China's Policy Balancing Act Faces Bumps as Bond Pain Swells

(Bloomberg) -- China's central bank faces a dilemma: Whether to raise borrowing costs and potentially undermine the nascent economic recovery, or hold firm and risk spurring capital outflows as Federal Reserve policy tightening cuts into the country's interest-rate advantage.

The People's Bank of China is trying to take the middle road, boosting money-market rates as a way of containing company leverage, while allowing bank borrowing to largely continue unchecked. At the same time, authorities have ramped up capital controls to quell outflows after the yuan's biggest annual decline in more than 20 years.

Policy makers have chosen a more cautious route after rate cuts in recent years inflated bubbles in stocks and property, according to Gao Yuwei, a researcher at the Bank of China Ltd.'s Institute of International Finance in Beijing.

“They want to be more steady and neutral, supporting the real economy without triggering more bubbles,” Gao said. “The PBOC needs to balance the short-term and long-term interest rates to achieve its goal of maintaining growth while deflating asset bubbles gradually.”

The central bank's pivot spurred a resumption of money flowing into the country and stability in the yuan this year, but it also hit the bond market. Increases in various short- and medium-term lending tools at the PBOC's disposal over the past month have sent three-month Shanghai interbank rates to the highest level relative to Libor in 21 months. That's crimped borrowing, with net financing for corporate debt negative for a second month in January, only the second time that has happened in 15 years, according to PBOC data.

The impact is already being seen. There have been six publicly-traded bond defaults in China this year, data compiled by Bloomberg show, with the yield demanded on AA rated, five-year company notes over sovereign debt recently swelling to the most since May. The uptick in money-market rates also helped drive a Bloomberg China government bond index lower for a fourth month, the longest losing streak in data going back to 2010.

Companies Wedged

While the economic rebound has gathered pace in recent months -- with data Wednesday showing an acceleration in manufacturing -- companies' inability to expand their borrowing or roll over existing debt is weighing on earnings and output, according to Haitong Securities Co. Industrial profits rose at the slowest pace in a year in December while factory production missed economist estimates.

“The costs of long-term sovereign bonds are already beyond what the economy can take,” Haitong strategists led by bond analyst Jiang Chao in Shanghai wrote in a recent report.

Though bond issuers are feeling the pain, the PBOC's approach will likely invigorate capital inflows, as the increase in money-market rates acts as a way for China's monetary policy to re-couple with the Fed's, according to Harrison Hu, Greater China economist at NatWest Markets in Singapore.

More Hikes

“We see another one to two hikes along with more efforts to reign in credit expansion,” Hu wrote in a report this week, referring to the rate on reverse-repurchase operations. “Though benchmark bank lending and deposit rates may be left unchanged.”

More details on economic objectives, such as the growth target, will be revealed in coming days as top leaders gather for the National People's Congress this weekend in Beijing. The PBOC has pledged to pursue what they describe as prudent and neutral monetary policy in 2017 as the bank works to contain the credit boom and curb risks to the economy.

For more on the forthcoming NPC and China's economic targets, click here.

Cheap cash prompted the surge in leverage last year. Bank of America Merrill Lynch's China Broad Market bond index climbed for 11 quarters to the end of September, a record rally, while overnight repurchase transactions climbed to an all-time high of 52 trillion yuan ($8 trillion) in August.

“The rampant carry trade and leveraged trade led to higher risks in the financial system,” prompting the PBOC's current course of action, said Wang Yifeng, an analyst at China Minsheng Banking Corp.'s research institute in Beijing. “When the domestic environment allows, the PBOC can give more considerations to external factors.”

--With assistance from Heng Xie Miao Han and Ran Li

To contact Bloomberg News staff for this story: Helen Sun in Shanghai at hsun30@bloomberg.net, Xize Kang in Beijing at xkang7@bloomberg.net.

To contact the editors responsible for this story: Richard Frost at rfrost4@bloomberg.net, Malcolm Scott at mscott23@bloomberg.net, Emma O'Brien, Robin Ganguly

With assistance from Helen Sun, Xize Kang