By Vaibhav Tandon

As we highlighted in recent commentaries, investors have turned sour on various Chinese assets like equities, the currency, and the original wealth creator – the real estate sector.  But there is one asset class in China that is experiencing a buying frenzy. 

Chinese government bonds are in high demand.  Domestic investors are piling into the country’s government debt market, the second largest in the world.  Assets in China’s bond funds have grown 39% since the start of 2023, according to Wind.  Bond funds now account for over one-third of all Chinese fund assets, compared with 9% for stock funds.  Yields on long-term government securities have dropped sharply since the start of the year. 

The shift reflects increasing pessimism towards an economy wrestling with a property market downturn, local government debt concerns and deflation risk.  Falling rates on bank deposit accounts are another factor driving depositors’ money into this perceived safe haven asset.

Though falling yields are helpful in a struggling economy, a subsequent snapback in the bond market could trigger problems for Chinese banks. New bond issuance promises to be especially heavy in the months ahead, which could devalue the holdings of financial institutions (which are the largest holders of Chinese government bonds, by a wide margin).  This could cause a bout of financial instability.

Panicked by plummeting yields, the People’s Bank of China (PBoC) has started to intervene in markets. The central bank is employing a quantitative contraction: borrowing long-dated government bonds from banks and selling them into the market to drive down prices.  On the regulatory front, the PBoC has been even more direct: issuing warnings and fines to smaller banks, prohibiting and cancelling bond purchases and requiring additional stress tests.

The flight to quality among Chinese investors is another element of a negative psychology that will be difficult to arrest.  If the country is to avoid deflation in the prices of assets, goods, and services, Chinese policy makers will have to change the national mood…and fast.