China’s Bond Warning
The strong dollar will test China’s financial markets and economy.
Beijing is learning about bond vigilantes. Last Thursday, after the U.S. Federal Reserve raised interest rates and projected more rises next year, China’s bond market fell out of bed. Investors are realizing that despite the government’s best efforts to prepare and isolate the domestic economy, China remains vulnerable to a stronger dollar.
Bond trading had to be suspended briefly on Thursday until the People’s Bank of China injected about $22 billion into the money markets to calm nerves. The PBOC also extended emergency loans to financial firms to encourage them to keep trading, a positive sign that the authorities have learned from their mistake of suspending stock trading after the June 2015 stock-market crash. But corporate-bond yields continue to rise and new issuances have been cancelled.
Government interference had pushed China’s bond market into bubble territory over the past two years. Beijing encouraged companies to issue bonds to reduce their reliance on bank lending, while prodding others to buy them. The authorities also rescued troubled companies to prevent them from defaulting, which has led to a fundamental mispricing of risk that will make the correction all the more painful.
As always, the bursting of a bubble reveals who was swimming naked. Last week, brokerage Sealand Securities defaulted on a bond-financing transaction allegedly made by a rogue employee. Rumors are also circulating that investors are pulling their money out of funds holding bonds. Firms that used high leverage to deliver promised returns now face margin calls.
The larger question is whether China’s real economy is itself a bubble. According to official figures, bank lending and social financing are growing at roughly double the rate of GDP. Total debt now stands at 260% of gross domestic product, up from 154% in 2008. That doesn’t count the trillions of dollars in loans that banks have classified as “investment receivables” and other such dodges.
China’s central bank tried this year to tighten credit, but its power is limited. The People’s Bank of China shares oversight with the China Banking Regulatory Commission and China Securities Regulatory Commission, an arrangement that allows financial institutions to move assets around to deceive regulators. Powerful interests within the government also want to keep the money spigots open to hit growth targets.
But questions about the durability of that growth are increasing. Easy money has eroded productivity. Companies evade capital controls and move their money abroad into dollars.
Beijing’s foreign-currency reserves, while still massive, shrink month by month. Keeping the yuan from devaluing too quickly will require raising domestic interest rates, which will hurt growth and cause some companies to fail.
Even though the Chinese bond market doesn’t price risk accurately, it still reflects interest-rate expectations. Last week’s mini-tantrum suggests investors understand that China’s central bank won’t be able to keep rates low if the Fed carries through on its promised tightening. A stronger dollar is set to test China’s financial institutions and its real economy.