Chinese investors are pouring money into government bonds. They have bid up prices that, in the way of bond math, have brought yields down to near-record lows. The move has upset People’s Bank of China (PBOC) authorities, who have expressed considerable concern over what will happen to China’s financial stability when the rally reverses and people, especially banks, suffer losses.
Behind the anxieties expressed by the PBOC, however, is a much bigger and more fundamental concern about what such low bond yields say about China’s economic prospects.
The decline in Chinese government bond yields began in earnest a year ago this past January. At the start of 2023, the 10-year government bond yielded just about 3 percent. Buying pushed yields down gradually to 2.7 percent by October 2023. After that, the move gained momentum, driving yields down to 2.4 percent by February and then to 2 percent, where things were of this writing.
Investment monies from just about every quarter of the economy have contributed to this rally. Chinese bond funds have grown some 39 percent from the beginning of 2023 to mid-August, according to the most recent data available. Bond investing now accounts for some 35 percent of all Chinese fund assets, compared with less than 10 percent for equities investments. Commercial banks have about doubled their holdings of government bonds since 2022.
Analysts at the PBOC have kept their remarks largely technical in nature. Saying that yields have deviated “significantly from reasonable core levels” (without explaining what such a statement could mean), they worry that when the rally runs its course and reverses, investors will suffer losses and that many will go into bankruptcy, creating a cascade of losses and financial turmoil. Reasonably, they worry especially about the fate of depositors should banks go this route. These are not unreasonable concerns.
The bank’s solution is to issue more government debt and, it hopes, sate the demands before they push yields down too much further. It is not apparent that such a strategy will work or can avoid unintended consequences, for such heavy debt issuance can do as much damage to financial stability as the aspects of the situation in the front of the PBOC’s mind today.
The PBOC has failed to mention it, but there clearly is a more worrisome and more fundamental problem implicit in this bond rally. By flooding out of other investments—equities and real business ventures—to buy government bonds, Chinese investors, individuals, businesses, and banks are announcing that nothing else in the Chinese economy is attractive.
This heavy bond buying and the remarkable fall in yields announce, in other words, that neither the Chinese householder nor the Chinese businessperson expects to get good returns from real economic activity. It is a prescription for slow-to-no economic growth. Indeed, while the dark future envisioned by Chinese householders and businesspeople impels them to avoid real economic activity in favor of bonds, they set the stage for a self-fulfilling prophecy, for those same dour expectations are stalling spending and slowing growth in much of the economy.
In many ways, the picture relates to a core principle of economic theory. It holds that bond yields generally, if not on any specific sort of bond, mirror prospects for returns in the real economy. When these prospects are good, people happily use their own capital and borrow to take advantage of them. Their neglect of bonds raises yields to reflect those expectations of high real economic returns. When people have low expectations, the causality occurs in reverse, and that is what China is experiencing.
The PBOC is quite right to have the concerns that it does, but the issues are also more fundamental than the analysts there either realize or care to admit. Rather than just issue more debt, with all the risks such practices entail, the bank would do better to use all the tools at its disposal to stimulate the Chinese economy, something that strangely it seems reluctant to do, since it just recently decided to make only the smallest effort to do so.
