Finance

China Contemplates Embracing Bond Trading Tactics of Western Central Banks

An October speech by Chinese President Xi Jinping has recently been brought to light, hinting at the potential for significant shifts in China's monetary policy. The remarks, which were only publicized after featuring in a newly published book and a newspaper article, indicate that China may start trading government bonds as a measure to regulate market liquidity, aligning its strategies closer with those used by the Federal Reserve and other major global central banks.

The concept introduced by President Xi for the People's Bank of China (PBOC) to "gradually increase the buying and selling of government bonds" in its open market operations has sparked widespread speculation among investors and traders. The last notable government bond purchase in China occurred more than a decade ago, in 2007. This raised questions among market participants about the possibility of a new approach to liquidity.

Liu Lei, a researcher at the National Institution for Finance and Development, a respected state think tank, emphasized the importance of sovereign credit in the issuance of money by central banks across the world. He suggested that adopting this practice is a critical step for the modernization of China's central bank and monetary system.

Despite the recent buzz around these comments, some industry players initially thought Beijing might be weighing the option of quantitative easing (QE). QE, a controversial and unconventional form of stimulus, involves the purchase of government bonds and other assets to depress yields and stimulate economic activity. This methodology was pioneered by the Bank of Japan over 20 years ago and was later adopted by the Federal Reserve among other central banks after the global financial crisis and during the coronavirus pandemic.

China's economy has encountered numerous challenges recently, particularly in the property sector, triggering discussions on whether it would adopt radical policies for stabilization. Several strategies have already been implemented, such as targeted lending programs, which some analysts compare to QE because they expand the PBOC's balance sheet.

However, many economists are hesitant to classify President Xi's encouragement for bond trading as a groundbreaking shift in the nation’s financial policy. It is noteworthy that President Xi’s speech mentioned both buying and selling, a clear distinction from QE, which typically involves only the purchase and retention of assets, especially at a large scale. Interest rates in China remain noticeably higher than zero, leaving room for traditional interest rate policy maneuvers before requiring the adoption of emergency measures like QE.

Bloomberg News reached out to the PBOC for a comment on this subject but did not receive a response. The central bank has historically expressed skepticism towards QE; past governors have highlighted the potential hazards, such as distorted markets, devalued credibility of central banks, and the creation of moral hazards.

Nevertheless, the PBOC's cultivation of various mechanisms for injecting funds into the economy is well-recognized. Instruments like the monthly medium-term lending facility support commercial lending, while the possibility of reducing the cash reserves banks are mandated to maintain exists. Yet these methods are not without their flaws. The reserve requirement ratio has diminishing room for reduction. Loans necessitate renewal, and any miscalculation in liquidity demand forecasts could precipitate a severe cash squeeze.

Economists from UBS Group AG, Nina Zhang and Wang Tao, in a recent note, articulated the necessity of the PBOC having increased flexibility managing liquidity and more tools to broaden its balance sheet. Given the growth of the government bond market over time, more robust central bank bond trading has become both essential and possible, they added.

Even with the clear direction from China's most powerful individual, the exact timing for the adoption of bond trading remains uncertain. NIFD's Liu Lei suggests that we're still in the process of crafting the upcoming practices and that any actual implementation is likely to progress slowly. In contrast, Goldman Sachs Group Inc. economists anticipate the PBOC may initiate bond purchasing sooner, potentially within the current year. This action could ease the expected liquidity pressure from the planned issuance of 1 trillion yuan ($138 billion) worth of special sovereign debt in 2024.

The influence of increased bond purchases on Chinese yields is still under debate. Short-term yields would probably decrease, as posited by Philip Yin, a strategist at Citigroup Inc., who supposes that the central bank’s debt purchases would foster market confidence regarding liquidity and the absorption of future government bond supply. The long-term effects, however, are less predictable and could vary if China complements liquidity measures with further policies to solidify economic growth, potentially causing investors to divert their interests from safer assets to riskier alternatives.

No matter the direction taken by China, the significant attention garnered by Xi's comments is understandable. As demonstrated by the Bank of Japan's historical experience, once a central bank embarks on trading government bonds, the strategy can quickly gain momentum, sometimes blurring the lines between using purchases as a liquidity management tool and as a means of economic stimulation.

This intriguing development in China's monetary strategy leaves the global financial community attentively watching, as any significant moves by the world's second-largest economy will undoubtedly resonate throughout international markets.

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