China’s Bond Bubble

A boom in fixed-income debt risks repeating the stock-market debacle.
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A pedestrian walks past the People's Bank of China (PBOC) headquarters in Beijing on Jan. 18.  
A pedestrian walks past the People's Bank of China (PBOC) headquarters in Beijing on Jan. 18. Photo: Bloomberg News
 

The boom and boost in Chinese stocks taught Beijing a valuable lesson about the dangers of government trying to take the risk out of capital markets. And if you believe that, we have a bond to sell you.

China’s bond market is booming, and while the absence of small investors makes this less politically dangerous than last year’s stock bubble, the economic implications are equally worrying. As with stocks, Beijing’s goal of building a mature capital market to finance growth is worthy. But it has reversed the proper order by pushing rapid growth before structural reforms.

Last year Beijing began to ease restrictions on the issuance and purchase of corporate bonds and gave the municipal-debt market a boost with new issues to bail out local governments. So when stocks crashed in June, many institutional investors shifted into supposedly safer fixed-income securities.

Corporate-bond issues last year totaled 2.94 trillion yuan ($450.6 billion), a 21% increase on 2014.

Yet demand was so strong that, even as the supply increased, yields fell to five-year lows. The spread between corporate- and sovereign-bond yields shrank to the lowest level since 2007.

That is strange considering the economy is slowing and Chinese companies are adding debt even as their profits fall. Corporate debt hit 134% of GDP in 2014, up from 90% in 2007, according to J.P. Morgan. JPM -4.18 % In the U.S. it is 70%. Ratings agencies downgraded a record number of Chinese companies last year and banks have become more cautious in lending.

So are bond investors irrationally exuberant? Not if one considers that China’s corporate debt appears to be risk-free. With a few minor exceptions, whenever companies are unable to pay bondholders, government entities engineer a bailout. Meanwhile, regulators have given indications that they regard the bond-market boom as a benign way to stimulate the economy with fresh credit without stressing banks’ stretched balance sheets.

Chinese officials periodically suggest that they will allow defaults to happen, but they’ve always backed down for fear of market instability. As the bond market grows and yields fall, the costs of a major default grow.

Highly leveraged property-development companies figure prominently among the issuers of bonds in recent months, even though they are sitting on high levels of inventory after a real-estate bubble in third-tier cities burst. And in another sign of a frothy market, some investors are using bonds as collateral to borrow money to buy more bonds. As happened with stocks, a market correction could amplify if margin calls force investors to sell.

China’s bond market has expanded to $7 trillion, the world’s third largest, from practically nothing in the space of a decade. And growth is accelerating, with January’s corporate bond issues up 150% year on year. That level of manic activity may be less visible than a stock bubble, but it should also ring alarm bells.

It’s worth remembering that China’s bond market remains a small part of the economy, since banks continue to provide about 60% of the country’s credit. That means a correction probably wouldn’t pose a systemic risk. But as with last year’s stock disaster, it would be a major setback for reform.

The longer Beijing continues to prevent defaults, the more distorted the market becomes. The loss of about $4 trillion in stock market capitalization in the past eight months should have taught China’s leaders the cost of creating bubbles.

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