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Is the rout on Chinese government bonds finally easing? This week’s Chart Room looks at how a steep 7-month back-up in CGB yields has recently paused for breath near a key resistance level. And there are more potent fundamental reasons for a limit to how far yields can continue rising from here.
The outlook has broad implications - not just for investors in China’s government bonds but for corporate funding. Onshore credit markets have been rattled by a recent spate of defaults among corporate bond issuers, notably state-owned enterprises. This means companies have been hit by a double whammy to funding costs when both government bond yields and corporate credit spreads rise.
Attention to detail
At first look, the response from policymakers to carry on normalizing might appear contrarian, but the move is gradual and the context and nuances are important. Despite a robust V-shaped recovery in China’s economic activity, disinflationary pressures remain. Headline consumer price inflation fell year-on-year in November for the first time since October 2009 as pork prices dropped following a supply recovery from last year’s swine flu epidemic. Perhaps more importantly, Core CPI, which excludes the impact of food and energy costs, has edged lower this year and remains only slightly positive, while PPI is recovering slower-than-expected and remains in deflationary territory.
Slowly, steady policy
By pursuing policy normalization, the People’s Bank of China is looking beyond these persistent disinflationary pressures and beginning to slow the flow of credit to the economy. The year-on-year growth of Total Social Financing, the broadest measure of credit growth, fell in November for the first time this year (albeit still better than consensus estimates). We think the PBOC’s policy is based on some important nuances in the outlook for inflation. Leading economic indicators point to a continued strong recovery in GDP growth, property prices are also appreciating at a healthy rate, and PPI is being held back mainly by subdued oil prices that will likely rise once a Covid-19 vaccine is widely rolled out.
Nevertheless, if history is a useful guide, we can expect the PBOC to take a cautious approach to normalizing monetary policy. Back in 2016, the central bank used gentle open-market operations to soak up excess liquidity while PPI was recovering from an earlier prolonged bout of deflation, and as a result it didn’t hike policy interest rates until 2017 when PPI was positive and core CPI was also trending up.
In this context, Chinese government bonds look appealing. The benchmark 10-year government bond yield is back to its pre-pandemic level at around 3.2 per cent. This is an attractive nominal and real yield compared to the other major government bond markets, and the asset class continues to benefit from international investor inflows - even as yields have been rising.