The seemingly relentless decline in the CGB yield 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 compounded by stalling consumption - in the absence of strong and decisive fiscal stimulus measures.
However, 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 years. Moreover, the "multiplier effect" (money velocity) of stimulus usually diminishes when deflationary pressures become even more entrenched.
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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. Below, we provide a summary of structural issues facing China, a comparison of those with Japan's experience, lessons learnt, and potential implications for China.
Similarities and differences
Both Japan and China have elevated debt in the system. Japan's credit creation surge was fuelled by guided inward credit demand in services and properties after the Plaza Accord ignited yen strength and drove manufacturers abroad. For China, the Global Financial Crisis has encouraged increased fiscal spending, with credit creation via infrastructure being ramped up.
While credit creation channels differ slightly, with Japan via banks and Housing Financing Co during the bubble and China primarily via banks and local government financing vehicles (LGFV), these loans are mainly collateralised by properties.
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Bad loan capitalisation plays a crucial part in a post-bubble burst in both cases - Japan's bank nationalisation from 1998 was considered late to prevent the lost decades, while China has been relatively quick with capital injections into six big banks and the RMB10 trillion ($1.8 trillion) hidden debt swap being announced in 4Q2024.
Lessons learnt and potential implications for China
The lessons learnt from Japan are that supply-side reforms do not fix demand deficit while low levels of "real water" infrastructure fiscal spending have led to productivity declines through the years. For Japan, the next step is real wage growth after its lost decades.
For China, a backstop is needed as a buyer of last resort to stop further property price plunges. In our view, some initial actions have been enforced. Additionally, a new growth engine is required alongside domestic demand boost policies.
On the bright side, China has a bigger manufacturing base despite the trade headwinds, more wiggle room from a policy viewpoint, and major state-owned banks with less solvency concern. There is also room to grow gross domestic product per capita, with China relying on next-gen growth engines derived from AI, EVs, chips, semiconductors and renewables.
Having said that, China is facing an uphill battle. The population peaked in 2022, creating an additional structural headwind to the recent weakening of the property market. This is a major contrast to Japan, where its population peaked in the early 2010s despite the bubble burst in the 1990s.
In our view, the potential implications for China in the mid-term are a gradual decline in potential growth from the current 5% to 3%, a secular decline in rate following lower credit velocity (banks faced with ample excess liquidity), a somewhat stable but weaker currency and Chinese equities still regarded as a trade, not an investment, with less structural demand; thus, a nimble, tactical approach is favoured.
The opportunity for investors
We believe CGBs should not be ignored by investors, particularly as their low volatility is virtually unrivalled in today's highly uncertain environment for fixed income.
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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. This pickup has emerged as worries of Japanification have eased, with a stable RMB and seemingly secular yield declines helping to propel returns to the asset class. The outperformance has been evident on a local currency, USD unhedged and hedged basis, and in both absolute and risk-adjusted terms.
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.
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, which is generally a favourable 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.
Masahiko Loo is a senior fixed-income strategist at State Street Global Advisors
