China's Bond Markets Aren't A One-Way Bet Anymore

| About: iShares China (FXI)

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By Stuart Burns

Many economists and market observers have been warning for some time that with cheap cash sloshing through the Chinese economy, and attractive investments in the real economy remaining scarce, investors had plowed too much money into the country's bond market.

The Financial Times reports China's 10-year government bond yield fell from 4.6% in January 2014 to 2.65% by late October. Banks borrow overnight and buy longer-dated bonds in what appears a clear carry trade, but to work, the market requires stable and low market rates.

With the People's Bank of China (PBoC) trying to raise short-term rates and ease long-term rates, it has been trying to squeeze speculators out of the market, while maintaining liquidity for long-term industry and commercial borrowers. However, like all bonds worldwide, China's are under pressure from the U.S. Federal Reserve's plans for faster interest rate increases next year.

The Wall Street Journal suggests the country may guide its own rates higher to prevent the currency from weakening faster against the dollar, a trend that would further squeeze Chinese borrowers in need of cheap finance. China's total debt surged to around $27 trillion this year, or 260% of gross domestic product, compared with 154% in 2008 at the start of a stimulus program to offset the nation's financial crisis. It is continuing to grow at more than twice the pace of economic growth, with a considerable sum of new investment going into unproductive areas like shoring up bankrupt companies or adding further unproductive production capacity.

Bad Debts? Fueling More Debt?

As much as 15% of the value of bank loans to Chinese companies may go unpaid, the WSJ reports, citing researchers at the International Monetary Fund. Even riskier, the newspaper suggests is an estimated $8.5 trillion in off-balance sheet "shadow" finance issued by a matrix of banks and lightly regulated institutions.

It is unclear how much of China's bond market is owned outright and how much was bought with money borrowed under China's shadow finance market, raising risks. Analysts' estimate of the level of leverage in the system overall is wide, simply because no one knows. Estimates say it could be between 1.2 and 5 times the value of the assets, still a relatively low figure, although in pockets of the market it can go much higher, and therefore leaves open the possibility of failures in certain industries or areas of market activity.

One of the biggest signs of domestic confidence in the system and the currency is outflows of capital this year. China's currency has fallen to its lowest level against the U.S. dollar since 2008 as more Chinese move their wealth out of the country despite strict capital controls. As the exchange rate falls overseas, dollar-denominated borrowings become harder to service if the Fed rises push up the dollar next year. Nationally, the PBoC has the firepower to handle this, but individual companies may not have such reserves. All in all, China's bond market is likely in for a rocky ride next year, giving Beijing yet more things to focus on in an increasingly uncertain global economic and political landscape.

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