For China's money supply managers, cutting interest rates and bank required reserve ratios (RRR) is risky and over-reliance on short-term reserve repos is unsustainable, but the secondary bond market may finally be available for use as more flexible tool for liquidity management.
People's Bank of China (PBOC) Governor Zhou Xiaochuan told reporters last week that "all tools must be made available" to control money supply, in response to questions as to whether he preferred open money market operations to changes to interest rates and reserve requirement ratios, as recent PBOC behaviour suggests.
Bond trading in the secondary market is a common tool used by other central banks to manage money supply, but a combination of an overabundance of inbound foreign currency flows and an underdeveloped bond market has kept China from using this option itself. That situation has changed, but so far the PBOC has contented itself with reverse bond repurchase agreements, which inject money into the banking system for a period of only one or two weeks.
Data shows that the central bank may also have intensified its usage of refinancing tools - such as direct lending to commercial banks and "rediscounting" short-term debt - to help add medium-term liquidity. Such short-term injections have the advantage of maintaining short-term liquidity without encouraging a long-term liquidity wave that might distort investment behaviour, but their surge-in, surge-out nature keeps market participants jumpy and erodes long-term base money, traders say.
Historically, the PBOC has not regularly traded in the secondary spot bond market to adjust money supply, but traders told Reuters that is likely to change, because bonds have significant advantages over other tools. The primary advantage of bonds is their timing flexibility: A one-year bond can be bought and held until maturity, or bought one day and sold the next, depending on needs, and the same goes for a 10-year bond.
For the last decade, Chinese central bankers have been kept busy buying up the massive foreign exchange flows into the country to slow the yuan's appreciation, and the result of this process automatically injected yuan base money. Once the money was injected, the PBOC then "sterilised" part of it by issuing longer-term bills, which drained liquidity and prevented runaway inflation.
But a narrowing trade surplus, a global flight to dollars and concern about the sharp slowdown of China's economy have all conspired to ease the flow of foreign exchange into the country, relieving a source of inflationary pressure but also a source of base liquidity. PBOC data has showed signs of capital outflows since late last year, as shrinking external demand weighs on export growth and as foreign direct investment slows, meaning the PBOC no longer needs to buy so many dollars to prevent the yuan's rise.