China's scarcity of low-risk assets hinders the central bank’s treasury bond market plans

A scarcity of low-risk assets in China's financial industry is impeding the central bank's plans to expand its monetary policy arsenal by returning to the government bond market after a 17-year absence. Following a mandate from President Xi Jinping's speech in October 2023, the People's Bank of China (PBOC) has committed to restoring treasury bond trading to fix its increasingly weak monetary policy transmission mechanisms.

The PBOC's bond trading effort aims to strengthen the bond market by increasing liquidity and decreasing volatility. This approach aims to attract additional issuers and investors, allowing businesses and other entities to lessen their reliance on inefficient bank loans. However, in the past, the central government has used riskier local government issuers to fund investment projects, resulting in unsustainable debts while maintaining a light balance sheet. As a result, there are currently insufficient liquid benchmarks to support a vibrant bond market.

"Using treasury bond trading as the main market operation tool would greatly improve the PBOC's monetary policy framework, especially interest rate transmission," said a policy consultant who requested to remain anonymous owing to the sensitive nature of the subject. "But the conditions are not right. We have an asset famine."

The PBOC did not immediately respond to a request for comment. In a statement to Reuters on May 8, it stated that bond trading "can be used as a liquidity management method and a reserve of monetary policy tools," highlighting that the trade would be "two-way."

Distortions in the Chinese bond market were underlined last week with the release of the first batch of ultra-long government notes this year, where prices jumped 20 per cent on illiquid platforms, pushing yields below central bank policy rates and causing trading suspensions. More issuance is anticipated through November, totalling 1 trillion yuan ($138 billion), or approximately 0.8 per cent of GDP.

In April, state media quoted an unidentified central bank official as saying that government bond issuance needed to be large and consistent to avoid significant interest rate fluctuation. The prevalence of credit in the Chinese economy, which is primarily controlled by state institutions, has generated worries about capital misallocation. Repeated rate cuts and liquidity injections by the central bank have failed to alleviate deflationary concerns.

Analysts point out that cheap finance continues to flow to state-owned enterprises with large production capabilities, regardless of project quality, whilst private firms receive less favourable loan conditions due to perceived increased risks. According to the central bank, significant amounts of money sit idle in the financial sector rather than moving into the real economy.

The analysts at Rhodium Group pointed out that "what corporates in China seem to be doing is taking cheap 2-3 per cent bank loans and channelling the money back into banks' wealth management products, long-term time deposits, or other investment products." According to China bond data, Chinese businesses are the world's second-largest bond issuers after the United States, with bonds worth approximately 106 trillion yuan, accounting for 84 per cent of GDP. This includes roughly 30 trillion yuan in treasury bonds, which are typically issued by local governments and policy banks and held by banks until they mature.

The PBOC last purchased bonds in 2007 to form the sovereign wealth fund China Investment Corp. Its current holdings are 1.52 trillion yuan or around 3.5 per cent of its total assets. Low turnover makes it difficult to use these holdings to increase liquidity in secondary markets and effectively manage the yield curve. Selling could raise yields, tightening financial conditions amid a hard 5 per cent growth objective, whilst purchasing could push yields too low and deepen the already negative 200 basis point spread with US benchmarks, creating capital outflow concerns, and depressing the yuan currency.

To proceed, the PBOC may need to wait for more issues to enter the market, limit its purchases to tiny amounts, and carefully time any purchases to prevent impressions of deficit monetisation. Shuang Ding, Standard Chartered's head economist for Greater China and North Asia, predicts the PBOC would "initially buy a small amount, and trade both ways." He points out that it will take a "relatively long period" for PBOC trading to "serve as a tool to inject liquidity."

Ting Lu, Nomura's senior China economist, believes the PBOC will launch bond trading "perhaps within the next six months, though the timing is highly uncertain." He suggests that the PBOC might choose a period of volatile interbank rates to stabilise the market.

(With inputs from Reuters)