Three months ago, something unprecedented happened to China’s economy: for the first time since 1998, China reported a current account deficit for the first half of the year.
While we expounded on the full implications previously, they could be summarized as follows: greater reliance on foreign funding, a more open capital account, a weaker CNY and deeper and less manipulated capital markets.
Of the four, the increasing reliance on outside capital was likely the most important as it implied that China’s economic well-being would be increasingly left to the generosity of foreigners, much the same way foreigners have for decades funded America’s generous way of life.
Only last month something troubling happened on China’s road to foreign reliance: global investor enthusiasm for Chinese corporate bonds collapsed. Whether due to China’s weaker currency, or the collapsing premium of Chinese over U.S. interest rates, foreign holdings of yuan-denominated, domestically traded bonds in China rose by just 250 million yuan ($35.9 million), or 0.02%, to 1.44 trillion yuan in October, according to the WSJ citing data provider Wind. As shown in the chart below, the rate of growth has been decelerating since June, when it peaked at 8.9% month on month, the fastest in 21 months.
Even more troubling, after adjusting for valuation effects, ChinaBond calculated that foreign investors actually reduced their holdings of Chinese bonds. While this reduction was modest, JPMorgan noted that it nonetheless represents the first outflow since February 2017, highlighting the risk of continued currency depreciation exacerbating the capital outflow picture.
Meanwhile, as Bank of America notes, China’s weakening economy has led Chinese bond prices to rally sharply in the past year, pushing yields down, even as rising interest rates send U.S. bonds in the other direction. That means Chinese sovereign debt now offers a much thinner premium over U.S. Treasurys. Yields on benchmark 10-year Chinese securities fell to 0.24 percentage point above Treasurys late last week, the narrowest gap since July 2010.
It’s not just the collapsing yield differential that confirms the economic slowdown and is a threat to Chinese capital inflows: in addition to the near contracting Chinese PMI, as the chart below shows the Korean KOSPI, Macau-exposed WYNN, Caterpillar and Chinese property giant China Evergrande, have all slumped this year.
So why does Chinese bond flows matters? As the WSJ explains, foreign institutions, such as central banks and pension funds, own just 1.7% of China’s overall $12 trillion bond market, the world’s third largest behind the U.S. and Japan. Still, they have already become influential players in the narrower field for central government debt, where they own 8.1% of what is a roughly $2 trillion market.
Still, a reversal in bond flows is the last thing China’s economy, whose current account surplus is now virtually non-existent, can afford. According to Peter Ru, Shanghai-based chief investment officer of China fixed income at Neuberger Berman, foreign investors slowed their purchases of Chinese bonds mostly because of the yuan’s fast depreciation: “Given the uncertainties over the trade war, nobody can be sure how much more the yuan may weaken.”
He is right: foreign investors have decided to sit on the sidelines as they await potential initiatives from Beijing, such as further monetary easing, said Jason Pang, Hong Kong-based China government bond portfolio manager at J.P. Morgan Asset Management. And yet, such easing would result in even further depreciation, making the choice whether to resume buying Chinese bonds a complex one: on one hand, one would need to hedge bond exposure (which is virtually impossible as anyone who has shorted the offshore Yuan knows the central bank’s tendency to periodically “murder” speculators), and absent that there would have to be an expectation of currency stability, something which the central bank increasingly is unable to provide; as such not even a most generous stimulus can offset the risks of rapid currency devaluation, ensuring that foreign investors will stay on the sidelines for the foreseeable future.
There is one alternative: Pang said he sees Chinese government bonds as a “trade war hedge.” Their prices have rallied as Beijing has taken measures such as loosening lending conditions to offset the impact of worsening trade frictions, he said. “If you believe that the trade war will escalate, there’s all the more reason that you should own some Chinese government bonds,” Pang added.
Of course, bond prices may simply be rallying because investors expect a sharp, disinflationary slowdown in the economy; and should China itself fall into a deflationary liquidity trap, then all bets are truly off and the last thing bond investors will want to do is allocate capital to a country which is about to have a debt crisis during deflation.
In any case, the PBOC now finds itself trapped, on one hand facing the end of China’s current account days, and on the other facing the danger that Beijing’s increasingly ad hoc response to the US trade war which includes continue yuan devaluation, will scar foreign bond investors, leaving Beijing with no source of outside capital. And since the only offset to these two developments would be a surge in domestic saving – and collapse in domestic Chinese consumption – the result for China should foreign investors indeed pull their money, would be nothing short of a recession or worse.
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