What is behind China’s perplexing bond-market intervention?
Many governments live in fear of bond-market “vigilantes”, investors who punish errant policies by aggressively selling the sovereign’s debt, driving down its price and thereby pushing up its yield. Financial regulators also worry about bond-market malfunctions, such as unsettled trades, when one party to a transaction fails to honour its promises. These mishaps can send ripples of anxiety through an entire financial system.
Such fears do not seem to apply to China’s financial authorities. On August 9th regulators in the southern province of Jiangxi ordered several rural banks not to settle their recent purchases of government bonds, according to Bloomberg, a news service. Similar lenders elsewhere have also been reported to the People’s Bank of China (PBoC), the country’s central bank, for using their own accounts to buy bonds on behalf of others. Rural banks have been instructed to stick to their main business of lending to local enterprises, rather than to the central government.
The measures are part of an attempt by the central bank to stem a relentless rally in the government’s bonds. Earlier this month yields dropped below 2.1% on ten-year securities, down from almost 2.6% at the start of the year. The causes are clear: China’s economy has slowed, borrowers have retreated and inflation has vanished. Nonetheless, officials have been warning since April that yields would not stay low for ever. In July the PBoC unveiled plans to sell government securities borrowed from other financial institutions if required. The central bank was, in other words, “preparing to short its own government’s bonds”, as Adam Wolfe of Absolute Strategy Research, a consultancy, put it. In the end, the bank left the vigilantism to other members of its posse. On August 5th state-owned banks sold bonds heavily, driving the price down and the yield back up a notch.
Most analysts assume they were acting at the instigation of the PBoC. Pan Gongsheng, its governor, has portrayed the buying and selling of government bonds as one of several necessary reforms to its monetary-policy apparatus. Even by the standards of a hands-on government, that apparatus has an extravagant number of knobs and dials (see diagram). The central bank sets a seven-day interest rate via reverse repos (buying securities from financial institutions that need cash with an agreement to sell them back seven days later). But it also provides a “medium-term lending facility” that offers one-year loans to banks each month. This heavily influences banks’ “loan-prime rates”, which are supposed to be the interest rate they charge their best customers.
Mr Pan would like to settle on a single policy rate, the seven-day reverse repo rate—in the process downplaying the role of the medium-term lending facility. He also wants to improve the “transmission” of changes in this policy rate to other prices and yields in the financial markets. To this end, he has narrowed the corridor within which short-term bank borrowing costs can fluctuate. The reduction in volatility should make it easier for futures markets to operate, according to Mr Wolfe. In other countries, financial markets map out an expected path for policy rates into the medium term. Therefore a central bank’s tweaks to a one-week rate is able to influence even distant maturities.
Yet, on the face of it, the central bank’s new eagerness to throw its weight around in the bond market contradicts its other reforms. Even as officials aspire to make the seven-day rate their principal policy lever, they are not content to let market forces set the price of other longer-term instruments. As a consequence, the PBoC evidently has a semi-official policy on the ten-year government-bond yield, too.
What explains the approach? There are three possible answers, each somewhat flawed in its reasoning. Mr Pan has said he is worried about a repeat on China’s shores of last year’s Silicon Valley Bank debacle in America. If financial institutions buy too many bonds, will they be able to withstand the losses when interest rates rise and bond prices drop? But the prospect of rate hikes in China is so distant that this danger seems remote. And the threat would be best resolved through bank regulation, not bond-market manipulation.
A second fear may be a weakening yuan. China’s interest rates are much lower than America’s, which is putting downward pressure on the country’s currency. PBoC policymakers may feel that the exchange rate is particularly sensitive to bond yields. That would help explain why it is clumsily propping them up, even as it tentatively brings interest rates down.
The central bank’s third fear may be flat, rather than low, yields. During the Bank of Japan’s long experiments in monetary easing, its policymakers worried that the yields on long-maturity bonds were falling into line with those on short maturities, rather than sitting comfortably above them. This flattening undermined the profitability of financial institutions that “lend long” and “borrow short”. The PBoC may be trying to avert a similar danger. Central banks should “maintain a normal upward-sloping yield curve”, Mr Pan said in a speech in June. But if the central bank wants financial institutions to profit from the yield on long-term bonds, why is it so worried about banks buying them?
In the long run, the best way to lift yields is to warm up the economy, which is likely to require more borrowing and spending from the central government. Its fiscal stimulus would be more powerful if the central bank supports spending with further interest-rate cuts. In other words, yields may have to fall before they can rise. If China’s government is to succeed in reflating the economy, the PBoC will need to act like an accomplice, not a vigilante. ■
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