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China's Monetary Policy And The Bond Market


- China's monetary policy is complicated but is moving toward using a market interest rate as a key instrument. This should make it easier to understand.

- A monetary policy that is more interest rate based would mean that bond yields become important for passing on policy changes to financial conditions and the real economy.

- Government bonds already respond quickly to changes in market expectations about monetary policy. For a given surprise move in the one-year swap rate, bond yields move one quarter to half as much in the same direction. The effect is weaker at longer maturities.

- We expect China's short-term de facto policy rates to be kept low to offset other deleveraging policies and stop financial conditions from tightening too much. This will help keep a lid on government bond yields.

Feb. 22 2019 — As China opens up its bond market, it is moving gradually toward using a market interest rate as a key instrument in its monetary policy. This should mean that bond yields become more important for financial conditions and growth in China and, over time, other parts of Asia-Pacific. S&P Global Economics has examined how changes in market expectations about China's monetary policy affect government bond yields across its domestic yield curve.

Understanding these effects is important for the outlook as policymakers balance efforts to lower financial stability risks with economic growth. Already, monetary policy has been kept supportive to partially offset the impact of tightening elsewhere, especially in financial sector regulation and supervision, housing policies, and local government financing. While deleveraging may have paused following the sharper-than-expected slowdown in recent months, we do not expect a reversal. This means that there is little room to tighten monetary policy even if the government tolerates slower growth this year. With easy monetary policy helping to cap bond yields, this should help prevent an overtightening of financial conditions.

China's Monetary Policy Is Complicated

The first challenge in working out what China's monetary policy means for bond yields is its complexity. It is hard to understand how it works. The reasons for this are profound and they reflect China's unique history. The reasons also suggest that change will only be gradual.

First, as International Monetary Fund authors have noted, China's central bank, the People's Bank of China (PBOC), has not yet achieved full operational independence. Many decisions are still taken at higher levels and reflect a broad range of stakeholders.(1) Second, banks, especially state-owned banks, still dominate the financial system. In the past, banks took direct instructions from policymakers. The legacy of providing "window guidance" persists today. Third, financial markets are still maturing in China, which means that a truly market-based and transparent monetary policy can evolve only gradually.

Multiple objectives of monetary policy…

China's complicated monetary policy is also explained by the many objectives that have been set for the PBOC. Like all central banks, the PBOC cares about growth and inflation. However, PBOC monetary policy also seems to have many other objectives, which vary in importance according to the circumstances at the time.

Among these multiple objectives are the exchange rate, credit growth, and financial stability. It does not stop there. We can add to the list supporting certain activities, including banking recapitalizations and low-income housing. The PBOC also tweaks policy to ease funding for smaller banks and improve financial conditions for small and midsized enterprises. Other central banks have taken on more objectives since the global financial crisis, especially maintaining financial stability, but the PBOC's list is still longer than most.

…have encouraged a large but complicated toolbox…

It is not a surprise, then, that the PBOC has accumulated a large and unwieldy toolbox over the years. As its objectives have grown, it has added new tools without explicitly retiring old ones. Counting the number of tools is not easy but, even if we exclude prudential tools, we get to a number around 20.(2) These include foreign exchange reserves, required reserves, open market operations, and various interest rates and administrative measures. The U.S. Federal Reserve, in contrast, uses five to six tools although definitions may vary. (3)

…and cloudy communication

The PBOC's communication is "evolving," according to a recent paper by IMF authors, as a result of its many objectives and other constraints. Aside from the sometimes vague language used by the central bank, market participants may find it hard to interpret how the PBOC is changing its policies in part because it has so many moving parts. Easing here (for example, reducing required reserves) may be offset by tightening there (for example, by mopping up the resulting liquidity with open market operations).

Moving Toward Interest Rate-Based Policy

Despite all this complexity, PBOC Governor Yi Gang in a speech recently confirmed what was becoming increasingly clear: the PBOC is moving toward a market interest rate-based monetary policy.(4) He also suggested that quantity-based tools (such as required reserve ratios, or RRRs) will not be discarded yet, so China will operate a hybrid system for a while longer.

There are limits to a hybrid strategy though, and this provides clues on what we should be focusing on. Take as an example changes in RRRs. When the PBOC cuts the RRR, it will increase the excess reserves of banks. Banks can opt to earn interest at the excess reserve rate of 0.7% or lend to other banks and financial institutions for a short period, say seven days, at 2.5%. If the banks' demand for funds has not changed, however, the interbank rate will fall because supply has risen. The PBOC now has a choice--let the interbank rate decline or absorb the additional liquidity, offset the RRR cut, and keep the interbank rate stable.

Our view is that the PBOC increasingly wants to control interest rates rather than quantities. Quantitative tools, such as RRR, are being used more to re-distribute liquidity across the financial system and less to change the broad stance of monetary policy.

