

ING's chief economist, Lynn Song, stated that private enterprises are still hesitant to approve new investments, and households are also tightening their budgets, resulting in a continued lack of quality borrowing demand.

This year, authorities have pledged to prioritize increasing consumption and stimulating credit demand by reducing corporate financing and household borrowing costs.

This year, investors may still search for "risk-free yield sources" due to the uncertainty caused by potential tariff action from abroad, Song stated, emphasizing that "there are still some question marks regarding the strength of domestic policy support."

No better alternatives

The slowdown in loans is due to mortgages, which were previously driving credit demand, remaining in a bottoming stage, according to Andy Maynard, managing director and head of equities at China Renaissance.

Chinese investors face a challenge in finding "investable assets" for both financial and physical markets, according to him.

According to official data, China's annual inflation rate in 2024 was 0.2%, indicating that prices barely increased, while wholesale prices decreased by 2.2%.

Government bonds are becoming more popular among institutions as they expect economic fundamentals to remain weak and hopes for a strong policy push to fade, according to Zong Ke, portfolio manager at Wequant in Shanghai.

Ke stated that the current policy interventions are aimed at preventing economic collapse and mitigating the impact of external shocks, and are solely intended to prevent a freefall.

'Perfect storm'

Since June, the rate of increase in the yield on the U.S. 10-year Treasury has accelerated, and on Wednesday, it reached 4.7%, almost equaling the levels seen in April.

The widening gap between the returns on Chinese and U.S. government bonds could potentially lead to capital outflows and intensify the depreciation of the yuan relative to the dollar.

On Wednesday, the Chinese onshore yuan reached a 16-month low against the dollar, while the offshore yuan has been declining for several months since September.

Sam Radwan, founder of Enhance International, stated that the combination of lower government bond yields, a prolonged real estate crisis, and the effects of rising tariffs pose risks to foreign investors' sentiment towards onshore assets.

The widened yield differentials between Chinese government bonds and U.S. Treasuries has little impact on the performance of Chinese bonds due to the "small share of foreign funds," according to Winson Phoon, head of fixed income research at Maybank Investment Banking Group.

Silver lining

As ING's Song stated, the falling yields provide a silver lining to Beijing, which is expected to increase new bond issuance this year, resulting in lower funding costs for policymakers.

In November, Beijing announced a $1.4 trillion debt swap program to address the local government financing crisis.

Song stated that policymakers intervened whenever the 10-year yields hit 2% for much of 2024. However, the PBOC stopped intervention quietly in December.

The central bank is anticipated to reveal new monetary easing measures this year, including reducing the main interest rate and increasing the amount of cash banks must hold as reserves, according to investors. At the beginning of the year, PBOC stated that it would cut key interest rates at a suitable time.

According to the statement on Jan. 3, the bank will enhance its monetary policy toolkit, engage in buying and selling of treasury bonds, and closely monitor long-term yields.

The bond rally will continue only if there are prospects of rate cuts.

According to a note by economists at Standard Chartered Bank, the bond rally is expected to continue in 2021, but at a slower pace. They predict that the 10-year yield may drop to 1.40% by the end of 2025.

As stimulus policies begin to impact specific sectors of the economy, economists predict that credit growth will stabilize by mid-year, resulting in a slower decline in bond yields.

The People's Bank of China announced on Friday that it would temporarily suspend purchasing government bonds due to an oversupply and scarcity in the market.