TOKYO – Has China’s Paul Volcker moment arrived?

Stock punters can’t help but wonder as the People’s Bank of China (PBOC) opts against refilling the proverbial monetary punchbowl, helping to send mainland shares sharply lower. It is also proving quite the contrast to a US Federal Reserve opening the liquidity tap ever wider.

For years now, observers wondered if the PBOC might emulate the hawkish policies of Volcker, who ran the Federal Reserve from 1979 to 1987 while keeping financial leverage on a very tight leash. Volcker’s policies, along with the hard-money ways of the Bundesbank of old, set the standard for monetary sobriety.

Now, there’s good reason to think PBOC Governor Yi Gang is reading more from the Volcker playbook than from those of Fed Chairman Jerome Powell or Bank of Japan Governor Haruhiko Kuroda.

Though Yi’s team hasn’t said that specifically, the 15% rout in Chinese stocks over the last month proves the point that Beijing will grit its teeth and tolerate the economic pain the West isn’t willing to endure.

Over the last year, President Xi Jinping has avoided the kinds of broad stimulus that characterized Washington’s Covid-19 rescue efforts. Japan, too, as Tokyo churned the equivalent of 40% of gross domestic product (GDP) of fiscal largesse into the economy. Governments throughout Asia also opened their wallets as rarely before.

As Xi’s team pursues a less stimulus-centric approach to the pandemic, Yi’s team appears to be putting pragmatism ahead of giving markets what they want.

Can it last? Only time will tell. But the volatility in mainland shares suggests punters are realizing 2015 was a long time ago.

Chinese economist, banker, reformist and bureaucrat Zhou Xiaochuan, now the retired 11th Governor of the People’s Bank of China. Photo: AFP/Chen Weisong/Imaginechina

Easy money past

In that year, before Yi assumed PBOC leadership, predecessor Zhou Xiaochuan led Beijing’s epic response to plunging share prices.

At the time, Team Xi pulled out all the stops: loosening leverage and reserve requirement protocols; turning off initial public offerings; halting trading in thousands of listed companies; allowing punters to put up apartments as collateral so they could buy shares; and urging average Chinese to buy the market out of misplaced patriotism.

Zhou’s team did its part by refilling the monetary punchbowl early, often and conspicuously, giving rise to the “PBOC put.”

The reference here is to how the Alan Greenspan Fed that succeeded Volcker’s and the Mario Draghi era at the European Central Bank – 2011 to 2019 – bailed out markets at the slightest hint of trouble.

For a time after the summer of 2015, when China’s benchmark CSI 300 Index plunged 30% in a matter of weeks, it seemed the PBOC would be an even bigger offender of easy-money strategies that warp market dynamics and investment incentives.

That was then. Now, PBOC decisions over the last year – and the last month, especially – suggest traders can’t rely on a “Yi put.”

That’s not to say PBOC policies have been ideal. Yi’s staff could be doing more to reduce financial leverage and police the US$10 trillion-plus shadow-banking system. The central bank could be acting faster to facilitate full convertibility for the yuan.

Even so, the PBOC isn’t likely to emerge from the Covid-19 era with the same baggage as the Fed, BOJ and ECB. All three of these monetary powers pushed crisis support into territory that many investors didn’t know existed, even after the 2008 global crisis.

Where’s the QE exit?

It was in the months after Wall Street’s near collapse that the Fed followed the BOJ down the quantitative easing path. So did the ECB, Bank of England, Reserve Bank of Australia and other major central banks. What none of these monetary powers figured out, though, was an exit strategy.

The BOJ tried in 2006, when it pulled off the first of two interest rate hikes. Within two weeks, officials in Tokyo were moving borrowing costs back to zero. By 2013, Kuroda was supersizing the BOJ’s QE by cornering the government bond market and supporting stocks with ginormous exchange-traded fund purchases. Hence the Nikkei 225 Average traded at 30-year highs – even as the pandemic fans deflation risks anew.

