China's central bank is facing a significant challenge in its efforts to mitigate financial stability risks amid a rising bond market. This situation contrasts with its economic outlook, which anticipates long-term soft growth and low inflation.
The People's Bank of China (PBOC), having pledged to include treasury bond trading in its monetary policy arsenal, has repeatedly warned against the falling yields in long-term government bonds but has yet to alter the trend.
The PBOC is under increasing pressure to act on its statements, potentially ending a 17-year hiatus from the bond market by selling bonds. Given its limited resources, some traders and investors speculate that the PBOC might even short-sell treasuries by borrowing.
However, the central bank finds itself in a dilemma.
Implementing such measures would reduce liquidity at a time when most analysts believe the economy needs more support to achieve China's 2024 growth target of around 5%. Conversely, inaction would imply accepting the risks it has identified, particularly that regional banks' preference for long-term bonds mirrors the type of trade that caused Silicon Valley Bank's collapse in the U.S. last year when the market shifted. Analysts also suggest that the PBOC is concerned that lower yields might increase selling pressure on the yuan and lead to capital flight.
This situation underscores the difficulty Chinese policymakers face in balancing ambitious growth targets with financial stability after decades of debt-driven expansion.
"A laissez-faire approach could lead to systemic risk."
Yields on ten- and thirty-year bonds have fallen 30-40 basis points from this year's highs to 2.30% and 2.53%, respectively. The PBOC's warnings against falling yields in recent months have coincided with these levels.
CRYING WOLF?
Market expectations of PBOC bond trading have shifted dramatically in less than three months.
An October 2023 speech by President Xi Jinping, instructing the PBOC to gradually increase treasury trading, surfaced in late March and sparked speculation of Federal Reserve-style quantitative easing. Later, the PBOC clarified that trading could go both ways. Soon after, it expressed concerns over falling yields, drawing comparisons with the Silicon Valley Bank collapse. Its latest warning, issued in a May 30 statement to Reuters, indicated it would "sell bonds when necessary," using its strongest language to date.
A subsequent rise in yields was short-lived, suggesting markets are testing whether the PBOC's warnings are genuine.
The PBOC holds only 1.52 trillion yuan ($210 billion) in bonds, about 5% of the treasury bonds in circulation and 1.4% of the total local bond holdings worth $14.6 trillion by Chinese entities.
"Fighting bond investors is an unenviable task," said a bond fund manager who requested anonymity due to the sensitivity of the topic. "I hope the central bank starts selling bonds soon, because if its credibility crumbles it would be costly to rebuild," he added, noting that the PBOC could also short-trade the bonds.
Analysts say the demand for long-term government bonds stems from various sources.
Concerns over deflation and uneven growth push investors towards safer assets. The property crisis and a crackdown on municipal debt limit investment alternatives.
"Protecting wealth should be prioritized over increasing wealth," said Li Zhao, head of investment at hedge fund house White Whale Investment.
Deposit rate cuts aimed at encouraging spending and borrowing are redirecting household and corporate savings into wealth management products that channel money into bonds.
Regional banks, facing weak demand for loans in sluggish small-city economies, have few options but to increase their bond holdings, exposing themselves to the risk of a market turnaround.
"The 4,000 or so small and medium-sized banks will be particularly vulnerable to interest rate risks," said Larry Hu, chief China economist at Macquarie.
WHAT GIVES
Hu argues that the bond rally could reverse if global demand for Chinese goods, which has sustained growth so far this year, weakens, prompting more aggressive fiscal stimulus and further debt issuance from Beijing. Strong stimulus could lift growth and inflation expectations, catching investors off guard.
However, Peng Chengjun, head of fixed income at Invesco Great Wall Fund Management, told investors on a roadshow that bond yields "fully reflect fundamentals" and in a fragile economy they can only "gravitate downwards."
Peng believes PBOC action could cause short-term volatility at most. "Any corrections in bond prices can actually be a good buying opportunity," he said.
Paraphrasing text from "Reuters" all rights reserved by the original author.
