ROI-China escapes global bond rout, but for the wrong reasons: McGeever

Sovereign bonds are getting slammed globally, as worries ​over rising prices, policy credibility, and unsustainable debts push government borrowing costs in many major economies to multi-decade ​and even record highs. But there's one notable exception: China. The yield on the ‌benchmark ​10-year Chinese government bond (CGB) has fallen below 1.7%, more than 300 basis points lower than the yield on the 10-year U.S. Treasury note . That's the widest gap between the two since January last year, and if current trends continue, it will be the largest on record very soon.

It's remarkable to think that for more than ‌a decade, from 2010 to 2022, CGB yields were higher than Treasury yields. Inflation is playing a big role here. While the rest of the world is scrambling to tamp down persistently elevated price pressures, China is continuing its multi-year fight against deflation. The property crash that began in 2021, the biggest in history, is still weighing on consumption, economic activity, and consumer price inflation.

But there are tentative signs that a corner is being turned. Annual producer price inflation, which had been negative for almost ‌four years, burst into positive territory earlier this year, topping 4% in June. China's GDP deflator also turned positive in the second quarter after being negative for four years. So shouldn't bond yields in China be trending higher, ‌if not as steeply as G7 yields, but at least rising?

FISCAL MIRAGE Some may point to the country's fiscal foundations, which appear more robust on the surface than those of many peers. China's official government debt-to-GDP ratio this year is projected to be 75%. That's substantially lower than the debt loads of all G7 countries except Germany's.

However, there is a fair degree of opacity surrounding the country’s debt levels, with the lines between central, state and local governments often blurred. The International Monetary Fund's "augmented debt" measure for China, which includes other borrowings like those through local government financing vehicles, paints ⁠a much ​less rosy picture. This debt load is expected to hit 136% ⁠of GDP this year and rise above 150% by the end of the decade.

That's closer to U.S. and Italian levels of indebtedness, which the current “bond vigilante” narrative suggests are unsustainable. "If one were looking only at the fiscal profile, China's bond yields should be higher than the West's, not ⁠lower," analysts at Barclays note. "A deteriorating balance sheet, a collapsing property market that has gutted local government revenue, and off-balance-sheet liabilities – this is not the profile of a 1.70% borrower. Yet here we are."

TRAPPED So what explains China’s low yields?

The answer mostly comes down to ​China's unique domestic dynamics: a huge pool of domestic savings, capital controls that make it difficult for those savings to leave the country, and a lack of safe alternatives to sovereign bonds. China's gross domestic savings rate ⁠is 43% of GDP, more than twice the U.S. equivalent. This savings glut has to go somewhere, and Beijing’s capital controls keep most of it in the country. There are also few safe alternatives to sovereign bonds. Property is no longer the go-to option, and equities remain too volatile for many ⁠investors ​still scarred by losses suffered in the housing crash. The blue-chip CSI 300 Index is still down 20% from its 2021 peak. Many Chinese households continue to buy bonds, even if they offer paltry returns.

That means there should be plenty of demand for Chinese bonds moving forward, even if Beijing decides to increase issuance to boost growth. Analysts at HSBC expect the 10-year CGB yield to fall as low as 1.50% later this year as a result. But the ⁠savings glut also speaks to China’s deflationary struggles. Chinese consumers simply aren't spending, and if the country ever wants to switch from a capital-intensive growth model to a consumption-driven one, this will need to change.

While investors may ⁠be rightly nervous about rising developed-market bond yields, that doesn’t mean ⁠China's sinking yields should be seen as a sign of fiscal or economic health. They're more a reflection of trapped money with nowhere else to go. (The opinions expressed here are those of Jamie McGeever, a columnist for Reuters)

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(By Jamie McGeever; Editing by Marguerita Choy)