China’s Bond Market Faces Risks

China’s central bank has raised alarms over potential instability in the country’s bond market as the government prepares to issue a significant amount of new debt before the year’s end. This warning comes amid a surge in the prices of 10-year central government bonds, which has driven yields below 2.2%, creating concerns about a possible market reversal.

As of July, the Chinese government still had to issue approximately RMB 2.68 trillion ($376 billion) in local and special central government bonds for 2024, with a substantial portion of the planned issuance yet to be completed. The People’s Bank of China (PBoC) is concerned that this massive issuance could lead to a sharp rise in yields, potentially destabilising the financial system.

The ongoing economic slowdown in China has led to an increase in bond issuance, including special local government bonds for infrastructure projects and ultra-long-term treasury bonds aimed at stimulating the economy. However, despite the planned increase in issuance, weak economic conditions and a sluggish stock market have driven investors, particularly banks, to seek the relative safety of government bonds, pushing yields to historic lows.

Xu Zhong, deputy secretary general of the National Association of Financial Market Institutional Investors, has warned that long-term bond yields have deviated from reasonable levels, indicating the formation of a market bubble. The PBoC has expressed concerns about the risks posed by leveraged investment funds and the potential for financial instability similar to the Silicon Valley Bank collapse in the U.S. if interest rates reverse.

Analysts caution that a flattened yield curve could pressure China’s state banks’ profitability, further threatening financial stability. The PBoC is working on reforming its monetary policy tools, including setting a new benchmark policy rate and fine-tuning the rate transmission mechanism, to better manage the risks in the bond market.

However, the PBoC faces challenges in implementing yield curve control, a strategy used by other central banks to cap yields, as China’s bond market lacks the depth to support such an approach. While the PBoC aims to modernise its monetary policy, analysts note that the transition is still in its early stages and will be a gradual process.

China’s bond market remains under close scrutiny as the government moves to meet its debt issuance targets, with the potential for significant market disruptions if yields reverse sharply in response to the influx of new bonds.