BREAKINGVIEWS-Bond bulls put Beijing on the horns of a dilemma

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

By Chan Ka Sing

HONG KONG, Jan 28 (Reuters Breakingviews) - Robust demand for China’s government bonds is helping Beijing to raise funds inexpensively to support growth in its fragile economy. Yet a relentless plunge in yields is creating entrenched expectations the People’s Republic is becoming a low-interest-rate country and is undermining President Xi Jinping’s desire for a strong yuan.

Last year was pivotal for China’s sovereign debt market. The Ministry of Finance completed the sale of 1 trillion yuan ($138 billion) in ultra-long-term special sovereign bonds and pledged further issuances to spend its way out of a consumer confidence crisis. The bill for achieving that goal could surge if U.S. President Donald Trump slaps higher tariffs on Chinese exports.

Yet despite the large increase in supply, an extraordinary bull run has ensued and defied all expectations. Prices surged and the yields for China’s benchmark 10-year bonds ended the year nearly 100 basis points lighter at around 1.65%, a historic low.

At first glance, this looks like a win-win situation: Chinese investors get a low-risk place to park their money at a time when domestic stocks and property prices are sagging, while Beijing minimises the financial burden of a higher fiscal deficit, which could climb to a record 4% of GDP this year, Reuters reported in December, citing sources.

Keeping a lid on the interest bill will be important. The central government budgeted nearly 800 billion yuan, roughly $109 billion, to service repayments in 2024, a 12% increase year-on-year. Personal taxes contribute about 1.45 trillion yuan in income.

The problem is China’s yield curve is flattening quickly, and its long-dated 30-year sovereign bonds now yield less than their equivalent in Japan, where the central bank went on a massive bond-buying spree to combat deflation and “lost decades” of economic stagnation.

Such comparisons are not welcomed in Beijing, but China’s consumer price index has been hovering around negative territory since early 2023. Another unwelcome development is the arrival of speculators alongside banks that dominate purchases; trading volumes, per bond market regulator NAFMII, surged 45% year-on-year in 2024.

Indeed, the People’s Bank of China spent the first half of last year trying to tame the bond bulls. In July when yields of the 10-year tenor threatened to drop below 2% for the first time, it even threatened to short-sell its own treasuries.

However, the PBOC did little to follow through on this threat. Instead, the central bank started aggressively mopping up government bonds in the secondary market, appearing to prize the need for stimulus above other concerns.

The central bank’s net purchases amounted to 1 trillion yuan from August through December and its bond holdings increased for the first time since 2008 as a result. The buying spree only stopped in January when the yuan continued to weaken amid a brutal selloff in global markets.

For now, the PBOC’s holdings amount to less than 10% of the outstanding sovereign debt market compared to around 50% for the Bank of Japan. Yet China’s net purchase of government bonds could top 3 trillion yuan this year, economists at Bank of America estimate.

This strikes at China’s dilemma. It wants cheap funding but last month the regulator also said it does not want the market to develop “one-sided expectations” that could become “self-fulfilling”. It may already be too late, judging by nosediving bond yields which imply further monetary easing.

Two-thirds of investors surveyed by Goldman Sachs think the yield on the 10-year bond will be below 1.6% at end-2025, in line with the bank’s view that rates in China may remain low for longer. Economists at CITIC Securities, meanwhile, reckon the bond rush is factoring in another 40 basis point cut to the one-year lending rate which currently stands at 3.1%.

This is all bad news for Xi’s desired strong currency. A record gap of 300 basis points between Chinese and U.S. 10-year bond yields has pushed the yuan to a 15-month low against the dollar. Here is where it gets complicated: Beijing’s ongoing tightening of its capital controls ought to help it to limit outflows and prevent a drain on its $3.2 trillion foreign exchange reserves like the one it experienced in 2015 and 2016, but these controls are not watertight.

One way China is relieving some pressure is by speeding up approvals for mainland companies to list in Hong Kong. That will allow those with international growth ambitions, like battery maker Contemporary Amperex Technology 300750.SZ, to raise hard currency instead of trying to convert yuan. What’s more, China may also be weakening its currency to give Washington a taste of how it will offset the impact of higher tariffs.

However, the most effective way for China to deal with these problems holistically is to spend its way out of its economic slump. That is why yields probably need to fall before they rise again, and why Beijing’s balancing act will get harder.

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(Editing by Una Galani and Oliver Taslic)

((For previous columns by the author, Reuters customers can click on CHAN/ KaSing.Chan@thomsonreuters.com))