China's central bank resorts to bond market coercion

Marketisation and monetary policy reforms could suffer as a consequence.

The Chinese central bank has shown no hesitation in applying coercive pressure to bond market players, after prices went awry in response to Beijing’s flagging of loose monetary policy next year.

It recently summoned major institutional players to lecture them on their "radical trades," in a bid to lighten up long-term yields.

PBOC takes bond investors to task

On the morning of 18 December, the People's Bank of China (PBOC) - being the Chinese central bank - held a meeting with financial institutions that it deemed to have engaged in irresponsible trading during the latest round of bond market activity.

China's bond market has seen long-term yields fall to recent record lows, after the Central Economic Work Meeting in mid-December signalled that it could loosen monetary policy to levels last seen immediately after the Global Financial Crisis (GFC).

Yields on 10-year treasury bonds fell from 2% to less than 1.8% within days, closely chasing the 1.7% threshold. Yields for 30-year treasuries also sank to close to 2%.

At the meeting, PBOC warned financial institutions to be on guard against interest rate risk, and the possibility that their bond holdings could shrink in value if rates were to rise or hold firm instead of decline.

Treasury futures all posted declines in afternoon trading on the same day, with futures for 30-year treasuries seeing the biggest fall.

At close of trading, 30-year treasury contracts had fallen 0.44%, while 10-year contracts had declined 0.10% and 5-year contracts 0.02%.

Why PBOC is intervening in the bond market

PBOC's intervention in the bond market is intended to stymie further declines in yields.

"The fall in bond yields has been excessively fast of late," said Zhang Xu (张旭), chief economist at Everbright Securities, to state-owned media.

Zhang believes China's commercial banks bear much of the blame for swift squeeze on bond yields.

According to Zhang, banks are struggling to boost profits via new loans, because Chinese authorities have brought lending rates down in a bid to spark economic activity.

This has prompted some Chinese banks to chase profits on the bond market, instead of making loans for productive activity.

China's lending drive has undesirable outcomes

While Chinese authorities hoped to support economic activity by putting pressure on lending rates, its actions may have had the opposite effect.

Zhang points out that incentivising banks to bet on bonds instead of extending loans reduces their support for the real economy.

He further notes, however, that any near-term improvement to China's economic metrics could put the kibosh on further rate cuts, which would be unfavourable for bond holders.

The active fiscal policy promised by Beijing could also counteract the impact of loose monetary policy, and have an adverse effect on the Chinese bond market.

Moral suasion could undermine China’s reform agenda

In official boilerplate, China’s policy helmsmen continuously pay lip service to the need for reforms that lead to better “marketisation” of the financial system.

This comes from a place of genuine intent, following four decades of reform and liberalisation that have provided them with first-hand evidence of the heightened efficacy of market-based systems.

Ad hoc interventions by PBOC for reasons of short-term expediency could undermine such reform efforts, however, by weakening confidence and trust in the market amongst its key players.

A central plank of China’s ongoing financial reforms, for example, is to move towards global best practices when it comes to monetary policy and interest rate adjustments.

This involves the central bank first making direct adjustments to its official short-term rate, before they are transmitted to interest rates of all tenors across the financial system.

Under ideal conditions, the market’s collective deliberations should lead to prices that result in an optimal allocation of funds.

PBOC’s discretionary application of pressure to select bond investors could severely undermine the effectiveness of this pricing mechanism, by warping market expectations and creating apprehension over government interventions.