Latest / China Economy with Fexingo: Beijing's Policies, Trade, and Asia-Pacific Markets / Why Chinas Yuan Weakness Is Boosting Its Bond Market
Transcript
- Lucas: Luna, the Chinese yuan is trading at 6.76 per dollar as of this week — that’s its weakest level since early 2023. And yet, foreign investors just bought the most Chinese government bonds in two years. Luna: Right, that seems backwards. Usually a weaker currency scares foreign capital away. What’s driving this? Lucas: It comes down to the yield gap. Chinese 10-year government bonds are yielding around 2.8 percent. Comparable US Treasuries are at 4.2 percent. But after hedging out the currency risk — using forward contracts — that gap narrows, and for some maturities it actually flips in China’s favor. Luna: So investors are doing a carry trade essentially — borrowing in dollars, buying yuan bonds, and pocketing the difference? Lucas: Exactly. And the People's Bank of China has been keeping short-term rates stable while the Fed is still signaling caution. That stability makes the carry trade more predictable. Plus, Beijing has been gradually opening its bond market — making it easier for foreigners to participate. Luna: But the yuan is still weakening. Doesn't that currency loss eat into returns? I mean, if the yuan drops another 2 percent, your yield advantage disappears. Lucas: That's the risk. But the forward hedge protects against that. When you buy a one-year forward contract to sell yuan and buy dollars, the cost of that hedge is built into the trade. And right now, that cost is low because the market expects the yuan to depreciate only modestly — maybe another 1 to 2 percent over the next year. So the net yield after hedging is still positive compared to US Treasuries. Luna: So the key is that the PBOC is signaling they won't let the yuan drop too fast. They want stability, not a free fall. Lucas: Correct. They're using the daily fixing rate to guide expectations. The yuan is allowed to move 2 percent either side of that fixing, and the PBOC has been setting it slightly weaker each day — a controlled depreciation that aligns with the trade surplus and a strengthening dollar. But they’re not letting it overshoot. Luna: And the trade data backs that up. Exports are still strong, but imports are growing even faster. The latest numbers — April 2026 — show a trade deficit of about 56 billion dollars. That's actually a smaller deficit than the previous month, but still a deficit. So the yuan weakening makes sense: it helps exports, but with imports rising, the currency isn't under as much pressure to appreciate. Lucas: Right. And the current account deficit — which was 191 billion dollars in the fourth quarter of 2025 — has been improving. That also reduces pressure for yuan strength. So foreign bond investors see this as a managed process. They get a decent yield, a stable policy backdrop, and they're diversifying away from US debt. Luna: I've seen estimates that foreign holdings of Chinese bonds rose by about 12 billion dollars in May alone. That’s notable after years of net selling. Lucas: It's a real reversal. Since 2022, foreigners were pulling money out of Chinese bonds due to Covid lockdowns, regulatory crackdowns, and geopolitical tensions. But now, with the yuan stabilizing in a weaker range and yields still attractive on a hedged basis, they're coming back. And it's not just government bonds — policy bank bonds and even some local government bonds are seeing inflows. Luna: So what does this mean for the broader China economy? Does this bond inflow help offset some of the capital outflows from the stock market? Because we’ve seen FXI, the China large-cap ETF, down nearly 5 percent in the past five days. Lucas: It does provide a cushion. The bond market is much larger than the stock market. If foreign investors are adding to bond holdings, that’s a stable source of capital that doesn't flee as quickly as equities. And it helps finance the government's fiscal stimulus — the local government bond issuance has been ramping up this year. So it's a positive feedback loop: more foreign demand keeps bond yields lower, which makes it cheaper for Beijing to borrow, which funds infrastructure and support for factories. Luna: And it also strengthens the case for the PBOC to keep rates where they are. If they cut rates to stimulate the economy, that yield advantage would shrink and the carry trade would unwind. Lucas: Exactly. The PBOC is in a bit of a bind. They want to support growth — especially with the property sector still weak — but they also want to keep the bond market attractive for foreigners. So far, they've chosen to hold the line on policy rates and use targeted lending instead. Luna: It reminds me of something we've talked about before: the yuan is becoming more of a funding currency for global carry trades, similar to the yen. That's a shift from a few years ago when it was seen as a high-growth, appreciating currency. Lucas: That's a great observation. The yuan's role is evolving. And if this bond inflow continues, it could actually