China's Interest Rate Corridor

Governor Yi indicated that the PBOC is following a conventional path for interest rate-based policy. The PBOC, like other central banks, now operates a "corridor system," which helps it to manage the level of the interest rate it uses to conduct monetary policy.

Chart 1: China's Monetary Policy Interest Rate Corridor

Note: The PBOC reverse repo seven-day rate is the implied interest rate from operations in which the PBOC purchases collateral eligible debt instruments from interbank market participants and sells it back to the market seven days later (liquidity injection). Source: People's Bank of China, CEIC, and S&P Global Economics.

The PBOC has emphasized that it is trying to target the seven-day repurchase (repo) rate for depositary institutions (or DR007 for short). This is the rate at which banks lend to each other over periods of seven days and is similar to the fed funds rate in the U.S. DR007 fluctuates in a corridor in which the floor is the rate paid on bank's excess reserves held at the central bank. The ceiling is the rate at which banks can borrow from the PBOC through the standing lending facility (SLF). The PBOC uses open market operations, including regular injections and withdrawals of liquidity, to help keep DR007 close to the middle of this corridor.

For the broader financial system, including non-banks, funding costs are reflected by the seven-day repo rate. This market-determined rate closely follows DR007, which indicates that banks are able to arbitrage between the two.

A Trilemma--Less Exchange Rate, More Interest Rate-Based Policy

This policy shift has implications for the trilemma--the impossibility of having interest rate control, exchange rate control, and capital mobility all at the same time. China's policymakers will most likely continue to actively manage where they are in the trilemma, based on the circumstance they face. In other words, we'll see partial control of all three. Still, we sense a gradual and structural shift away from the exchange rate and toward interest rates as the key price target for policy.

Indeed, Governor Yi also reiterated the importance of a flexible exchange rate, albeit flexibility with limits. We can already see the results of this change in monetary policy management in the shifting relative volatility of short-term interest rates (lower) and the renminbi's value versus the dollar (higher). This indicates that the PBOC is exerting less control over the bilateral exchange rate and more control over the repo rate. This is consistent with moves to a more interest rate-based monetary policy.

Chart 2: Comparing The Volatility Of The Exchange Rate And Repo Interest Rates

Note: The dots get larger and lighter in color the more recent the observation. Volatility in annualized terms. Source: S&P Global Economics.

Benchmark Lending Rate Is Becoming Less Relevant

Governor Yi did not mention the benchmark lending rate once in his recent remarks. This rate, which used to be an important tool before lending rates were (formally) liberalized in 2013, has been de-emphasized by the PBOC more recently. The PBOC has kept it unchanged since late 2015 and banks' actual lending rates are increasingly diverging from this benchmark, suggesting that it has become less important for the actual pricing of loans.

Chart 3: Benchmark And Effective Lending Rates

Source: PBOC, CEIC, and S&P Global Economics.

Market Expectations Of China's De Facto Policy Rate In Swaps

China's de facto policy rate, the DR007, is very short term, typical of most central banks. We can obtain an estimate of how the market expects this policy rate to evolve in the future by using interest rate swaps. One of the most heavily traded swap rates is the one-year rate for which the floating leg is priced off the average fixing of the seven-day repo rate. Average nominal principal during 2018 was about 380 billion renminbi, almost twice the level for the next most popular one-year swap based on the three-month Shanghai Interbank Offer Rate (SHIBOR). As Chart 1 showed, repo closely tracks DR007.

We would loosely interpret the swap rate as the market's estimate of the average level of the de facto policy rate over the next 12 months.(5) The two rates move together but since 2015, the swap rate has started to move a little ahead of the repo rate (see chart 4). In part, this may be because banks and investors are now expressing their policy rate views more actively in the swaps market.(6)

Chart 4: Seven-day Repo Rate And The One-Year Swap Rate

Source: CEIC and S&P Global Economics.

Swap Rates Help Price The Yield Curve

Swap rates should affect government bond yields at maturities all along the curve. Banks and investors will compare the swap rate to other market yields of similar maturities and credit risk when deciding on their asset allocation.(7) There may be some slight premium for swaps over Chinese government bond (CGB) yields of the same maturity due to counterparty risk but, over time, we do see a fairly close relationship between swaps and CGB yields.

So now we have a relationship linking the PBOC's de facto policy rate, the DR007, to long-term CGB yields through swap rates. For investors in more mature bond markets, none of this would be too surprising, but for China, this is all quite new.

Chart 5: Swap Rate And CGB Bond Yields

Source: CEIC and S&P Global Economics.


