Courtesy of Also Sprach Analyst:
The People’s Bank of China (PBOC) may purchase government bonds in the future, according to a Yicai report yesterday.
The potential move to purchase government bonds in the secondary market, according to the report, will be used to inject liquidity into the banking system. The new move will be used to address the problem of capital outflow, which has become rather consistent of late. As trade surplus shrinks and capital inflow ceased, the old ways of liquidity creation through exchange rate intervention has stopped working, as we have explained for countless times. With slowing economy and increasing expectation of Chinese Yuan depreciation, the PBOC cannot hope that capital will start flowing in anytime soon.
The fact that the central bank may buy government bonds is not all that surprising, even though claims on government only accounts for a very small portion of PBOC’s balance sheet. Even in a non-QE world, major central banks use open market operations to control short-term interest rates by buying or selling government securities, although mainly in the short-end of the curve. Now as the liquidity creation mechanism through exchange rate intervention is not creating money (in fact, it might be destroying money), capital outflow will eventually shrink PBOC’s balance sheet by depleting the FX reserve (which is already happening, albeit still very slowly), as the PBOC seeks to prevent rapid depreciation of the currency. The PBOC can ease the liquidity pressure by cutting reserve requirement ratio (RRR), but one obviously can cut RRR to below zero.
The chart below from Dong Tao of Credit Suisse shows the composition of PBOC’s holding. Currently, PBOC only has about 5.4% of its assets in government’s debts.
Source: Credit Suisse
We believe that PBOC’s bond purchases will eventually be very likely should trade surplus falls, capital outflow continues, and the economy continues to slow. Bond purchases will create bank reserve, easing liquidity in the banking system. But as the experience in the US, UK and Japan shows, the size of excess reserve banks have has no close relationship between credit growth. Certainly, against the backdrop of continuous capital flow which eventually shrinks the balance sheet of PBOC (through shrinking foreign reserve), bond purchases in this environment is really the only way to maintain the size of PBOC’s balance sheet, such that liquidity is maintained. Indeed, we will not be surprised if the PBOC eventually buys just all assets imaginable in the event that the government is determined to stimulate growth.
However, as we mentioned quite a while ago, it would be quite impossible for PBOC to maintain exchange rate of Chinese Yuan unchanged with the US dollar while at the same time having independent monetary policy and free capital flow. In other words, if China is determined to maintain exchange rate stable amid depreciation pressure and capital outflow (while trade surplus remains weak), the PBOC will need to tighten monetary policy, not ease. If the PBOC needs to ease policy by buying government bonds, we believe that either China has to stop defending Chinese Yuan, so to speak, or China has to stop capital outflow (by whatever means).
Should the PBOC really buy government bonds against the backdrop of continuous capital outflow, we believe that although that could be positive for monetary condition, Chinese Yuan will very likely depreciate further.