Chinese commercial banks have a huge problem.

As consumers and businesses view the prospects of the world’s second-largest economy bleakly, credit growth has stalled. Beijing’s stimulus measures have so far failed to boost demand for consumer loans and have not yet sparked a significant recovery in the flagging economy.

So what do banks do with their cash? Buy government bonds.

Chinese government bonds have staged a strong rally since December, with 10-year yields falling to all-time lows this month, falling about 34 basis points, according to LSEG data.

“The lack of strong consumer and business credit demand has resulted in capital flowing into the government bond market,” said Edmund Goh, fixed income investment director at abrdn in Singapore.

However, “the biggest problem on land is the lack of fixed assets,” he added, as “there are currently no signs that China can emerge from deflation.”

Total new yuan loans fell over 20% year-on-year to 17.1 trillion yuan ($2.33 trillion) in the 11 months ended November 2024, according to data released by the People’s Bank of China. In November, new bank loans reached 580 billion yuan, up from 1.09 trillion yuan a year earlier.

Loan demand has not picked up despite Chinese authorities unveiling sweeping stimulus measures since last September, when the economy was on the verge of missing its full-year growth target of “around 5%.”

Goldman Sachs expects growth in the world’s second-largest economy to slow to 4.5% this year and expects credit demand to slow even further in December from November.

“There is still a lack of quality credit demand as private companies remain cautious about approving new investments and households also tighten their wallets,” said Lynn Song, chief economist at ING.

This year, authorities have vowed to make boosting consumption a top priority and boosting credit demand through lower corporate financing and private borrowing costs.

Due to high uncertainty over possible tariff measures from abroad, investors may continue to look for “sources of risk-free returns” this year, Song said, noting that “there are still some question marks about how strong domestic policy support will be.” becomes”.

The slowdown in lending is because mortgages, which used to drive credit demand, are still at their lowest point, said Andy Maynard, managing director and head of equity at China Renaissance.

Chinese onshore investors are struggling with a lack of “investable assets to put money into, both in the financial market and the physical market,” he added.

Official data on Thursday showed China’s annual inflation rate was 0.2% in 2024, suggesting prices barely rose, while wholesale prices continued to fall, falling 2.2%.

“Institutions are increasingly bullish on government bonds as they believe economic fundamentals will remain weak, coupled with fading hopes of a forceful policy push,” said Zong Ke, portfolio manager at Shanghai-based asset manager Wequant.

Ke said current policy interventions were merely “efforts to prevent economic collapse and cushion external shocks” and “simply to prevent a free fall.”

The 10-year U.S. Treasury yield has risen faster since June, and a rise on Wednesday pushed the yield to 4.7%, approaching levels last seen in April.

The widening yield differential between Chinese and U.S. government bonds could lead to capital outflows and put further pressure on the yuan, which has been weakening against the greenback.

China’s onshore yuan hit a 16-month low against the dollar on Wednesday, while the offshore yuan has been on a multi-month downward trend since September.

“You have the perfect storm,” said Sam Radwan, founder of Enhance International, citing lower government bond yields, the ongoing housing crisis and the impact of rising tariffs as risk factors weighing on foreign investor sentiment in onshore investments.

While the attractiveness of Chinese bonds for foreign investors is declining, the wider yield differentials with U.S. Treasuries have little impact on the performance of Chinese government bonds due to the “low proportion of foreign funds,” said Winson Phoon, head of fixed income research at Maybank’s investment banking group.

Falling yields offer Beijing a bright spot – lower financing costs – as policymakers are expected to ramp up new bond issuance this year, ING’s Song said.

Beijing unveiled a $1.4 trillion debt swap program in November aimed at easing local governments’ funding crisis.

“For much of 2024, policymakers intervened whenever 10-year yields reached 2%,” Song said, noting that the PBOC “quietly stopped” intervention in December.

Investors expect the central bank to announce new monetary easing measures this year, such as additional cuts in the key interest rate and the amount of cash banks must hold in reserves. At the turn of the year, the PBOC said it would cut interest rates at an “appropriate time.”

“The bank will enrich and improve its monetary policy tools, conduct purchases and sales of government bonds and monitor movements in long-term yields,” the Jan. 3 statement said.

However, the prospect of interest rate cuts will only propel the bond rally further.

Economists at Standard Chartered Bank expect the bond rally to continue this year, albeit at a slower pace. The 10-year yield could fall to 1.40% by the end of 2025, it said in a note Tuesday.

Loan growth could stabilize by midyear as stimulus begins to boost certain sectors of the economy, economists said, leading to a slower decline in bond yields.

China’s central bank said on Friday it would temporarily stop buying government bonds due to excess demand and tight supply in the market.