How the transformation of Chinese monetary policy could hamper money supply growth
PBOC's efforts to increase liquidity by overhauling monetary policy implementation may have had the opposite effect.
The Chinese central bank is undertaking an overhaul of the way it conducts monetary policy, by adjusting its open market operations to more closely resemble those of the US Fed.
The People's Bank of China (PBOC) – which is the Chinese central bank, plans to gradually step up its purchases of government debt, in a move that could dramatically swell the size of its balance sheet.
Beijing hopes the shift will improve the ability of PBOC to inject liquidity, and timed it to coincide with the issuance of trillions in ultra-long treasuries that will overcome an "asset drought" in the market.
The plan may have had the unintended consequence, however, of temporarily undermining PBOC's ability to deal with faltering growth in the money supply, by shifting investor expectations of treasury price movements.
How China plans to transform monetary policy
Open market operations (OMO) are the specific area where the Chinese central bank is adjusting its implementation of monetary policy.
The shift will see PBOC gradually increase the outright purchase and sale of Chinese treasuries to adjust levels of liquidity in the financial system.
This will bring China's OMO more in line with the way the US Federal Reserve pursues its monetary policy goals.
Standard practice for the Fed at present is to first set a target for the federal funds rate, which influences other short-term and long-term interest rates.
The New York Fed then trades government treasuries with primary dealer financial institutions, in order to adjust the supply of liquidity so that the target rate is achieved.
At present, PBOC's OMO involves the use of 7-day reverse repos and medium-term lending facilities (MLF), which are essentially collateralised loans to Chinese primary dealers that expand liquidity in the financial system.
Instead of setting a target rate for short-term interbank lending, PBOC employs a more elaborate system for signalling its interest rate objectives.
PBOC first sets interest rates for the 7-day reverse repos and MLFs that it uses to channel liquidity into the banking system. The Chinese central bank refers to these as its "policy rates."
The policy rates in turn influence the loan prime rates (LPR) that PBOC has designated as the key benchmark rates.
The LPR are not set at the full discretion of policymakers, but are derived from interest rate quotes provided by a cohort of China's leading commercial banks.
While PBOC's OMOs involve the use of treasuries as collateral, they are not considered outright trading of government debt by the central bank itself.
"In recent years, China's central bank has widely used treasuries as collateral for monetary policy, as well as cooperated with the Ministry of Finance (MOF) in undertaking support operations for treasuries," writes Wen Bin (温彬), chief economist at China Minsheng Bank.
Wen points out, however, that PBOC's balance sheet indicates its holdings of treasuries remain comparatively low.
They hit a peak of over 1.6 trillion yuan at the end of 2007, but fell below that threshold by the end of 2009, and have held steady ever since at around 1.52 trillion yuan.
Most of these are special treasuries that were issued in 2007, and rolled over in 2017 and 2022.
The new form of OMO could see PBOC's balance sheet expand considerably, once it purchases increasingly large volumes of Chinese treasuries to inject liquidity.
Why is China changing its monetary policy practices?
Domestic observers say the changes to the implementation of monetary policy are intended to improve PBOC's ability to make liquidity adjustments, as China grapples with synchronous challenges of regional deleveraging, an ailing housing market and uncertainty surrounding growth.
"The widespread market discussion of the central bank's increase in the trading of treasuries is primarily focused on the extremely critical crossroads of China's economic recovery," Wen Bin writes.
"This includes the dissolution of real estate and local government debt risk, increasing the propensity of households to consume, and raising the confidence of enterprises to invest.
"The trading of treasuries by China's central bank is a standard monetary policy tool for the adjustment of liquidity."
Miao Yanliang (缪延亮), executive director of the research department of China International Capital Corporation (CICC), said the trading of treasuries by PBOC offers a range of advantages compared to current OMO.
In an essay entitled "Is the Chinese central bank's purchase of treasuries quantitative easing?" (我国央行购买国债是量化宽松吗), Miao writes that "compared to current OMO tools, the purchase and sale of treasuries by the central bank provides more direct and effective adjustment of market rates, and reduces the time lag and disruptions of quantitative operations.
