DDN Business Insider | PBOC's operation of govt bonds borrowing: What changes will financial market face?

Editor's note: The People's Bank of China (PBOC) announced last week that it would borrow government bonds from some primary dealers in open market operations. How should we interpret the purpose of PBOC's announcement? What impact will it have on the bond market? How should we understand the impact of the central bank's series of operations on government bonds? Read on for the full scripts of our latest edition of DDN Business Insider.

【Anchor】Hello everyone, welcome to DDN Business Insider. I am Yunfei Zhang. The People's Bank of China (PBOC) announced last week that to "maintain the stable operation of the bond market" and "based on prudent observation and evaluations of current market situations", it would borrow government bonds from some primary dealers in open market operations. Regarding this topic, we have invited Liu Tao, vice president of Guangzhou Development Chief Economist Research Center, and Hu Dinghe, member of the China Economic and Social Council and editor of the Tsinghua Financial Review to bring their comments and analysis. Hello!

As the PBOC announces to intervene in government bond trade, the medium to long bond rates rise. First of all, Mr. Liu, how should we interpret the purpose of PBOC's announcement?

【Liu】On July 1st, PBOC announced plans to conduct government bond intervention operations with primary dealers. The central bank's purpose is very clear: it is to prepare for directly selling these bonds in the secondary market. From a practical point of view, the move to intervene in the government bonds itself already sends an unequivocal political signal to the market. That is to say, after the announcement, the government bond yields are bound to experience a significant jump.

【Anchor】Mr. Liu, what do you think will be the next step after the central bank borrows government bonds? What impact will it have on the bond market?

【Liu】In theory, after the PBOC gets involved in government bond borrowing, the next step is to buy and sell these bonds in the secondary market. Through these interventions, the central bank can regulate government bond yields and prices, and also further adjust the money supply and the level of interest rates according to market demand, supply and liquidity conditions.

Of course, the intervention's actual impact on the bond market depends on the size of PBOC's bond sales and whether this operation is temporary, targeting specific objectives or will become a regular operation. Generally speaking, central bank purchases of government bonds have two different applications. First, is buying directly in the primary market, and second, is buying in the secondary market. According to the Law of the People's Republic of China, the PBOC is not allowed to buy government bonds in the primary market, but it has never been restricted from buying and selling government bonds in the secondary market. In essence, the central bank's trading of government bonds in the secondary market is part of its open market operations.

It is quite similar to common open market operations, such as repurchase agreements, spot trading, and the issuance of central bank bills. Once government bond trading is included in the monetary policy toolbox and thanks to the diverse maturity structure of government bonds, long-term bond trading can help to address the short-term limitations of spot trading and central bank bills. Thus allowing a flexible mix of long, medium, and short-term instruments to jointly create a suitable liquidity environment.

【Anchor】Alright. Mr. Hu, how should we understand the impact of the central bank's series of operations on government bonds?

【Hu】On July 1st, PBOC decided to launch government bond intervening operations to primary dealers in the open market

This is indeed a prudent decision made by the central bank based on its observation and assessment of the current market situation.

The announcement will affect the supply and demand in the bond market, which in turn will influence interest rate trends and prevent the medium- and long-term bond interest rates from deviating too much from the dynamic level. It also stated that the central bank will not solely buy bonds, but will also sell bonds, and adjust the market expectation through selling bonds. The goal of the PBOC's operation is to maintain the long-term stability of the government bond market and to avoid the potential risks caused by short-term sharp and irrational fluctuations in the market. In March 2023, the aggressive interest rate hikes by the Feds led to a wave of bank fa, including the Silicon Valley Bank, as a result of the maturity and structural mismatch of some banks' assets.

Meanwhile, the governor of PBOC, Pan Gongshengannounced on the Lujiazui Forum this year on June 19th and 20th that PBOC will include government bond trading in the secondary market in its monetary policy toolbox. The purpose is to correct the accumulation of blocking risk, to maintain a normal upward sloping bond yield curve, and to maintain the market's positive incentives for investment. This is conducive to the long-term stability of the government bond market and the national economy.