The Fed experienced a similar about-face. In late 2015, then-Fed chair Janet Yellen pulled off Washington’s first rate increase since 2006. Yet once then-US president Donald Trump hired Powell in February 2018, the Fed scurried back down the QE rabbit hole. Once the coronavirus arrived, the Fed went all-in on taming the bond market and boosting stocks.

By March 2020, the Fed’s balance sheet reached a Japan-like $5 trillion. That milestone told the story of global policymakers expanding mandates with each passing day. Valentijn van Nieuwenhuijzen, chief investment officer at NN Investment Partners, puts it well. “This was the kitchen sink thrown left, right and center from central banks across the globe,” he noted.

The US Treasury building in Washington, DC. Photo: AFP

US Treasuries? No thanks

Recent drama concerning US government bond auctions suggests all that sink-throwing is coming back to haunt markets. The fear is that, suddenly, too many Treasuries are hitting the market amid too few buyers. And that the supply-demand disconnect could pose major risks for makers in 2021 and beyond.

On Thursday, the US Treasury’s sale of seven-year notes drew tepid interest for the second month in a row. The bid-to-cover ratio, a key measure of demand, was below-average at 2.23 times, suggesting “the market is still nervous,” said strategist Gennadiy Goldberg at TD Securities.

“It was a reminder to the market,” Goldberg told Reuters, “that supply events are now risky.”

Part of Washington’s demand troubles are low US yields that investors worry don’t adequately cover the risks one takes as Washington’s debt burden tops $28 trillion. The 10-year US yields are just 1.62%, roughly half of the 3.21% that comparable Chinese bonds pay.

A key reason for the disparity is the tale of two central banks going in different directions.

On one side, you have Powell in Washington admitting the Fed will keep its foot on the accelerator until at least 2023. On the other, the PBOC is rationing the monetary booze.

Officials in Beijing, after all, still have 385 basis points of room to cut the one-year loan prime rate should fresh Covid-19 infection waves roll in.

Not a great scenario for short-term traders betting on China’s $16 trillion government market. But the PBOC’s conservatism during this period may pay dividends in the years ahead.

Chinese 100 yuan notes and US 100 dollar notes. International confidence is growing in China’s currency, but there is still work to be done. Photo: AFP/Nicolas Asfouri

Prudent PBOC

It’s an unappreciated component of Beijing’s efforts to cut leverage and limit “hot money” flows. That, and the PBOC’s tolerance – no doubt with Xi’s approval – of the yuan rising versus the US dollar.

Though PBOC “tapering” talk seems premature, odds are Beijing will be much quicker than Washington to normalize the interest rate landscape.

“China’s policy exit remains one of the most important uncertainties to its own recovery and financial markets ahead,” said economist Li-Gang Liu of Citigroup.

Yet trading in Shanghai and Shenzhen markets make for an intriguing microcosm of the PBOC’s challenge. Like most top indexes, the CSI 300 ended up rallying strongly in 2020 as central bank liquidity rushed into financial assets. By February 2021, the index was up 65% from its 2020 low, before it began to stumble last month.

Yi Gang, governor of the People’s Bank of China, is the financial world’s new ‘Mr Prudent.’ Photo: AFP/Sonny Tumbelaka

Jean-Louis Nakamura, chief Asia-region investment officer for Lombard Odier Darier Hentsch, speaks for many when he says “the prospects of tighter domestic macro policies” had the firm taking profits on China A-shares.

It’s a precarious balancing act, of course. Memories of 2015 are still fresh for investors and policymakers alike. That episode meant a summer of global discontent as China’s stumble shook markets everywhere.

The PBOC wants to avoid creating another global incident. Few risks could precipitate one faster than the second-biggest economy declaring “last call!” too soon. Yet as China’s Vocker moment arrives, it’s hard not to hope Powell’s team in Washington is paying close attention.