Unravelling the Chinese Carry Trade: Why Foreign Investors Are Fleeing Chinese Government Bonds

In recent months, foreign investors have significantly reduced their holdings in Chinese government bonds, unwinding a previously lucrative carry trade that capitalised on favourable cross-currency swap rates and higher yields compared to U.S. Treasuries. This strategy involved borrowing in U.S. dollars, converting to renminbi (RMB), and investing in Chinese sovereign debt, yielding returns up to 6%, surpassing those of U.S. Treasury bonds.

However, Beijing's announcement of a substantial stimulus package in September triggered a sell-off in Chinese government bonds and a rebound in the RMB, leading to losses for investors engaged in this trade. Consequently, foreign investors sold a net RMB 275.8 billion (approximately $38 billion) of Chinese debt in September and October, predominantly government bonds. This included a record reduction of RMB 62.8 billion in interbank negotiable certificates of deposit (NCDs), short-dated government notes favoured in this strategy.

The attractiveness of this carry trade diminished due to less favourable cross-currency swap rates and rising U.S. Treasury yields. The People's Bank of China's (PBOC) interventions, including monetary support for stock markets and debt swaps for heavily indebted local governments, led to increased volatility in bond prices and a surge in 10-year Chinese government bond yields by 0.17 percentage points over three days in late September. This volatility, coupled with increased bond issuance by the Ministry of Finance, reduced the appeal of Chinese bonds to foreign investors.

Additionally, the strengthening U.S. dollar and potential increases in U.S. tariffs have contributed to a weakening RMB, further dampening foreign demand for Chinese government bonds. Analysts suggest that investors with higher risk appetites may shift focus to Chinese equities instead.

MY ANALYSIS

The unwinding of this carry trade underscores the sensitivity of cross-border investment strategies to policy shifts and market dynamics. The rapid sell-off highlights the risks associated with currency fluctuations and yield volatility. For investors, this scenario emphasises the importance of monitoring policy developments and market conditions, particularly in emerging markets where interventions can significantly impact returns.

The increased volatility in Chinese bond yields and the strengthening of the RMB following policy announcements illustrate the interconnectedness of fiscal measures, currency markets, and investor behaviour. As U.S. Treasury yields rise, the relative attractiveness of Chinese bonds diminishes, prompting a reallocation of capital. This situation serves as a reminder of the complexities in managing currency risk and the necessity for diversified investment strategies to mitigate potential losses from sudden market shifts.

In conclusion, the recent developments in China's bond market highlight the intricate balance between policy actions, market reactions, and investor strategies. For those engaged in international investments, staying attuned to such dynamics is crucial for informed decision-making and effective risk management.