【Anchor】Alright. At the same time, we also find that the government bond borrowing operation is different from previous models such as repo and bill swap. It is a newly created monetary policy tool by the central bank. Mr. Liu, why do you think the central bank chose to create this new tool at this time?

【Liu】PBOC's announcement of intervening in the government bond and preparing to buy and sell in the secondary market at this time is related to the issuance of 1 trillion yuan ultra-long special government bonds this year.

Additionally, the announcement is also related to the recent continuous decline in ultra-long-term bond yields. This is also a good time to announce to mitigate long-term interest rate risk. Finally, the announcement may also be considered in coordination with a series of reforms such as policy interest rate reform, monetary policy framework reform, etc.

【Anchor】Alright. While long-term government bond yields have continued to fall since the beginning of the year, there have been discussions in the market about interest rate risk. Mr. Liu, what do you think the risks are?

【Liu】PBOC's clear objective in conducting government bonds intervention at this time is to address the phenomenon in the bond market this year where certain financial institutions, such as insurance companies, rural commercial banks, etc., have been aggressively purchasing long-term government bonds. This has led to a continuous decline in the long-term government bond yield.

The announcement may bring a certain level of volatility to the bond market. Since the beginning of this year, the central bank has repeatedly warned the public of the risk of long-term bond interest rates. So the central bank's intervention in government bonds at this time will send a clear policy signal to the market. Subsequent open market operations will further affect the supply and demand of bonds in the secondary market and guide the market to rational expectations. This will help to prevent further escalation of interest rate risks on long-term bonds, and at the same time will facilitate the smooth issuance of ultra-long special treasury bonds.

【Anchor】Alright. Mr. Hu, what do you think?

【Hu】Since this year, due to hedging needs, some institutions and individuals have poured a significant amount of funds, even blindly, into long-term government bonds, leading to a sharp decline in long-term bond yields. The interest rate risk arising from this situation is that if China's economy and price levels rebound significantly in the future, capital will flow out of the bond market, causing a sharp rise in yields and a sharp fall in the price of medium and long-term government bonds. At that time, non-banking entities such as insurance companies and individuals who hold these bonds will suffer a large loss.

Therefore, on July 1, the PBOC introduced this new monetary policy tool, through government bond intervention. This operation serves as a communication with the market by way of warnings, signaling to reduce the current speculative sentiment of long-term government bonds. It is still uncertain of the duration and size of the subsequent intervention, and whether, when, and how much the bonds will ultimately be sold. But this announcement itself has already had a significant impact on the market price.

【Anchor】Alright. Does the central bank's operation mean that the current trend of the bond market will come to an end for the time being? Mr. Liu, what do you think about the next stage of the bond market?

【Liu】The central bank's intervention and trading of government bonds could indeed temporarily cool down the overheated bond market, prompting all parties involved to be more rational.

From the perspective of the Merrill Lynch Investment Clock, China's economy is now in steady recovery, and there may be a certain degree of volatility between the bond and equity markets. However, from the global perspective and a longer-term viewpoint, with the Fed's interest rate cut imminent, the depreciation of US dollar assets and the sharp appreciation of RMB assets are both highly probable events. There is also a clear trend of cross-border fund flows from the US back to emerging market countries such as China. Large amounts of foreign capital will flow into China's stock and bond markets, a trend that is already underway. With foreign investors investing in RMB assets with safety and growth, China will likely experience simultaneous       (in)flow in both the stocks and bonds market. Of course, the premise is that China's securities market reform accelerates, and the stock market and bond market regulation become more standardized, thereby significantly boosting investor confidence.

【Anchor】Okay. Mr. Hu, what do you think about the future of the bond market?

