China’s Central Bank Faces Crucial Test in Managing Bond Market Rally Amid Economic Concerns

People's Bank of China

The People’s Bank of China confronts challenges in curbing financial stability risks posed by a rising bond market, balancing economic support with financial stability. Learn more about the ongoing situation and its implications.

China’s central bank is facing a significant challenge in managing the financial stability risks associated with a rallying bond market, which contradicts its view of the economy by suggesting a long-term outlook of soft growth and low inflation.

The People’s Bank of China (PBOC) has pledged to include treasury bond trading in its monetary policy toolkit and has issued repeated warnings against the dropping yields in long-dated government bonds, but these warnings have not reversed the trend.

The pressure is mounting on the PBOC to follow through with its statements, potentially ending a 17-year absence from the bond market by selling bonds. Due to its limited resources, some traders and investors speculate that the PBOC might even short-trade treasuries by borrowing to sell.

The central bank finds itself in a difficult position. Selling bonds would withdraw liquidity from the system at a time when most analysts believe the economy needs more support to achieve China’s 2024 growth target of around 5%. However, doing nothing implies tolerating the risk it identified, mainly that regional banks’ appetite for long-dated bonds could lead to a collapse similar to the Silicon Valley Bank in the United States last year when the market turned. Analysts also point out that the PBOC is concerned lower yields may increase selling pressure on the yuan and cause capital flight.

This situation highlights the challenges Chinese policymakers face in maintaining ambitious growth targets and financial stability after decades of debt-fueled expansion.

“Individual bond investment decisions collectively translate into risks for the central bank’s dual mandate of supporting the economy and heading off financial risks,” said Xia Haojie, analyst at Guosen Futures. “A laissez-faire approach could lead to systemic risk.”

The PBOC did not immediately respond to a request for comment.

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 similar levels.

Market expectations of PBOC bond trading have drastically shifted within less than three months. When an October 2023 speech by President Xi Jinping instructing the PBOC to gradually increase treasury trading surfaced in late March, it sparked speculation of Federal Reserve-style quantitative easing. Later, the PBOC clarified that trading goes both ways. Soon after, it expressed concern over falling yields, drawing comparisons with the Silicon Valley Bank. Its latest warning came in a May 30 statement to Reuters, saying it will “sell bonds when necessary,” its strongest language so far.

A subsequent rise in yields was short-lived, suggesting markets are testing whether the PBOC is serious about its warnings.

After all, the PBOC holds only 1.52 trillion yuan ($210 billion) worth of bonds, about 5% of the treasury bonds in circulation and 1.4% of all the local bond holdings worth $14.6 trillion by Chinese entities.

“Fighting bond investors is an unenviable task,” said a bond fund manager, requesting anonymity due to the topic’s sensitivity. “I hope the central bank starts selling bonds soon because if its credibility crumbles, it would be costly to rebuild,” he said, adding that the PBOC could also short-trade the bonds.

Multiple factors drive the appetite for long-term government bonds. Concerns over deflation and uneven growth push investors towards safer assets, while 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, which channel money into bonds. Regional banks face weak loan demand in sluggish small-city economies, leaving them few choices but to increase bond holdings and expose themselves to market turnaround risks.

“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.

Hu argues the bond rally could reverse if global demand for Chinese goods weakens, prompting more forceful 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 that bond yields “fully reflect fundamentals” and in a fragile economy, they can only “gravitate downwards.” Peng suggests PBOC action could cause short-term volatility at most.

“Any corrections in bond prices can actually be a good buying opportunity,” he said.

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