Photographer: Zhang Peng/LightRocket via Getty Images

China's Central Bank Is Working Hard to Stand Still

  • PBOC using increasingly complex tools to manage money market
  • Market volatility shows effort isn’t always flawless

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While some of the biggest central banks are agonizing over changing direction, the People’s Bank of China is working hard to stay right where it is.

That’s because, as the U.S. Federal Reserve or the European Central Bank are heading into phases of tighter policy, China’s monetary authority is engaged in an increasingly complex effort to preserve the status quo while the world changes around it. According to 60 percent of economists in a Bloomberg survey conducted this month, the PBOC’s broad policy stance will remain "roughly the same" through the end of 2017. It’s how they maintain the hold, though, that matters.

Through the use of a wide range of monetary instruments, the PBOC is attempting to meet two seemingly conflicting goals at once -- weed out excessive borrowing in the financial system while ensuring credit to an economy that’s on a long-term slowdown. The need to maintain the balance is especially acute amid the political sensitivity around the approaching leadership transition of the 19th Party Congress in the fall.

"High leverage has put the central bank in a dilemma where easing could further expand the scale of debt and where tightening pushes up interest expenses and weighs on growth,” said Wen Bin, a researcher at China Minsheng Banking Corp. in Beijing. "The PBOC is using open-market monetary tools to stay flexible and strike a balance."

Achieving those aims, without a change in the benchmark lending rate, in practice means constant fine-tuning of daily conditions in the inter-bank money market. Over the past year, the PBOC has poked and prodded traders using an array of lending and cash-absorbing instruments of different maturities. Here’s that process in charts:

Using different tenors to inject and withdraw funds from markets is the practical aspect of the PBOC’s stated policy of keeping liquidity "neither tight nor loose." Yet at the same time, for much of the past year, gradually-rising interbank rates have been desirable amid a push to stabilize debt -- crimping incentives to lend short-term within the financial system, while remaining wary of choking off credit to the real economy.

The PBOC’s preference for longer-dated tools such as 28-day reverse repo has raised borrowing costs. Now, as the economy may be set for deceleration in the second half of the year and some progress in debt reduction has been achieved, use of longer-dated repurchase agreements has been pared back.

That management process isn’t perfect though, especially as the PBOC doesn’t often spell out what it’s trying to do. Last week investors were left scratching their heads over whether a data error in a closely-watched interbank benchmark rate -- the one-week weighted average -- was just that, or a hidden policy signal.

Read more about China’s interbank market mixup here

In the old days when China ran a big trade surplus, the government used to spend large amounts of cash trying to keep the currency from appreciating. The PBOC thus accumulated a huge pile of outstanding funds for foreign exchange -- the main component of China’s base money.

Read more about China’s $5 Trillion Balance Sheet

Now, with the trade surplus declining and the yuan becoming more flexible, the PBOC’s injections in interbank markets are growing in importance as a contributor to base money. That has to some extent exacerbated the volatility of funding costs for small banks and non-banking institutions, who don’t have direct access to the central bank for liquidity, but have to borrow from bigger commercial banks at a higher cost.

While not directly addressing that issue, the PBOC said earlier this month that it would "enrich" the maturities of the reverse repurchase agreements that it uses to keep funding stable. That means that, barring an external shock or an unexpectedly sharp deceleration in the domestic economy, the PBOC will seek to keep tinkering with its monetary toolbox rather than take any bigger steps.

The PBOC will improve the "flexibility and delicacy" of its liquidity management in the open market in the future, said Ming Ming, Beijing-based head of fixed-income research at Citic Securities Co. and a former PBOC official. "Market liquidity levels in the second half will become more stable with less volatility." 

— With assistance by Yinan Zhao, Cynthia Li, Sirui Ma, and Robin Ganguly

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