put a floor under the currency — because those foreign investors need to convert dollars into yuan to buy bonds. That demand supports the yuan. So ironically, the very flows attracted by a weak yuan could help prevent it from falling too far. Luna: Let’s look at the broader picture — how does this fit into the global context? Other emerging markets like India and Indonesia are also seeing bond inflows. Is this a broad EM rally, or is China unique? Lucas: There's a bit of both. Globally, investors are looking for yield anywhere they can find it, with US rates still high but expected to eventually come down. But China stands out because of the sheer size and liquidity of its bond market — it's the second largest in the world. And the PBOC's credibility on currency management gives investors confidence. Compare that to, say, Turkey or Argentina, where currency risk is much higher. Luna: And the geopolitical angle — trade tensions with the US are still simmering. Does that scare off some investors? Lucas: It does, but perhaps less than you'd think. The bond market is less politicized than equities. A Chinese government bond is a straightforward claim on the central government. There's no regulatory risk like in tech stocks. And with the Trump administration focused on Iran and domestic issues recently — like the Lisa Cook firing attempt — trade hasn't been the top headline. That gives a window for these flows to continue. Luna: Alright, so if you're an investor looking at this, what’s the key risk to watch? I'd say it's the PBOC losing control of the yuan — if depreciation accelerates beyond their target, that hedge cost spikes and the carry trade collapses. Lucas: Absolutely. And that could happen if us china relations suddenly deteriorate — say, a new round of tariffs. Or if China's domestic economy slows more sharply than expected, forcing a rate cut. But for now, the data suggests a stable equilibrium. The yuan is weak enough to support exports but not so weak that it destabilizes the financial system. And the bond inflows are a vote of confidence in that management. Luna: We’ve been focusing on bonds, but stocks are having a rough week — FXI down 4.9 percent, KWEB down 4.8 percent. Is that just a risk-off mood globally, or is there a China-specific factor? Lucas: It's mostly global. The Fed’s cautious stance last week spooked markets, and tech stocks sold off. But China stocks are also reacting to the weaker yuan — if you're a US dollar investor, your returns are hit by currency depreciation. So even if the stock doesn't move, you lose value when you convert back to dollars. That’s another reason why the bond carry trade is more attractive right now: it explicitly hedges that currency risk. Luna: So in a weird way, the yuan weakness is actually boosting one part of China's capital markets — bonds — while hurting another — stocks. It's like a split personality. Lucas: Exactly. And that divergence could persist as long as the PBOC keeps this managed depreciation policy. For bond investors, it's a win. For equity investors, it's a headwind — unless you're in export-oriented sectors that benefit from a weaker yuan, like solar manufacturers or EV makers. Luna: Speaking of exports, we've seen China's solar exports surge despite trade barriers. But that's a topic for another day. Lucas, before we wrap, I want to pause for a second. We do this show ad-free and listener-supported, and if walking through these economic dynamics has made something click — or if you just find value in a weekly deep dive on China's markets — you can support the show at buy me a coffee dot com slash fexingo. It's a simple way to keep us going, and we really appreciate it. Lucas: Yeah, completely. It's a small gesture that makes a big difference for us. And it helps us stay independent and focused on the data without any sponsor pressure. So thank you to anyone who chips in. Luna: Alright, back to the markets. One thing listeners might be wondering: where does the yuan go from here? The trade-weighted dollar index has eased a bit — down to 119.5 this week — but the yuan is still weakening. Is there a target level from the PBOC? Lucas: They don't announce targets, but market participants watch the daily fixing closely. Currently, it's around 6.76. Many analysts think the PBOC is comfortable with a range of 6.7 to 7.0 for now. If it approaches 7.0, they might step in with stronger signals — maybe widening the fixing band or using liquidity tools. But I don't think they want it to break 7.0 unless there's a major shock. Luna: And the Fed is still on hold, so the dollar isn't going to weaken dramatically. That suggests the yuan could stay in this range for a while. Lucas: Probably. Unless we see a surprise trade deal or a sharp slowdown in China. But the base case is a slow grind weaker, with the PBOC managing the pace. And that's exactly the environment that's attracting bond investors. Luna: Good analysis. Thanks, Lucas. Lucas: Thanks, Luna. Next week we'll dig into how China's solar exports are navigating the new tariffs. See you then.