Are Negative Interest Rates in Democracies Driving Capital to China?
Beijing is playing Washington and Europe against each other, and banks, investors, and ultimately taxpayers are paying for the opportunity to do the bidding of their occasional adversary.
In mid-November, China borrowed €4 billion euros at extremely low-interest rates. Some of the debt was sold as five-year bonds at -0.152 percent, meaning that lenders had to pay China to borrow the lenders’ money. Usually, it’s the other way around—China has to pay interest to the lenders. This was the first time the Chinese sold debt at negative interest rates, and they were no doubt laughing all the way to the bank. They didn’t have to go far, however, because they were the bank.
China is a particularly risky and opaque place to do business, and capital flows out of the country are restricted. The Chinese Communist Party (CCP) has near totalitarian control over the economy and is an avowed adversary of the values that the West and its allies hold dear, namely democracy and human rights. Every dollar China borrows can and likely will be used to improve its economy and empower its military, which increasingly threatens the cherished ideals of the lenders in democracies who are loaning China money.
What explains this perverse relationship between lenders in democracies, and the authoritarian Chinese government? Most simply, the global downturn is making it difficult to find anywhere to stash money where it will not lose its value. Central banks in Europe are “offering” negative interest rates to force investors to put their money to work in Europe’s economy, boosting jobs and GDP during a downturn. The banks also want to boost inflation to their goal of 2 percent annually so they don’t get mired in a deflationary recession, which is exactly where Europe now finds itself.
To pull itself out of economic quicksand, European monetary policy has driven the European Central Bank’s (ECB) deposit rate to -0.5 percent. The five-year German bund yield was down to -0.749 percent on November 19. Euro-denominated bonds offered by Spain and due in October 2026 were yielding -0.319 percent on November 18. China’s yield of -0.152 percent beats the ECB, Germany, and Spain by a fraction of a percentage point, so some investors were willing to accept the increased country risk from China and preferred the Chinese debt.
On Nov. 30, the International Monetary Fund (IMF) recommended a further cut to the ECB deposit rate. But central bank interest rates in Europe that are so low that they chase capital to negative interest rates in China defeat the purpose of boosting jobs and GDP in Europe.
About 9 percent of the total onshore Chinese central government debt is held by foreign investors. Investors seek the highest yield they can find in a liquid investment that can be easily traded for cash, and the market has set that yield to negative when they want their money back from China in five years. According to some analysts, investors want exposure to China, which they see as having defeated the coronavirus and returned the economy to positive growth. The MSCI Emerging Market index and Barclays Global Aggregate Bond index will now include Chinese A shares and Chinese bonds, which will get passive investors committing capital to China.
“Wall Street and other Western financial firms speak enthusiastically of the flows likely to come to China, which dwarf the EUR borrowings,” according to George Magnus at Oxford University’s China Centre.
But China’s GDP growth in 2020 is expected to be just 2.3 percent in 2020, which is stressing corporate and government borrowers used to higher growth rates of 6 percent. What’s more, investors are relying on China’s self-reporting on the economy and the coronavirus. The CCP bars Western reporters from much information in China, and the Chinese press is state-controlled propaganda. Nevertheless, investors seem to be buying the story of negligible impact from the coronavirus in China, and a return of a strong economy. They are at least looking the other way as they purchase negative-interest rate debt.
This is a mistake, according to Magnus. “Which investors or financial firms in the West, for example, read or even understand Chinese rating agency ratings?” he asked. “Or trust management information? Or should take at face value corporate information that may have been shaped by party committees?” Magnus noted that “as much as our governments are trying to draw lines with China in the 2020s, finance firms, it seems to me, look like they're pulling in the other direction.”
According to the Wall Street Journal, “Fund managers are willing to buy bonds that offer negative yields in part because they are betting that the ECB will continue scooping up the debt, allowing them to sell the securities for a profit.” So in effect, the ECB is paying China to hold euros, and banks are making a few euros as middlemen. It is unclear whether the ECB believes that China will use those Euros to purchase European goods, thus boosting the European economy. But it has been argued that China wants to decrease its reliance on U.S. dollar markets even as they seek Wall Street’s help. China is playing the United States and Europe against each other, and banks, investors, and ultimately the taxpayer are paying China for the privilege.
It’s also possible that China is simply sitting on euros to increase its foreign exchange reserves while raking in negative interest. It’s always nice to get paid to have an option if anyone is daft enough to do the paying. China may be using the money to establish efficient yield curves, create strong pricing benchmarks for corporate borrowers from China, develop external markets, or improve relations with foreign bankers desperate to put their cash anywhere where its dwindling nature is at least minimized. Whatever the reasoning, China is getting paid to take euros from the West.
A total of $16.9 trillion worth of debt is trading at negative interest rates globally, which would not be so bad if that money were solely utilized in European, U.S., and allied economies. But central bank largesse is leaking into China, which will boost China’s economy, taxation, and thus government funds available for China’s defense expenditures. China’s military is increasingly geared towards forcing the United States out of Asia, including through modernization of its blue water navy and expansion of its nuclear weapons stockpile. This will put democratic allies in Asia, such as Japan, South Korea, Australia, New Zealand, Taiwan, and the Philippines, at increased risk. Economists typically don’t consider these political and military variables in their modeling.
Economists will argue that the latest €4 billion is small change compared to China’s total economy. But that is just the tip of a massive pile of low-yield debt and equity from the democracies that are now fueling, and at-risk in, China’s economy. The more that foreign creditors put their assets at risk in China, the more China becomes too big to fail, incenting those creditors to act as lobbyists back home to encourage government policies that ensure China’s solvency.
There have been at least seven major bond defaults at China’s state-owned enterprises in 2020 already, without local governments stepping in to make investors whole. This has rattled the nearly $4 trillion market in Chinese corporate debt, of which about half has been lent to state-owned enterprises (SOEs). China’s total bond market is now over $15 trillion, second only to that in the United States.
Local governments and SOEs are five times more reliant on bank loans than on the bond market, something Vice Premier Liu He, advisor to Xi Jinping, would like changed. “To reduce this imbalance—and more importantly lessen the moral hazards arising from the incestuous links between local governments, state banks and state-owned enterprises—Liu needs Wall Street’s help to increase the size and sophistication of China’s bond market,” according to the Financial Times.
Perhaps it is time for the United States and European central banks to do the opposite: raise interest rates enough so that China doesn’t soak up all the excess capital needed in democratic economies to boost jobs and GDP after the ravages of the coronavirus (which, let’s not forget, escaped China because of the CCP’s dissimulation and willful negligence). Economic revitalization of the democracies may require bans on lending and investment in China, more government infrastructure spending, and government investments into strategic industries such as the health-care industry, pharmaceuticals, medical goods, steel, shipbuilding, nuclear power, and defense production. If the democracies don't reclaim their capital, jobs, and strategic manufacturing from China, then China will continue to use its command-driven economy to grow at their expense. Free trade with China has since the 1970s failed to stop economic and industrial losses in Europe, the United States, and among the allies. It’s time to reverse the flow by whatever means necessary.
Anders Corr, Ph.D., is Principal at Corr Analytics, and Publisher of the Journal of Political Risk. He has a BA from Yale in political science, and a Ph.D from Harvard in government, and has worked in intelligence for five years, including for USPACOM and SOCPAC on Asia issues. He is the editor of Great Powers, Grand Strategies: The New Game in the South China Sea (USNI Press, 2018), and author of The Institutionalization of Power: Knowledge, Economic, and Political Hierarchies (Optimum International Publishing, forthcoming).