MNI: PBOC Eyes CGB Selling To Curb Bull Bond Market

The People’s Bank of China is likely to sell some of its longer-term bond holdings to defuse a debt rally it sees as fuelling financial risk and to prompt more lending to the real economy, but China’s lack of creditworthy borrowers as its population ages and growth slows will continue to buoy safe assets over time, policy advisors and economists told MNI.

The central bank could sell CGBs to temper a rally which has seen the average yield for the 10-year bonds reach just 2.3% in May, lower than the PBOC’s 2.5% benchmark medium-term lending facility, according to Tan Xiaofen, professor at the School of Economics and Management of the China Aeronautical University. The PBOC is increasingly concerned that high levels of liquidity are stimulating bond-market leverage rather than the real economy, he said.

However, CGB yields are expected to remain level over the longer term, the economist said, pointing to falling capital returns and the ending the of demographic dividend.

STRATEGIC DEPARTURE

In the past when the PBOC considered that long-term interest rates have declined too rapidly, it has typically tightened liquidity via open market operations, so a switch to maintaining ample interbank liquidity while continuing to address uncomfortably low yields would represent a departure for the central bank.

The PBOC needs to continue to ensure ample liquidity to support additional issuance of CNY1 trillion in special treasuries in a bid to aid fiscal stimulus, said Liu Lei, senior fellow at the National Institution for Finance and Development at the China Association of Social Science. The central government has also set a more accommodative monetary-policy tone and any tightness will not be in line with that goal, he said. (See MNI: Chances Rise PBOC Cuts RRR As Gov Debt Issuance Increases)

Financial News, the central bank's official media, stated at the end of May the PBOC could sell government bonds should a large amount of bank deposits flow into the bond market. A separate article in mid-May stressed the Bank considered a 2.5-3% range a reasonable yield for long-term CGBs.

The 10-year yield typically reflects investors' expectations for economic growth and inflation, and the PBOC has warned since April that overly expensive long-term CGBs were not in line with recovering economic performance. (See MNI INTERVIEW: China Eyes Significant Special Treasury Issuance)

FINANCIAL STABILITY FOCUS

The PBOC is also concerned that small banks’ heavy exposure to long-duration bonds means they would be at risk of a liquidity crisis when long-term interest rates increase, said Liu Xiaochun, deputy director of think-tank Shanghai Finance Institute and former president of Zheshang Bank.

Small banks, which include city and rural institutions, previously heavily invested in property and local-government funding vehicles which are now unattractive with the property market in trouble, buy CGBs for higher yields when credit demand remains soft.

A Beijing bond trader told MNI the PBOC’s warning had made CGB investors more cautious, a significant gulf exists between market expectations for the 10-year yield of 2.2-2.4% and the PBOC’s preferred range.

Weak economic fundamentals, easing policies and a lack of good assets simply do not support high long-term yields, he said, though he pointed to CGB sales last month by large state-owned banks when returns of ten-year CGB dropped below 2.3%, as a potential indication that the central bank would not tolerate a yield below that level.

While liquidity is loose, asset shortages will continue and long-term CGBs will remain attractive even if the PBOC sells bonds, the bond trader continued, adding that tighter liquidity could shock the bond market and jeopardise market stability.

Zhu Zhenxin, chief economist at Asymptote Investment Institute, said weak demand, easing policies and real-estate sector deleveraging have decreased the availability of low-risk assets. The improving economy and higher inflation should put an end to the bond bull market, but yields will remain low, and volatility will increase, he predicted.

In order to support demand, authorities should further loosen rules on property purchases, accelerate special-treasury and policy-bank debt issuance to support fiscal stimulus and lending, while cutting the PBOC’s pledged supplementary lending rate, he said.