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China's rising interest rates reflect wobbly financial markets

Capital flight, yuan depreciation, falling reserves bode ill

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The headquarters of the People's Bank of China in Beijing   © Reuters

SHANGHAI -- Various data suggests that Chinese financial markets remain fragile and may even worsen next year. 

The yuan has barely avoided plunges in value as well through regulation and what is known locally as window guidance -- government persuasion aimed at getting financial institutions to stick to official guidelines.  

The government bond market symbolizes the fragility of financial markets in China.

Futures on Chinese government bonds temporarily went limit-down on Dec. 15, bringing the 10-year yield, regarded as the nation's benchmark long-term interest rate, to the 3.4% level, up a sharp 0.6 percentage point from before the U.S. presidential election. The price plunge was triggered by news that Sealand Securities, based in the Guangxi Zhuang Autonomous Region, had incurred a huge loss as a result of unauthorized transactions by two former employees in its bond section.

The loss was reported to be about 1 billion yuan ($144 million), much smaller than a loss of around 100 billion yen ($853 million) resulting from unauthorized transactions by Toshihide Iguchi, a bond trader at Japanese commercial lender Daiwa Bank's New York branch, and losses incurred through Nick Leeson's fraudulent derivative trading that led to the collapse of Barings Bank of Britain.

But the Chinese government bond market was greatly shaken due to the lingering presence of other uncertainties besides Sealand Securities' loss.

Increasing oversight

Chinese financial authorities are "willing to promote deleveraging" to lower the percentage of debt on the balance sheets at financial institutions, said a bond trader at a major Chinese bank, referring to recent moves by the People's Bank of China, the nation's central bank, to add wealth management products to the assessment of risks.

Some small and midsize banks have formed and sold off-the-book wealth management products and reportedly used some of the funds raised for questionable loans. Banks are also allegedly investing in wealth management products in a bid to earn high returns.

Bonds account for 40-50% of investment destinations for wealth management products.

Reinforced oversight by the central bank over these products is not only aimed at preventing an unruly expansion of balance sheets, but also help reveal any investment practices seen as speculative. 

The outstanding balance of wealth management products totaled 26 trillion yuan at the end of June. Under closer official oversight, leeway to use those funds for buying bonds will be affected. 

Triple whammy

Higher interest rates also reflect another unfavorable development in China: the outflow of capital from the world's second-largest economy.

China's state-run banks hold most of the bonds issued by the Chinese government. But U.S., European and other foreign banks also invest in Chinese government debt through local subsidiaries. Expectations of the yuan's appreciation had remained until 2014, when Chinese interest rates had been higher than such instruments as U.S. government bonds.

But since steep rises in interest rates in China since November -- a result of plunges in bond prices, which move inversely to interest rates -- word has been circulating that some foreign financial institutions are reducing holdings of Chinese government bonds in the name of risk management. 

As China has neglected efforts to improve the bond market, even government bonds lack sufficient liquidity. Interest rates thus tend to rise sharply even on small-lot selling of bonds.

The simultaneous occurrence of the yuan's depreciation and falls in China's foreign exchange reserves is also discouraging investment in Chinese bonds.

The country's foreign exchange reserves still top $3 trillion. However, Chinese authorities are hinting -- through official newspapers and other media -- that reserves of $2 trillion are sufficient in light of such factors as its trade volume.  

With China's holdings of U.S. government debt rapidly decreasing -- the amount has fallen below the level of Japan's -- the limit of financial resources for intervention to sell dollars and buy yuan is coming into sight. 

The Chinese central bank has worked to keep the yuan stable against a basket of currencies. But its moves do not signal an end to China's intervention in the currency market. Beijing will be forced to resort to protecting its currency if it weakens against the euro, yen and pound as well. 

The yuan had been on the rise until early 2014 on expectations that China would maintain its high economic growth and advance the liberalization of its capital market. 

China has successively intervened in the market and introduced regulations for the avowed sake of stabilization. But its measures are greatly undermining market participants' trust in the government. Rising interest rates reflect only one of such silent complaints among them.

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