"It raises the transmission effects of monetary policy, establishing more effective interest rate control mechanisms and providing more vigorous support for efforts to drive the marketisation of rates."
Miao further points out that the policy rates of 7-day reverse repos and MLFs restrict their use as frequently applied liquidity management tools.
"Treasuries are a more flexible trading target for controlling short-term interest rates," Miao writes.
Ultra-long treasuries overcome asset drought
While China may be overhauling its OMO to become more in line with the practices of the US Fed, its monetary policy system remains highly distinct in one key regard.
In China, the central bank and the finance ministry both subordinate to the State Council - the country’s highest government authority. This grants final control of monetary policy and fiscal policy to a single government entity.
The arrangement distinguishes China from most other major economies, which keep monetary and fiscal policy largely segregated by conferring the central bank with a high degree of independence.
Central bank independence is designed to prevent political parties from exploiting its powers of money creation to pump up the economy in the run-up to elections, which can have severe inflationary consequences further down the road.
Given the dominance of the Communist Party in China, rigging of the money supply for political ends is not a concern for PBOC.
Chinese authorities instead frequently stress the need to effectively coordinate monetary and fiscal policy, in order better achieve macroeconomic outcomes.
The ability of the Chinese government to do this is embodied by the timing of PBOC's monetary policy overhaul to coincide with plans by MOF to issue trillions of yuan in ultra-long-term treasures over the upcoming several years.
The two moves are mutually complementary, and would appear to embody the advantages of keeping monetary and fiscal policy under one roof.
On the one hand, the issuance of trillions in ultra-long treasuries will create the necessary conditions for PBOC to transition to the new form of monetary policy execution.
The large-scale issuance will help to overcome an "asset drought" that observers say is stifling growth in liquidity and economic recovery, by creating an ample pool of secure assets that PBOC can use as the basis for transactions.
On the other hand, PBOC's willingness to trade treasuries will create the liquidity conditions that will facilitate their purchase by Chinese financial institutions.
This will expedite the provision of capital for the ambitious fiscal stimulus plans that MOF hopes to fund via the copious issue of ultra-long treasuries.
At first blush, this would appear to be a more efficient procedure when compared to the lack of synchronisation found in the macroeconomic policy implementation of other economies, where the central bank and finance ministry can often be at odds.
Unfortunately for China, however, this form of coordination may have temporarily undermined the ability of macroeconomic decision-makers to achieve intended policy outcomes.
Instead of adding a powerful new channel for PBOC to expand liquidity, it has potentially undermined the central bank’s ability to boost the money supply just at a time when its growth is on the wane.
M2 growth at historic lows
Growth in the money supply and declines in interest rates normally go hand in hand, as the mutually accompanying outcomes of expansionary monetary policy.
Since the start of the year growth in China's money supply has waned, however, even as interest rates across multiple tenors have held steady or come under pressure.
Figures from the central bank indicate that in April the M1 money supply fell 1.4% in year-on-year terms, while growth in the broad M2 money hovered around historic lows at 7.2%.
This decline arrived despite the one-year LPR holding steady at 3.45%, and the five-year LPR falling 25 basis points to 3.95% in February.
Chinese policymakers have also signalled plans to reduce interest rates via loosening measures or the application of window guidance. On 17 May, for example, PBOC announced the removal of the floor on mortgage rates.
One reason why money supply growth has eased so much despite an accommodating interest rate environment lies in the strong performance of the Chinese bond market.
Bond prices have been robust in 2024, with PBOC arguing that yields have remained weak due to expectations surrounding long-term growth and inflation, alongside China's aforementioned scarcity of secure assets.
As of the end of the first quarter, 10-year treasury yields had fallen to 2.29% from 2.56% at the start of the year. 30-year treasury yields had fallen to 2.46% from 2.84%.
As of 30 May, China's 10-year treasury yields edged lower to 2.28%, for a decline of 27.27 basis points year-to-date.