【Hu】I think the central bank's bond trading will have some impact on the interest rate pricing in the bond market, but it is not a decisive factor. In terms of the medium to long term, interest rates will still be decided by the changes in economic fundamentals. Changes in economic fundamentals are still the most important determinant of the level of the risk-free rate as well as the term premium. So I think the central bank's announcement is a short-term and tactical measure to address immediate issues. As for the actual cure, it depends on whether the fundamentals of China's economy will improve. And whether investors, institutional or individual, will have a wider range of choices rather than the single choice of long-term government bonds. For example, if the A-shares perform well and more high-quality companies are listed, including if some high-quality foreign stocks will choose to list here, similar to the U.S. stock market. This will give people more investment choices, which may be healthier for the bond market to move forward.

【Anchor】Alright. Mr. Liu, what do you think the central bank's concern about the bond market reveals?

【Liu】This trend is becoming more and more apparent in the recent series of strong regulatory initiatives. The central bank mentioned in both Q4 2023 and Q1 2024 China Monetary Policy Report that it aims to reasonably manage the relationship between bond and credit, the two largest financing markets, guide the reasonable growth of credit, balance funding allocation, maintain adequate liquidity, and match scale of social financing with expected goals of economic growth and inflation.

Therefore, I believe in addition to the short-term consideration of keeping the bond market stable and healthy and avoiding major ups and downs, the central bank's concern about the bond market and its timely action also involvesthe consideration of the overall economic operation. This includes preventing short-term overheating in the bond market, which may exacerbate deposits outflow, and lead to the continuous weakening of M1, M2, credit, social financing and other macro-financial indicators, and thus affect the medium-to-long-term stability of China's economy.

In addition to the central bank's trading of government bonds in the secondary market, the Governor of PBOC recently proposed to dilute the policy role of the MLF rate. Instead, they aim to have the 7-day reverse repo rate as the main policy rate, gradually smoothening the short-term and long-term transmission relationship. These actions fundamentally aim at bridging the boundaries between the money market, the credit market and the bond market. They seek to achieve a reasonable balance between the two largest financing markets, the bond market and the credit market, aligning the scale of strategic financing, monetary supply, with the projected goals of economic growth and debt level. In this way, China's economy and financial market will be promoted to a mature market-oriented market.

【Anchor】Alright. Mr. Hu, what do you think about this?

【Hu】The central bank's concern for the bond market not only reflects the importance it attaches to the stability of the financial market and the development of the economy, but also has a far-reaching and important impact on the overall economy through the operation of monetary policy, the prevention and control of financial risks, and the regulation of the housing market.

There are four aspects. First, the direction of monetary policy instruments. The bond market, especially the government bond market, is an important vehicle for the transmission of the central bank's monetary policy. Since the return on long-term government bonds is the benchmark for the return level of all financial commodities, the central bank, by adjusting interest rates and financing conditions in the bond market, can affect the cost of capital and liquidity conditions of the entire economy, which in turn affects investment, consumption and economic growth.

Secondly, it can promote a more stable and healthy development of the economy. The central bank influences the bond market through monetary policy operations, such as adjusting the deposit reserve ratio, open market operations, etc., thereby promoting the stable and healthy development of the economy. For example, this new policy tool, by maintaining a neutral monetary policy, is conducive to maintaining financial stability and preventing the economy from becoming overheated or overcooled, and will also have an impact on the bond market's issuance volume and financing conditions.

Third, it can strengthen the prevention and control of financial risks. The central bank's concern for the bond market is also reflected in the prevention and control of financial risks. By monitoring the operation of the bond market, the central bank can immediately detect or respond to potential financial risks. The central bank focuses on the bond market as well as other non-bank financial institutions. The purpose is to maintain the health and stability of the financial system, protect the interests of investors, and promote sustainable economic development. In addition, the central bank can also regulate the market. Through the bond market, the central bank can regulate the financing channels and credit risk of real estate enterprises, and thereby further influence the housing market. For example, it can establish a more diversified land supply and multi-channel security, promote a combined rental-and-ownership housing system, and encourage the development of professional and institutionalized housing enterprises. These measures will help stabilize the real estate market and promote the healthy development of the rental market.

【Anchor】All right, thank you to you all. That's all for this episode. Remember to follow us on YouTube or download our APP. I'm Yunfei Zhang, thanks for watching, and see you next time