China Bond Bears Better Brace for Disappointment
China’s bond market underwent a notable correction in October, with yields on 10-year government bonds rising as high as 3.93 percent from 3.62 percent in late September. Nonetheless, it's too early to get too bearish.
Unlike previous bond selloffs, the latest one doesn’t appear to be driven by concerns about domestic interbank liquidity as Monday's big move lower happened even though the People's Bank of China injected a net 40 billion yuan ($6.03 billion) into the financial system via reverse repurchase agreements. That followed net injections of 90 billion yuan Friday and 20 billion yuan Thursday. Instead, the weakness was likely driven by the drop in U.S. Treasuries and a halt in the PBOC’s cash injection during the twice-a-decade National Congress of the Communist Party.
Those two key factors are both likely to ultimately be positive developments for China.
First, a key message from the party congress was China’s commitment to higher quality economic growth. On Monday, the official Xinhua News Agency wrote an article explaining why 6 percent growth is achievable for China's economy beyond 2020, citing Chi Fulin, the head of the China Institute for Reform and Development. Chi said that level of growth is achievable “thanks to improvement in industrial structure, upgrading of consumer spending and progress of urbanization."
Chi noted that the value of the country's service sector will increase to about 50 trillion yuan from the 38.4 trillion yuan recorded in 2016. Retail sales of consumer goods will also expand, to about 50 trillion yuan from 33 trillion yuan last year. The integrated development of urban and rural areas is expected to generate investment and consumption of almost 100 trillion yuan. Faster and more sustainable growth is likely to lead to higher yields on longer-maturity bonds.
Second, the government is committed to deleveraging. Increased regulatory scrutiny is certainly a risk, and this has risen since Guo Shuqing took over the China Banking Regulatory Commission in March. However, the government is acutely aware of the potential impacts of regulatory crackdowns on liquidity conditions, particularly for smaller banks and the asset markets. As a result, policy makers will have to balance the goal of developing a more robust regulatory framework with that of maintaining financial stability. This is a considerable task, but as I pointed out in a previous Bloomberg Prophets commentary, new policy tools introduced over the past 18 months give the PBOC more flexibility in controlling liquidity.
Expect the PBOC to continue to increase the amount of liquidity in the market in the near term, via reverse repos. Also, cuts in the reserve-ratio requirement announced last month will take effect in January, which will add 800 billion yuan into the banking system. Indeed, focusing on deleveraging and a more robust financial regulatory framework is vital for China to avoid a “Minsky Moment” as flagged by China central bank governor Zhou Xiaochuan during the party congress.
Finally, there are ample amounts of domestic and overseas capital that could find its way into China's bonds. The recent launch of the Hong Kong-China bond connect program will slowly add additional capital into the domestic market. At the end of the third quarter, the amount of bonds that have been bought through bond connect stood at 65.4 billion yuan. While that's still small, it will become more significant over time, especially if China gets included in the three major bond indexes next year.
There's little doubt that the evolving regulatory landscape could put further pressure on the bond market in the near term, but there's no reason to start panicking. The PBOC has successfully kept previous bond selloffs from developing into systematic risks, and there remains ample domestic and foreign capital on the sidelines.
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