Monetary Policy Expectations And CGB Yields

A natural question to ask, then, is: What would happen to the CGB 10-year yield if the market suddenly expects the PBOC to keep the repo rate higher by 25 basis points over the next 12 months? Our aim is to focus specifically on monetary policy rather than other factors that could change bond yields. Market interest rates can change for many reasons, not just changing views of monetary policy.

Correlations cannot help us answer this question because they measure how interest rates and yields move together on average. For example, correlations suggest that swap rates and bond yields tend to move in the same direction. This does not tell us anything about the impact of monetary policy on yields.

Chart 6: Correlation Of Swap Rates, Bond Yields, And Equity Prices In China

Source: S&P Global Economics.

Note: Calculated using daily changes in swap rates, bond yields, and log equity prices since 4Q 2009.

We therefore consider only the days when swap rates rise and the equity market falls (or vice versa) (see table 1). This combination of events is unlikely to result from news about the economy, which lifts rates and expectations of firms' earnings (and equity prices) at the same time.(8) Instead, it more likely reflects expectations of higher interest rates alone, which means a higher discount rate for future equity market dividends and, potentially, lower economic growth and earnings.

Table 1  |  Download Table
Changes In Policy Expectations—Rates And Equities Move In Opposite Directions
Expectations for monetary policy:
Financial variable Looser Tighter
One-year swap rate Lower Higher
Equity market price Higher Lower
10-year CGB yield ? ?

Surprise Swap Rate Changes Shift The Entire Yield Curve

We estimate the impact on CGB yields using daily data starting in September 2010, when daily swap rates began to be published. Our model allows for the swap rate, equity market, and bond yield to all influence each other. Technical details are provided in the Appendix.

Our results suggest the bond market is already sensitive to changes in monetary policy expectations. An unexpected rise in the swap rate of five basis points (which is roughly a one standard deviation change) on days in which equity prices decline increases one-year, three-year, five-year, and 10-year bond yields by about 3, 2, 1½, and 1 basis points, respectively. The larger the change in swap yields, the larger the change in CGB yields. Chart 7 shows these effects after five days, after which the impact starts to wane substantially. As we might expect, yields move in the same direction as the swap rate but the impact is less the further along we go on the yield curve. In other words, a hawkish monetary policy surprise flattens the curve and a dovish surprise steepens the curve.

Chart 7: Impact Of A Surprise Rise In One-Year Swap Rate On The Yield Curve (Five-days)

Source: S&P Global Economics.

Note: Cumulative impulse responses to a one standard deviation shock to the swap rate calculated from sign-restricted Bayesian vector autoregression (VAR) models. Each bond yield response calculated from a separate 3-variable VAR, including the change in the swap rate, the log change in the equity market, and the change in the bond yield. The swap rate is the mean impulse response from all models.

What This Analysis Means For The Outlook

Our view remains that the Chinese government is trying to reduce financial stability risks over the medium term. Policymakers have made efforts mainly on three fronts. First, tightening financial sector regulation and supervision or macro-prudential policies. Second, imposing more controls on how local governments raise financing and how they spend. This is fiscal policy, broadly defined. Third, cooling demand for real estate through administrative housing policies at the local level. There have been other efforts, such as implementing supply-side reforms and encouraging state-owned enterprises to reduce leverage, but the first three are the most important at the macro level.

China Has Little Room To Tighten Monetary Policy Anytime Soon

Policymakers have also kept monetary policy fairly loose to offset some of this tightening and prevent growth from slowing too quickly. There are questions about how effective monetary policy can be in this cycle--we will not discuss that here. What is clear, though, is that if policymakers retain the current deleveraging strategy, which keeps macroprudential, fiscal, and housing policies tight all at the same time, China has very little room to tighten monetary policy even if the government tolerates slower growth this year. In turn, this means that the de facto policy rate, DR007, will be kept low, probably close to or even below current levels for at least the next 12-18 months.

Easy Monetary Policy Should Help Cap CGB Yields For Some Time

We believe the market has already priced in an accommodative monetary policy. Expectations of monetary policy tightening that built up in 2017 have unwound with the swap rate falling to about 2.5% from over 4% (close to current repo rate levels).

Low money market interest rates should help cap bond yields and stop financial conditions from tightening too much. As the swap rate fell by over 150 basis points, so the 10-year CGB yield has declined by about 100 basis points after peaking at about 4% in early 2018. This is important for financial conditions by setting the benchmark yield against which other borrowers, including local governments, can price their issuance.

We do not rule out higher bond yields--longer-term yields do not just reflect monetary policy but also factors such as U.S. Treasury yields and risk aversion. Capital flows and pressures on the currency also play a part. However, in our baseline, we do not expect monetary policy surprises from the PBOC to push bond yields too much higher over the next 12-18 months. This will be an important part of policymakers' difficult task to balance deleveraging and growth.