Interest rates and bond prices move inversely, so weakness in the yield environment means a rise in bond prices. This increases the appeal of any assets backed by fixed-income securities, such as certain types of wealth management products (WMPs).
On 30 May, PBOC's Financial News (金融时报) reported that growth in the M2 money supply balance had fallen as a result of a shift in preferences towards long treasuries.
According to the report, investors were buying up WMPs backed by bonds, leading to a depletion of bank deposits and a weakening of growth in the money supply.
"As bond prices rise higher, the yields for related WMPs increase," said Zhang Yuru (张瑜如), chief macroeconomic analyst at Huachuang Securities.
"It's quite obvious that the demand deposits of enterprises have 'moved house' into WMPs, and growth of the money supply in April slowed as a consequence."
Treasury purchases could undermine money supply
While China's macroeconomic stewards tout their license to coordinate monetary and fiscal policy, their plans to time the overhaul in OMO with ultra-long treasury issuance may have compounded prevailing problems with growth in the money supply.
Some observers argue that the low yields and high prices for Chinese treasuries are primarily due to supply and demand relations, with demand for longer-term bonds rising just as supply remains constricted.
While the mass issuance of ultra-long treasuries would at first blush appear to remedy this issue, the accompanying overhaul of Chinese central bank monetary policy may have negated the impacts of this expansion in supply.
This is because institutional investors now expect the changes to OMO to result in PBOC buying up government debt to increase liquidity and spur China's economic growth.
For this reason, ultra-long treasuries have been in hot demand ever since their debut issuance in May, according to a report from Securities Journal.
On 22 May, when ultra-long special treasuries made their market debut, trading activity was so frenetic that it triggered two temporary suspensions. Multiple banks have also reported that ultra-long treasuries rapidly sold out to retail investors as soon as they became available.
Strong demand for long treasuries could heighten the appeal of bond-backed WMPs, and contribute to further declines in the money supply due to deposit reductions.
This may have left PBOC trapped between the horns of a dilemma, where its newly adopted OMO model could prove to be of no avail.
While buying treasuries should be the key channel for releasing liquidity, under current circumstances it could further undermine the money supply by providing support to bond prices and improving the appeal of deposit-sapping WMPs.
"At present, even though the long-term rate for treasuries has already reached an extremely low level, if the central bank were to purchase a large volume of treasuries to continue to supplement liquidity, it would only exacerbate the asset drought," Wen Bin writes.
How PBOC is dealing with the problem
PBOC is making haste to deal with this issue, lest the contraction in money supply growth undermines efforts to keep borrowing costs low.
It's done so, however, by signalling the possibility of selling off treasuries - a move that would normally sap liquidity by absorbing it from financial institutions.
"If bank deposits flow in large volumes towards the debt market, and demand for risk-free assets further increases, PBOC should when necessary sell off treasuries," the Chinese central bank declared in an opinion piece published on 30 May titled "Why are long-term treasuries so hot? Experts warn: we should focus on risk" (长期国债这么火？专家提醒：应重视风险).
While such sales would normally absorb liquidity, PBOC's goal here may be to shore up liquidity, by increasing the supply of treasuries and reducing their prices. This would make bond-backed WMPs less appealing, and forestall the exodus of investors away from deposits.
Some analysts believe that PBOC may be able to pull off the feat of selling treasuries without shrinking liquidity, thanks to the broad range of tools that it retains at its disposal.
PBOC makes extensive recourse to the use of structured instruments to steer funds to designated areas, while also reserving the ability to apply window guidance to the largely state-owned banking sector.
This provides it with the means to make supplementary liquidity injections, in order to compensate for the absorption of base money resulting from treasury sales.
"When the central bank considers selling treasuries under necessary conditions, for example when deposits pour into the bond market, this can absorb a portion of liquidity," said Liu Tao (刘涛), deputy head of the Guangkai Shouxi Industrial Research Institute.
"The use of re-loans and other methods to provide loanable funds at reduced costs to banks can avoid a reduction in the ability of banks to make loans.
"The goal of this would be to strengthen the ability of banks to service the real economy."