(Bloomberg) -- The People’s Bank of China tightened its grip on interest rates, introducing a new mechanism to influence short-term borrowing costs as policymakers expand their toolkit to guide markets.
The central bank’s move to conduct new bond repurchase or reverse repo operations effectively narrows the corridor within which short-term rates can fluctuate. That will strengthen market expectations for the seven-day repurchase rate to become the new benchmark.
Pan Gongsheng, governor of the PBOC, has been taking greater control of market liquidity and borrowing costs across the yield curve this year. On top of signaling the bank’s preference for a single short-term rate, policymakers have flagged that the PBOC is preparing to cool a bond rally by selling longer-term securities that have soared amid booming demand for haven assets.
“This will give the PBOC more control over short-term rates and create greater flexibility to manage fluctuations in liquidity,” said Duncan Wrigley, chief China economist at Pantheon Macroeconomics. “If selling bonds results in overly tight short-term liquidity, the PBOC now has new tools to manage that, to prevent a liquidity crunch.”
The PBOC’s latest policy move helped push up benchmark 10-year bond yields to their highest since May on Monday.
President Xi Jinping’s economic officials are trying to balance bolstering growth with keeping the yuan stable, amid higher interest rates overseas and a property crisis at home that’s dragging on domestic demand. Trade tensions with the US and Europe are also blemishing the prospects of a manufacturing industry that’s overall been a bright spot this year.
The central bank will conduct bond repurchase operations between 4 p.m. and 4:20 p.m. on weekdays as needed, in addition to its traditional morning operations, according to a Monday statement. The term of the ad hoc repos and reverse repos will be overnight, and rates will be set at 20 basis points below and 50 basis points above the seven-day reverse repo rate, respectively.
The move is aimed at “ensuring reasonable and sufficient liquidity in the banking system, and to improve the precision and effectiveness of open market operations,” the PBOC said, without adding when operations would begin or their frequency.
The central bank didn’t announce that it had taken any additional market operations on Monday afternoon.
Such a move would narrow China’s interest rate corridor from about 230 basis points previously to 70 basis points now, said Becky Liu, head of China macro strategy at Standard Chartered.
“It will lead to a reduction of interbank rate volatility,” Liu said. With lower volatility, the seven-day reverse repo rate “will be used more widely as a benchmark reference rate across most assets and liability pricing across deposit rates and loan rates.”
Moves to refine the technical tools available to the PBOC might give the bank more flexibility, but won’t necessarily help answer some of the big questions that confront Chinese policymakers right now — like whether credit can prop up the economy when households and companies aren’t eager to take on more debt, or how to ease borrowing costs without weakening the yuan.
The latest announcement comes days after the PBOC revealed it had readied “hundreds of billions” of yuan of medium- and long-term bonds to borrow. That was taken as a clear sign officials are contemplating selling securities to stop longer-term bond yields from falling.
China’s sovereign bonds have surged this year on the back of the country’s gloomy economic outlook and expectations for interest rate cuts. The lack of attractive alternatives and a switch out of savings to financial investments has fanned demand. This led to a series of warnings from the PBOC on the risks of a bond bubble, particularly in longer-dated debt.
The new corridor around the seven-day reverse repo rate could signal a push to also tighten control on the other end of the yield curve, according to Bloomberg Intelligence.
“With the PBOC also set to control the longer-end of the curve via Treasury bond trading, China might be essentially adopting yield-curve control,” BI analysts Stephen Chiu and Jason Lee wrote in a note. “Future rate cuts could be done via the seven-day reverse repo first.”
That could also signal a move away from one of the bank’s headline instruments: the one-year policy loans known as the medium-term lending facility. Since it was introduced a decade ago, the MLF has become a major channel for the central bank to inject money into the economy and guide market rates.
But in recent months, banks’ demand for these funds has languished as it became cheaper for them to borrow from each other. The interest rate on the MLF has been held steady for 10 months, even as other borrowing costs in the economy plunged.
“Credit supply has become very volatile and sometimes was negative,” said Zhou Hao, chief economist at Guotai Junan International. The new operations show “the PBOC wants to keep a firm corridor for the cost of funds to deliver its policy credibility.”
--With assistance from Felix Tam, Cormac Mullen, Tania Chen and Helen Sun.
(Updates with bond market movements, and other details throughout.)
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