Year of the Snake: Lower for Longer Chinese Yields

Structural Challenges: Elevated debt levels, persistent deflation, and the worsening demographic landscape pose significant hurdles and further complicate the growth outlook. These challenges are compounded by policy dilemmas, such as balancing national security concerns with the need for market opening and reforms. Furthermore, policy constraints, such as the need to cut interest rates while maintaining bank profitability and the need to prevent capital outflow, introduce further limits.

Structural Imbalances: The past decade has witnessed an overemphasis on supply-side growth, leading to overcapacity, intense competition, and a deepening deflationary spiral. Industrial production and exports have surged beyond trend growth levels, while retail consumption and property investment have lagged significantly (see Exhibit 2). Rebalancing towards consumption is crucial to address this imbalance and break the savings glut cycle. While policymakers have pledged to "forcefully promote consumption" and "expand domestic demand," the scale of the "trade-in" program and wage rise for government employees remains relatively small.

China is known for its five-year plans, a series of initiatives that map out major social and economic strategies over five-year time periods. As 2025 marks the conclusion of the 14th Five-Year Plan, policymakers are likely to maintain the current 5% growth target. However, a large-scale stimulus package is unlikely, given the lessons learned from the Global Financial Crisis. Hence, the current policy pivot has proven to be insufficient and slow in its execution.

Property Market Remains Critical to Broader Recovery

Absent a larger fiscal stimulus, boosting household income, improving social safety nets, and restoring consumer confidence are critical steps. However, one of the biggest keys to recovery resides in the property sector. The lingering impact of the property downturn poses a significant challenge, particularly in lower-tier cities grappling with massive inventory overhangs. The lack of uptake for government "buyback" programs further exacerbates the issue. Until the property market heals, consumer confidence and private sector investment will remain subdued (see Exhibit 3).

Can China Avoid Japanification?

The decline of the 30-year Chinese government bond (CGB) yield below the 30-year Japanese government bond (JGB) yield raises concerns about a potential "lost decade" for the Chinese economy. While China faces significant demographic challenges, its lower gross domestic product (GDP) per capita and less leveraged households offer some advantages compared to Japan. However, the slow recovery of the property market and the risk of prolonged deflationary pressures remain significant.

Preparing for Tariff War 2.0

The potential for a new round of US tariffs poses a significant threat to China's growth. While China has taken steps to mitigate the impact of potential tariffs, the larger scale and broader scope of duties threatened by the new Trump administration, coupled with a weaker domestic economy, make the situation more challenging than the previous trade war.

China has made strides in protecting against trade threats, including diversifying its trade toward emerging markets (see Exhibit 4) and fostering technological self-reliance. However, the effectiveness of these measures remains uncertain. Additional measures that China could deploy in response to increased US tariffs include tit-for-tat tariff hikes and other retaliatory measures, such as export controls on critical minerals and restrictions on profit repatriation for multinational companies operating in China. Currency devaluation also could be used to partially offset the tariff shocks. Lastly, China can step up domestic monetary and fiscal easing policies. However, all of these measures come with economic trade-offs and potential geopolitical consequences. Further deterioration of US-China relations and the increased decoupling of the two economies pose significant risks.

Investment Implications

The "lower for longer" scenario remains the dominant outlook for CGB yields. The yield rally picked up speed in December due to the lackluster growth response from the policy pivot and shortage of haven assets amid unforeseen risks. The prolonged deflationary pressure is likely to drive CGB yield even lower, which may bode well for owning Chinese duration. Structurally slower growth with moderately easy fiscal policy and dovish monetary policy benefits CGB duration and bull flattening where long-term interest rates fall more than short-term interest rates, flattening the CGB yield curve. A continued lackluster credit impulse and the central bank’s quantitative easing also are additional catalysts for lower yields. Moderately increasing bond supply has not mattered to bond prices due to a captive buyer base. In addition, CGBs offer relatively high real yield and FX-hedged yield, low volatility, and low correlation with the US Treasury market for potential diversification benefits (see Exhibit 5).

Looking ahead, China continues to face significant hurdles and uncertainty. The National People’s Congress meeting in March may introduce further fiscal measures, but the market could be disappointed again if the interventions fail to reignite animal spirits with true reforms and structural rebalances. Furthermore, the People’s Bank of China (PBOC) needs to expand its balance sheet to provide more liquidity to the economy. The policy shift to focus on domestic consumption may have less spillover to other economies should China’s growth pick up. Lastly, the tariff war likely will reshuffle global supply chains further, creating new winners and losers.

The Chinese renminbi (CNY) still faces depreciation pressure from US dollar (USD) strength, negative interest rate differentials with the US, the pending tariff war, and slow growth. We expect CNY will continue to weaken versus USD in a controlled manner in the near term but may face strong headwinds that force a sharper depreciation to offset higher tariffs. CNY, which has not priced in severe tariff increases, remains strong against the China Foreign Exchange Trade System (CFETS) basket. Hence, we believe the currency has more room to depreciate if the reality turns out to be worse. Conversely, if the reality turns out to be better than expected, CNY should have room to appreciate. President Trump and Treasury Secretary nominee Scott Bessent have suggested that tariffs could be rolled out in a gradual manner, potentially allowing more time for a trade deal to be reached that could boost CNY.

Conclusion

The path ahead for the Chinese economy remains fraught with uncertainty. Addressing structural challenges, effectively implementing policy responses, and navigating geopolitical risks will be crucial for achieving sustainable long-term growth.

Index Definitions

The Consumer Price Index (CPI) is used to measure the change in the out-of-pocket expenditures of all urban households for a particular set of goods and services. In terms of its coverage, the CPI measures the cost of spending made directly by households for the items in its basket, with the notable exception that it also includes a measure of the rents that homeowners implicitly pay instead of renting their home.

The Producer Price Index (PPI) measures the average change in selling prices over time received by domestic producers for their output.

The Purchasing Managers’ Index (PMI) is an economic indicator of the prevailing direction of a country’s economic trends in the manufacturing and service sectors. It is a diffusion index that summarizes whether market conditions are expanding, staying the same, or contracting by surveying senior purchasing executives at private sector companies.