Why Chinese Government Bonds Warrant Attention… and Caution
The Chinese Government Bond (CGB) market has come in recent years to resemble that of Japan’s during that country’s “lost decades”. Notwithstanding differences in the nature and severity of the underlying structural issues, concerns have mounted that China may be experiencing its own “Japanification” scenario.
With yields tracking ever lower, US dollar-hedged CGBs have outperformed the bonds of major counterparts through market cycles over the past 20 years, from both a total return and risk-adjusted perspective. However, the geopolitical risk backdrop warrants investors’ attention, given the potential for China’s saber-rattling around Taiwan to take a more aggressive turn.
The seemingly relentless decline in the CGB yield (Figure 1) since the turn of the current decade has come to be viewed in some quarters as symptomatic of China’s losing battle against the “Japanification” of its economy and bond market. The worry is that China’s deflationary cycle will persist, with the drop in interest rates mirroring falling wages and investment – something that has been compounded by stalling consumption – in the absence of strong and decisive fiscal stimulus measures. But it should be noted that large fiscal stimulus did not save Japan from the period known as its “lost decades”. In the case of China, we doubt whether supply-centric stimulus spending would be effective enough when the underlying issue is a deficit in demand. For example, according to China’s producer price index (PPI), factory prices have remained in deflationary territory for more than two years1. Moreover, the “multiplier effect” (money velocity) of stimulus usually diminishes when deflationary pressures become even more entrenched.
Figure 1: China’s Long-Term Borrowing Costs Fall Below Japan’s
As illustrated in this article from February 20242 , China exhibits some of the same characteristics that pushed Japan into its lost decades. These include demographic decline, high debt levels, and a secular slump in potential growth driven by weak demand coupled with deflation. A summary of the structural issues facing China and the comparison of those with Japan’s experience is provided in Figure 2. In the subsequent table (Figure 3), we consider the lessons learnt from Japan and the potential implications for China.
Figure 2: Structural Issues: Demographics, High Debt, Low Growth
| Debt | Japan | China |
|---|---|---|
Debt-to-GDP Ratio |
Approx. 250% |
>250% |
Credit Creation Channel |
Banks, Housing Financing Co |
Banks, Local Government Financing Vehicle (LGFV) |
Difference / Similarity |
Plaza accord
|
Global Financial Crisis (GFC)
|
Credit Collateral |
Credit creation via banks (land collateral) |
Local govt debt from land sales etc. |
Catalysts Triggering Bust |
|
|
Bad Loan Capitalization |
Bank nationalization but considered too late (from 1998~) |
Capital injections to 6 big banks, 10tr CNY hidden debt swap Q4 2024~ |
Figure 3: Lessons Learnt from Japan, Potential Implications for China
Japan |
China |
|
|---|---|---|
Lessons Learnt |
|
|
What Next? |
|
|
Bright Side (for China) |
|
|
Potential Implications |
|
|
What do these implications mean for CGB investors? When we plot the returns of USD-hedged CGBs and Japanese Government Bonds (JGB) over the last 20 years, we see the divergence of performance in the latest five-year period as CGBs outperform (Figure 4). This pickup has emerged as worries of Japanification have seen a stable CNY, accompanied by seemingly secular yield declines, help propel returns to the asset class.
Figure 4: CGBs Outperformed in Total Return Terms (Jun 2005-Dec 2024)
The outperformance reflected in the chart above has been evident on a local currency, USD unhedged and hedged basis, and in both absolute and risk-adjusted terms (Figure 5).
Figure 5: CGB Outperformed on Risk-Adjusted Basis*
The Opportunity for Investors
Figure 5 illustrates why CGBs should not be ignored by investors, particularly as their low volatility is virtually unrivalled in today’s highly uncertain environment for fixed income. China bonds also add an element of diversification to investment portfolios, presenting a stark contrast to volatile and higher-for-longer rates expectations in developed markets (Figure 6). We think it is unlikely that China will pivot to stimulate growth on a massive scale, and that the most likely mid-term path forward is more rate cuts. High household savings and lower loan demands would leave banks flush with cash — that is generally a favorable environment for bond markets. Furthermore, the China bond market is arguably too big for investors to ignore at this point, as it accounted for more than 10% of the Bloomberg Global Aggregate Index at the end of December 2024.
Figure 6: Chinese Bonds Deliver Diversification
Geopolitical Risks Warrant Attention
A key factor that we believe is keeping investors away from investing in China is geopolitical risk around Taiwan. While the threat from US tariffs is known even if the extent/timing/scale of such action is unknown, the impact from any increase in Chinese aggression against Taiwan could have far-reaching implications. In such a “Grey Swan” scenario, we would expect to see a collapse in the currency and a vacuum in market liquidity. The experience of Russia in the aftermath of its 2022 invasion of Ukraine is instructive — Russian bond, currency, and stock markets ceased to function adequately after Russia lost access to the SWIFT system, hampering the ability of Russia and its financial institutions to conduct international business and settle payments. Russian debt was then downgraded to junk status, and the country continues to face severe restrictions in accessing global capital markets. Notwithstanding some movement towards negotiations, Russia’s foreign exchange reserves were still frozen in February 2025, a situation that has compounded its economic isolation. Should a similar scenario play out around China/Taiwan, that might seem too big a risk to take for a sub 2.0% 10-year CGB bond yield.