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China bonds the latest bubble to pop

Unauthorized trading aggravates confusion

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Chinese 100 yuan banknotes are seen in a counting machine while a clerk counts them at a branch of a commercial bank in Beijing.   © Reuters

HONG KONG -- The sharp sell-off in Shanghai stocks in the summer of 2015 is still fresh in memory, but it appears another bubble has burst in China's financial markets. This time it is the bond market's turn to pop.

After three consecutive years on the up, Chinese government bonds have taken a sudden plunge. A recent U.S. rate hike and other external factors had their hand in the fall, but it was also precipitated by an unauthorized-trading scandal involving former employees of a local medium-sized securities company. And there may be another shock in store, depending on how the industry watchdog reacts in accordance with China's "anti-bubble" measures.

The drop was triggered on Dec. 15 when Sealand Securities, headquartered in the Guangxi Zhuang Autonomous Region in the south of the country, released a statement acknowledging the incident through the Shenzhen Stock Exchange.

The statement said the company was prompted by news reports to conduct an internal investigation and found that two former employees had made the unauthorized transactions.

Local media also reported one of the two Sealand officials had absconded.

The former officials, who were with Sealand's bond division, had forged a company stamp and used it to repeatedly conduct unauthorized bond trades with other financial institutions.

After November's U.S. presidential election, bonds in the custody of a trading counterpart suffered losses as bond prices fell on expectations of an imminent U.S. rate hike and a recovery of Chinese growth.

According to local media reports, over 20 banks and brokerages were involved in the transactions, whose volume was estimated at between 10 billion yuan and 20 billion yuan ($1.44 billion to $2.88 billion). The losses were thought to total nearly 1 billion yuan.

Sealand suspended its shares from trading on the day it released the statement. The company also revealed plans to file a criminal complaint against the perpetrators. But when it held a meeting with officials from the companies involved, Sealand officials were also reported to have blasted the participants for not checking the authenticity of the stamp carefully enough.

Unrecovered losses could affect other parts of the financial system and institutions may sell off bond holdings -- such fears gripped the market, leading investors to dump Chinese government bonds. On Dec. 16, the yield on the 10-year bond rose nearly 0.3 percentage points in just two days to over 3.4% -- the highest level in 16 months.

Perhaps the most alarming aspect of the scandal is that the trading method employed by the perpetrators is apparently not that uncommon. So much so that it even has a name: "dai chi," roughly translated as "holding on behalf."

According to an analyst at a Japanese securities firm, it is "a trick I often hear about being used in the Chinese securities industry."

The former Sealand employees bought government bonds on the market in anticipation of rising prices, and, using them as collateral, borrowed money from a bank. That money was in turn used to buy more government bonds, put them up as collateral and place them in the custody of a securities firm, and the process was repeated over and over again.

"Dai chi" resembles repurchase transactions in which cash and government bonds are exchanged for a specified period, and the transaction itself is legal in China. This time, however, the perpetrators reportedly conducted excessively leveraged transactions, far beyond the scope allowed by the company.

Many believe similar practices have been rampant elsewhere. Some suspect this kind of trading drove the bond market bubble that sent yields on 10-year bonds to a record low of close to 2.6% -- down from nearly 5% reached at the end of 2013.

Another leveraged investment method is margin trading, which exploded on the Chinese stock market in the middle of 2015. Investors who used this scheme were then hit severely in a subsequent sell-off in Shanghai stocks. But it seems market insiders learned little from the experience.

The fact that Sealand, ranking around 30th in China in terms of total assets, was engaged in unauthorized, highly speculative bond trading came as a major shock. According to the company, the China Securities Regulatory Commission was quick to send investigators to the brokerage on Dec. 15 for on-site inspections.

Ironically, the incident coming to light coincided with the Central Economic Work Conference between Dec. 14 and 16. The meeting saw President Xi Jinping's administration discuss economic management policy for the next year, and decide that curbing financial risk would require a more central role.

China's financial watchdog has banned insurers from making speculative purchases of listed stocks, and introduced restrictions on overseas business mergers and acquisitions that may lead to fund outflow from China.

The body has had significant concerns about a bubble forming in the government bond market, and has maintained money market rates at relatively high ranges to make it more difficult for speculators to obtain funds.

According to a fund manager at a U.S. asset management firm, such regulators' common aim is to minimize term mismatches arising from investing funds raised for a short term to finance investment in long-term assets with low liquidity, as well as to bring down leverage. Looking back, such a mismatch and high leverage were distant factors that contributed to triggering past shocks, such as the global financial crisis and the Asian financial crisis in the 1990s.

In that sense, the latest sell-off in Chinese government bonds could be seen as something the Chinese government has intentionally caused as part of efforts to correct a bubble-prone investor tendency.

The hope now is that this bitter pill will not prove too potent and spread confusion throughout global markets.

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