China's central bank, the People's Bank of China (PBOC), is currently grappling with a significant challenge. This challenge revolves around its efforts to manage and mitigate financial stability risks within a rallying bond market. This situation is particularly complex as it contrasts sharply with the central bank's economic outlook, which anticipates long-term soft growth and persistent low inflation.
The PBOC has committed to incorporating treasury bond trading into its array of monetary policy tools. Despite issuing numerous warnings about the falling yields in long-dated government bonds, the central bank has yet to successfully reverse this trend, which continues to pose a potential risk to financial stability.
The pressure on the PBOC to take decisive action is intensifying. There is a growing expectation that the central bank will need to substantiate its statements with concrete measures, potentially ending a 17-year hiatus from active participation in the bond market by selling bonds. Given its relatively limited financial resources, there is speculation among traders and investors that the PBOC might even resort to short-trading treasuries, a strategy that involves borrowing bonds to sell them, with the intention of buying them back at a lower price later. This approach would be a significant departure from its traditional methods and highlights the severity of the situation.
However, the central bank is in a precarious position, balancing multiple conflicting priorities. Implementing such operations would effectively withdraw liquidity from the financial system. This is particularly concerning at a time when many economic analysts argue that the Chinese economy requires additional support to meet its ambitious 2024 growth target of around 5%. Withdrawing liquidity could stifle economic activity, exacerbating existing weaknesses in the economy.
On the other hand, inaction also carries substantial risks. By not addressing the falling yields, the PBOC may be tolerating the very risks it has been warning about. One major concern is that regional banks' significant investment in long-dated bonds could lead to a scenario similar to the collapse of Silicon Valley Bank in the United States last year, should the market conditions suddenly change. Moreover, lower yields could increase selling pressure on the yuan, leading to capital flight, which would further destabilize the financial system.
This dilemma underscores the broader challenges Chinese policymakers face as they strive to balance the twin objectives of ambitious economic growth and financial stability. After decades of expansion driven by debt, maintaining this balance has become increasingly complex. Xia Haojie, an analyst at Guosen Futures, highlighted that individual investment decisions in bonds collectively pose significant risks to the central bank's dual mandate.
This mandate includes supporting economic growth while simultaneously heading off potential financial risks. A hands-off or laissez-faire approach could lead to systemic risks, which might destabilize the entire financial system. The PBOC did not immediately respond to requests for comments on this matter, leaving the market in a state of uncertainty.
The yields on ten- and thirty-year bonds have seen significant declines, dropping by 30-40 basis points from their highs earlier this year to current levels of 2.30% and 2.53%, respectively. The PBOC's warnings against falling yields have coincided with these levels over recent months, indicating a persistent concern over this trend. This situation has led to shifting market expectations regarding PBOC bond trading.
Initially, following a speech by President Xi Jinping in October 2023, which instructed the PBOC to gradually increase treasury trading, there was widespread speculation that the central bank might adopt a Federal Reserve-style quantitative easing program. However, the PBOC later clarified that its trading activities would operate in both directions, not just involve purchasing bonds to inject liquidity into the market. Shortly thereafter, the PBOC expressed concerns about the declining yields, drawing parallels to the issues faced by Silicon Valley Bank.
The central bank's strongest warning came in a May 30 statement to Reuters, where it indicated a readiness to "sell bonds when necessary." Despite a brief rise in yields following this statement, the market's response was short-lived, suggesting that traders are skeptical about the central bank's resolve.
The PBOC's current holdings include 1.52 trillion yuan ($210 billion) worth of bonds. This represents about 5% of all treasury bonds in circulation and a mere 1.4% of the total local bond holdings worth $14.6 trillion held by various Chinese entities. This relatively small share highlights the challenges the PBOC faces in influencing the market through direct intervention. A bond fund manager, who requested anonymity due to the sensitivity of the topic, commented on the difficulty of opposing bond investors.
He expressed hope that the central bank would begin selling bonds soon to maintain its credibility, noting that if the PBOC's credibility were to crumble, it would be costly and challenging to rebuild. The fund manager also mentioned that the PBOC could potentially engage in short-trading bonds to navigate this complex situation.
Analysts have identified multiple factors driving the sustained demand for long-term government bonds. Concerns over deflation and uneven economic growth are pushing investors towards safer assets like government bonds. The ongoing property crisis and a crackdown on municipal debt further limit investment alternatives, leading more investors to seek the relative safety of government bonds. Li Zhao, head of investment at White Whale Investment, emphasized that in the current economic climate, protecting wealth should take precedence over increasing it. This sentiment is reflected in the investment strategies of many market participants.
Moreover, recent cuts in deposit rates, aimed at encouraging spending and borrowing, are redirecting household and corporate savings into wealth management products. These products, in turn, channel funds into bonds, further driving demand. Regional banks, particularly those in smaller cities with sluggish economies, face weak demand for loans. As a result, these banks have few options but to increase their bond holdings, which exposes them to significant interest rate risks if the market conditions change. Larry Hu, chief China economist at Macquarie, pointed out that the approximately 4,000 small and medium-sized banks would be particularly vulnerable to such risks.
Hu also suggested that the current bond rally could reverse if global demand for Chinese goods, which has been a key factor in maintaining growth so far this year, declines. A weakening in global demand could prompt Beijing to implement more aggressive fiscal stimulus measures, leading to further debt issuance. Such strong stimulus could raise growth and inflation expectations, potentially catching investors off guard and leading to a sudden market adjustment.
However, Peng Chengjun, head of fixed income at Invesco Great Wall Fund Management, offered a different perspective during a roadshow. He assured investors that current bond yields "fully reflect fundamentals" and that in a fragile economy, yields are likely to continue declining. Peng argued that any actions by the PBOC might cause short-term volatility at most and that corrections in bond prices could actually present good buying opportunities for investors.
This complex interplay of factors and the central bank's potential responses illustrate the delicate balancing act that the PBOC must perform. As it navigates these challenges, the outcomes of its actions will have significant implications for China's broader economic stability and growth trajectory. Source: Reuters
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14.06.2024
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