(Bloomberg) -- China has initiated stress tests with financial institutions on their bond investments, to make sure they can handle any market volatility should a record-breaking rally reverse, according to state-run media.
The People’s Bank of China has made a gradual start to the tests recently, wary that a bull run might lead to one-sided bets in long-term government bonds, according to a front-page report by Financial News. Its intention may not necessarily be to significantly push yields higher, the central bank-backed newspaper said citing an unidentified source.
Financial institutions should be able to cope with large drops in bond prices, as crowded holdings in debt positions could easily turn into a “stampede” in the event of a sharp yield reversal, Financial News said. That can raise the likelihood of a liquidity crisis and threaten financial stability, it added.
Investors should buckle up for continued heightened volatility in China bonds during the stress tests engineered by the authorities, said Zhaopeng Xing, senior strategist at Australia & New Zealand Banking Group. The PBOC will also seek a balance between its measures against one-way speculative bets and its mission to provide liquidity support for the economy, he added.
A stellar rally in Chinese bonds has stalled amid measures to cool sentiment including having state banks sell some bonds and gathering financial institutions for meetings. That has triggered a collapse in government bond trading as investors consider the regulatory moves.
In Monday’s operation, the central bank kept its policy loan rate on hold while draining a net 101 billion yuan ($14 billion) from the banking system, a move that will help keep excessive liquidity contained and help arrest the bond rally.
China’s 10-year government bond yields were little changed at 2.15%, compared with its record low at about 2.12% touched earlier this month.
Read: PBOC Holds Policy Rate Steady After Warning on Bond Rally (2)
Over the weekend, Bloomberg reported that the central bank did not seek to nor will it seek to ban legitimate investments or trading in its government bonds. However, it sees risks in a buying spree of the securities and believes persistent slide in long-term yields is not sustainable, people familiar with the PBOC’s thinking said.
By doing the tests, the authorities want to see if banks can handle drastic market swings in hypothetical and extreme conditions with their current holdings of assets, Financial News said. In the case of the bond market, officials may want to see how banks can react if yields surge by 10, 20 or even 50 basis points in a sudden move, it added.
Financial risks in key areas are being resolved in an orderly manner, PBOC Governor Pan Gongsheng said in an interview with state broadcaster China Central Television that aired Saturday. China will adhere to a supportive monetary policy stance and promote credit growth and gradual decline funding costs, he added.
“It is good that the PBOC is being more transparent about its policy intention to avoid market confusion,” said Xiaojia Zhi, an economist at Credit Agricole in Hong Kong. Meanwhile, a potential US interest-rate cut and reduced pressures on the yuan would also provide more room for the PBOC to further ease its monetary policy, she added.
(Update with comments, PBOC MLF operation)
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