China Bear Market Looms as PBOC Fails to Stop Flight to Safety

  • Shanghai Composite breaches lows during summer crash
  • Offshore yuan, Hong Kong dollar drop as government bonds gain

Making Sense of the Chinese Markets

Chinese stocks headed for a bear market while government bond yields fell to a record as central bank cash injections and a stable yuan fixing failed to shore up confidence in the world’s second-largest economy.

QuickTake China’s Managed Markets

The Shanghai Composite Index sank as much as 2.8 percent, falling more than 20 percent from its December high and sinking below its closing low during the depths of a $5 trillion rout in August. Investors poured money into government bonds after the People’s Bank of China added the most cash through open-market operations since February 2015, sending the yield on 10-year notes down to 2.7 percent. While the central bank kept its yuan reference rate little changed for a fifth day, the currency dropped 0.5 percent in offshore trading and Hong Kong’s dollar declined to the weakest since March 2015.

The selloff is a setback for Chinese authorities, who have been intervening to support both stocks and the yuan after the worst start to a year for mainland markets in at least two decades. As policy makers in Beijing fight to prevent a vicious cycle of capital outflows and a weakening currency, the resulting financial-market volatility has undermined confidence in their ability to manage the deepest economic slowdown since 1990.

"You can’t really find buyers in this environment,” said Ken Peng, a strategist at Citigroup Inc. in Hong Kong. “It’s a very, very fragile status quo China is trying to maintain.”

The government faces a dilemma with the yuan, according to Samuel Chan, a trader at GF International Investment Management Ltd. On one hand, a weakening exchange rate would help boost exports and is arguably justified given declines in other emerging-market currencies against the dollar in recent months. The downside is that a depreciating yuan encourages capital outflows and makes it harder to keep domestic interest rates low.

The monetary authority “doesn’t want the yuan to depreciate fast because it will push funds to leave China very quickly,” Chan said. The country saw capital outflows for 10 straight months through November, totaling $843 billion, according to an estimate from Bloomberg Intelligence. Foreign-exchange reserves, meanwhile, sank by a record $513 billion last year to $3.33 trillion, according to the central bank.

Yuan Intervention

Policy makers have had some recent success in supporting the yuan after the currency’s new year tumble rattled global markets. The PBOC has focused its efforts on the offshore Hong Kong market, soaking up the supply of yuan and pushing interbank borrowing rates for the currency to record highs earlier this week in an effort to deter bearish speculators.

The turbulence in Chinese markets is seeping into Hong Kong in other ways, too. The city’s benchmark Hang Seng Index dropped 1.6 percent on Thursday to the lowest level since September 2012, while the normally stable Hong Kong dollar is heading for its biggest decline since September 2011. The city’s economy also faces a weakening real-estate market and the prospect of capital outflows fueled by rising U.S. interest rates.

"With the Hong Kong stock market declining and heightened worries over China’s economy and markets, I see further weakening of the Hong Kong dollar," said Ken Cheung, a Hong Kong-based strategist at Mizuho Bank Ltd.

Stock Slump

China’s domestic stock market has become one of the most visible symbols of the government’s struggle to win back investor confidence. After cheerleading by state media helped fuel an unprecedented boom in mainland shares last summer, the market crashed as regulators failed to manage a surge in leveraged bets by individual investors. While a state-sponsored market rescue campaign sparked a 25 percent rally in the Shanghai Composite, those gains were wiped out on Thursday as the index headed for the lowest close since December 2014.

The Shanghai Composite dropped 1.1 percent to 2,917.52 at the midday break as telecom and industrial shares led declines. The yield on debt due October 2025 fell as much as three basis points to 2.70 percent, the least for a benchmark 10-year note in ChinaBond data going back to September 2007, before rising to 2.74 percent at 12:22 p.m. local time.

“Equities are not performing well, so bonds become the natural investment target, given their safety,” said Li Liuyang, the chief financial market analyst at Bank of Tokyo-Mitsubishi UFJ (China) Ltd. in Shanghai.

The yuan weakened to 6.6092 per dollar in Hong Kong’s offshore market, while the onshore rate fell 0.2 percent to 6.5893. Hong Kong’s dollar, which is kept in a range from HK$7.75 to HK$7.85 versus the U.S. currency, depreciated as much as 0.18 percent to HK$7.7738. Bets are mounting in the options market that the currency’s 32-year-old peg to the greenback will end, with one-year implied volatility almost doubling this year to 3.31 percent.

Money Rates

The overnight cost of borrowing yuan in Hong Kong declined 4.7 percentage points to 3.61 percent on Thursday, extending its decline from an an all-time high of 66.82 percent on Tuesday. Onshore money markets were stable, with the one-day repo rate little changed at 1.93 percent in Shanghai.

China’s central bank conducted 160 billion yuan ($24 billion) of seven-day reverse-repurchase agreements in its open-market operations on Thursday, up from 70 billion yuan a week ago. Traders are on alert for more official support, according to Melody He, the Hong Kong-based head of capital markets at CSOP Asset Management Ltd.

“The market is on watch for further policy changes,” she said. “Meanwhile, the current confusion on market direction and lack of positive sentiment could continue.”

The government will probably report fourth-quarter economic growth of 6.9 percent on Jan. 19, according to the median of economist estimates in a Bloomberg survey. They project that the final 2015 report will bring the full-year expansion to 6.9 percent, the slowest annual pace since 1990, and that gross domestic product growth will further slow to 6.5 percent this year.

— With assistance by Justina Lee, and Shidong Zhang

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