Caixin Explains: Why and How China’s Overhauling Monetary Policy (Part 3)

China's central bank, the People's Bank of China (PBOC), is undergoing significant changes in its monetary policy management to align more closely with other major economies like the U.S. and the European Union. This transformation has been highlighted by Pan Gongsheng, the Governor of PBOC, who emphasized better market communication to enhance transparency and clearly direct policy expectations [para. 1][para. 2].

The reform includes three primary adjustments: moving away from quantitative targets to focus more on interest rates, simplifying the currently complex interest rate system possibly down to a single main policy rate, and introducing government bond trading in the secondary market as a new instrument for managing liquidity [para. 3]. Previously, the PBOC abstained from trading in the secondary market due to insufficient holdings of Chinese government bonds (CGBs) to influence the market significantly, but recent directives and market developments have changed this [para. 5][para. 7][para. 9].

This strategy aims to stabilize the main policy rate, the seven-day reverse repo rate, by controlling the base money supply, which includes commercial bank reserves and general currency circulation. To manage the short-term liquidity, PBOC employed daily open market operations (OMOs) and medium-term lending facilities (MLF) for longer-term adjustments [para. 5][para. 21]. Trading CGBs in the secondary market gives the central bank more flexibility to regulate liquidity beyond short- and medium-term loans, helping manage both liquidity and interest rate expectations [para. 21][para. 22].

By trading CGBs, the central bank can manipulate the yield curve, which represents borrowing costs over different periods and reflects future interest rate expectations. The goal is to ensure a "normal yield curve," where longer maturities yield higher returns, countering any abnormalities caused by market conditions like the bond bull run observed this year [para. 24][para. 25]. The PBOC initiated this by swapping short-term bonds for long-term ones, making a significant net purchase to influence long-term yields [para. 27].

Challenges remain regarding the adequacy of the PBOC's bond supply for effective management. Currently, it holds only 1.52 trillion yuan of CGBs, less than 5% of all outstanding CGBs, which analysts deem insufficient for substantial market influence. To overcome this, the PBOC plans to borrow bonds from primary dealers and diversify its tools for bond trading [para. 28][para. 29][para. 30]. Coordination with the Ministry of Finance on the issuance of varied maturity bonds is also crucial, with plans already set for a multi-year issuance of special treasury bonds [para. 31].

Communication and transparency are critical for the success of these policies. Governor Pan has stressed the need for clear and timely communication about policy decisions to market participants to stabilize expectations and enhance policy effectiveness [para. 36]. However, direct trading of government bonds can send mixed signals about monetary policy, adding complexity to the central bank's communication strategy [para. 34][para. 35].

In conclusion, the PBOC's overhaul aims at refining the interest rate system, stabilizing the main policy rate through expanded liquidity management tools, and enhancing market communication to ensure policy transparency and manage future expectations effectively [para. 38][para. 39][para. 40].