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- Government debt apart: Why low Chinese bond yields are dangerous for the United States
Government debt apart: Why low Chinese bond yields are dangerous for the United States
The gap between the base cost of government debt in the United States and China has reached record levels. The yield spread on 10-year bonds reached almost 3.3 percentage points by mid-September and continues to increase. China's securities with the appropriate maturity yield 1.68%, reflecting the chronic shortage of demand for loans and deflationary pressures within the country. At the same time, the yield on similar U.S. Treasury bonds reached 4.97%, updating the maximum over the past three years. The situation where Chinese debt is more expensive than American debt is familiar, but now it threatens to exacerbate the already extremely dangerous imbalances in the global economy. Details are in the "Izvestia" material.
The Japanization of China
The decline in Chinese bond yields is not accidental. Beijing is struggling with the effects of a protracted crisis in the real estate market and a decline in domestic consumption. The People's Bank of China is forced to keep rates at minimum levels to maintain liquidity. Analysts note that the Chinese bond market is currently the most profitable among the major global benchmarks, but the reasons for this success do not always evoke positive emotions. The rapid rally in local debt securities prices is due to deep disinflation and a general slowdown in China's economic growth.
The current situation is shaping a phenomenon that analysts call the "Japanization" of Chinese capital. Since the 1990s, Japan, faced with a similar collapse of the real estate bubble and zero interest rates, has become a major global lender. The cheap yen was used to fund purchases of high-yielding assets around the world, primarily in the United States.
Today, China is assuming this role. Low yields within the country have triggered a boom in borrowing in offshore yuan. Multinational corporations and foreign governments actively use low rates to raise funds cheaply. For official Beijing, this process has obvious benefits: the growth of foreign borrowing in yuan contributes to the slow but systematic internationalization of the Chinese currency, reducing its dependence on the dollar infrastructure.
The downside of the cheap yuan is the uncontrolled outflow of capital. The difference of 3.3 percentage points creates ideal conditions for a carry trade: it is beneficial for investors to borrow in China and transfer funds to American assets. A further increase in the interest rate gap may increase the withdrawal of funds from China. This will not be the most pleasant news for the Chinese financial system, which has relied on strict restrictions on the movement of capital for decades.
The Chinese authorities are already taking emergency administrative measures to stop the problem. This year, the collection of taxes on foreign capital gains has been stepped up, and control over Hong Kong brokers and insurance companies, through which residents of mainland China have traditionally withdrawn their savings, has been tightened. In August, the government tried to put the process on a legal track by increasing the quota for domestic institutional investors to invest abroad by $6.8 billion.
Escape to high yields
However, the official quota figures are not comparable to the actual scale of capital flight. Analysts at Bank of America Global Research estimated the net outflow from China's financial account last year at almost $800 billion. Beijing's policy, they say, is to try to block the exodus of hundreds of billions by opening the front gates to make sure transactions go through controlled channels.
Capital flight and the subsequent weakening of the yuan exchange rate form another interesting effect. A cheap national currency automatically reduces the export value of Chinese goods on the world market. This mechanism acts as a fairly effective shock absorber, neutralizing the protective duties imposed by the US administration. In other words, protectionism is nullified by exchange rate disparity: the outflow of capital from China provides additional competitiveness growth to Chinese industry, guaranteeing the continuation of export expansion.
The United States, in turn, continues to increase its dependence on external financing. The yield of 4.97% on ten-year securities is the result of two factors: inflationary pressure (including due to high energy prices) and expectations of tough action from the Fed. However, the main reason for the increase in yields lies in the non-stop issuance of new debt to cover the budget deficit. At the moment, the latter accounts for 6.5% of GDP, and the total debt is 126%. Both are a lot by any world standard.
The debt party is in full swing
The US continues its "debt party," consuming more and more liquidity to service its obligations. An episode was significant when Treasury bond yields jumped sharply after Treasury Secretary Scott Bessent's plan to repurchase $6 billion worth of government securities frankly disappointed investors with its modest scale.
At the same time, there is a high probability that even a yield of 5% may not be enough to attract the necessary amount of capital to the US bond market. Investor Stanley Druckenmiller, a mentor of Bessent and new Fed chairman Kevin Warsh, recently said that rates are still low and could rise even more. The entire Wall Street is alarmed by the debt spiral, the parameters of which are getting out of control. This is especially true for long-term securities.
The budget deficits of Western (and not only) countries are too high. At the same time, there is no political will to reduce them by raising taxes or cutting spending. Concern about the sustainability of government debt in Western countries is becoming a determining factor in bond market pricing. It is characteristic that the current decline in the value of American and European securities, almost synchronously, is not accompanied by a similar decline in bonds of developing countries. This is a fundamental difference from the crises of the past, in which the whole world "got sick when Americans sneezed."
One way or another, global economic imbalances are intensifying. Americans are forced to keep rates high in order to siphon liquidity from the rest of the world (including Asia) to finance their budget deficits. And China maintains low rates to save the domestic market, paying for this with capital outflows and receiving in return a weak currency to support exports. Both models are currently experiencing serious difficulties. A further expansion of the yield spread could trigger a liquidity crisis, the way out of which would require a radical revision of fiscal and monetary policy in both Washington and Beijing.
If the former have to squeeze costs, which will almost certainly lead to an economic downturn, a stock market collapse, and a serious decline in living standards (possibly a full-fledged depression), then the latter need to find a way to rock the domestic market. The first means political suicide. The second is a problem that cannot be solved by current methods, as the 30—year experience of Japan since the 1990s clearly shows.
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