China has a bond vigilante problem

Chinese leader Xi Jinping is vying with little success to turn stock bears into bulls. But over in the bond market, China faces the opposite problem with irrational exuberance pushing long-term yields too low.

That has authorities scrambling to tighten their grip on the globe’s third-biggest government debt market. On Monday, prices tumbled as the People’s Bank of China (PBOC) intervened assertively in the market. It was the worst day in 17 months for China’s 10-year treasury futures, sending yields up 4 basis points.

The recent plunge in bond rates is putting downward pressure on the Chinese yuan at a moment when Xi favors a stable-to-firmer exchange rate. The problem for Xi and the PBOC is that bond bulls argue the rally is supported by underlying fundamentals – including slowing growth and deflationary pressures – and has room to grow.

Beijing regulators have consistently aimed to boost the proportion of direct financing. When bonds and stocks are added together, it amounted to just 31% of total social financing last year, with the rest dominated by bank loans.

In the US, by comparison, the figure is more than 70%. Xi’s Communist Party plans to sell more long-dated sovereign bonds to finance plans to hasten growth in China’s US$17 trillion economy.

Yet in recent weeks, PBOC Governor Pan Gongsheng warned of bubble troubles as walls of capital flowed from shaky stocks and plunging property into bonds.

In July, outflows from Chinese equities “are mainly explained by the lingering challenges that investors see in the Chinese economy,” said Jonathan Fortun, an analyst at the Institute of International Economics.

It hardly helps that Asia’s biggest economy is seeing powerful outflows of foreign investment at home. China’s