China’s circling of the wagons financial strategy
China’s bond market has been on a tear recently. Chinese banks, including both rural and city, along with the big national state banks, have been significantly increasing their purchases of central government bonds, leading to the rare event of 10-year and 30-year bonds trading below the central bank’s discount rate. The central government has even encouraged some banks to halt their bond purchases. Their stated reason, according to one PBOC official cited in the PBOC-backed Financial News, is that the unwinding of long dated bonds on bank balance sheets has the potential to cause a liquidity crisis among weaker banks, similar to the problems faced by the collapse of SVA Financial Group in the U.S. in 2023. Thus, Beijing is asking banks to stop buying bonds, or, in the unusual case of one bank, ordering it to halt trades before clearing.
However, the argument that liquidity risks will cause a banking crisis is weak. The banks are more tightly regulated than ten years ago. Then, during the heyday of shadow banking in China, there was legitimate cause for concern over highly liquid financial products that could (and often did) unwind in chaotic fashion. The regulators were playing catch-up in dealing with the sudden rise in bank assets, primarily among the weaker rural banks. That shadow liquidity no longer exists, and the regulators have a better understanding of bank balance sheets.
Instead, the real problem is that falling bond prices are signalling that asset deflation is discouraging investment and consumer expenditure. Banks don’t want to lend, companies don’t want to invest in a struggling economy, and consumers are hoarding cash as they watch their real estate decline in value and their job prospects dwindle.
At root, the bond-buying frenzy is the tail wagging the dog: the problem is not faulty regulation but how to stimulate the economy, and how to avoid a deflationary trap.
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