China’s central bank chief hinted at a blueprint for a new toolkit that could open the door to its biggest policy overhaul in years, as officials try to bolster growth in the world’s No 2 economy.

Pan Gongsheng, governor of the People’s Bank of China (PBOC), gave the clearest signal yet that the authority may start trading government bonds in the secondary market, during a speech in Shanghai on Wednesday. That shift has the potential to rewire how the central bank injects money into the economy and regulate liquidity.

Pan also hinted at interest-rate reform, signaling the bank will consider moving to using a single short-term rate to guide markets. That could reduce the importance of the current one-year policy rate known as the medium-term lending facility (MLF), introduced a decade ago.

The PBOC is also considering narrowing the interest rate corridor within which market rates are allowed to fluctuate, to signal a clearer policy target, he added.

“This clearly indicates a reform in monetary policy objectives and instruments over the next few years,” said Xing Zhaopeng, a senior China strategist at Australia & New Zealand Banking Group Ltd. It would be the “biggest reform” since 2014, he added, referring to when the MLF was introduced to funnel money to commercial and policy banks.

Any changes will take time and have gradual impact on the markets, Xing said in a report, noting the need for China’s interest-rate system to be more based on market forces rather than determined by authorities.

China’s 10-year government bond yield inched up slightly as Pan spoke, before heading back down to close two basis points lower at 2.24% in the afternoon. The offshore yuan was little changed at 7.28 per dollar.

Bond trading would give the PBOC a new tool that’s seen as more effective in managing liquidity than current instruments, because it impacts a broader swathe of market participants. It would also bolster the bank’s ability to help the government raise money to fund investment and other spending to support the economy.

That’s needed now more than ever as local authorities’ finances become increasingly strained, crimping their ability to help an economy challenged by deflation and a property downturn.

Over the past decade, the PBOC has mainly injected money into the economy by lowering the amount of cash it requires banks to keep in reserve. With that ratio approaching the implied 5% minimum level, as policymakers try to maintain ample liquidity to encourage lending, the central bank has growing reason to find fresh tools.

The PBOC last revamped its interest rate framework in 2019, introducing the de facto benchmark lending rate, or the loan prime rate (LPR), to make lending rates more market-driven.

Pan didn’t clarify whether the PBOC would introduce a new short-term rate, but said a daily tool that allows banks to borrow against their bond holdings - known as the seven-day reverse repo - was already “basically shouldering this role”.

A shift to prioritizing that more agile rate over the MLF “would allow them to more directly influence short-term market rates,” according to Zhou Hao, the chief economist of Guotai Junan International.

“The PBOC seems focused on using a range of operational tools to fine-tune monetary conditions, while avoiding the perception of aggressive easing that could fuel inflation or financial stability risks,” Zhou said.

The PBOC chief also said the monetary authority, along with the finance ministry, was studying how to implement government bond trading, noting it would be a gradual process. He sought to dispel the idea the central bank was embarking on massive stimulus.

“Including government bond buying and selling into the monetary policy toolbox doesn’t mean we’ll do quantitative easing (QE),” said Pan, referring to the once-unorthodox central bank policy of buying government bonds to stimulate the economy.

The remarks come as expectations are growing for the PBOC to start purchases and sales of government bonds, after comments by President Xi Jinping made public this year called for such a tool to regulate liquidity. However, there have been few details on how this may be done and when it may begin.

In addition, a months-long bull run in government bonds also dented any need for immediate central bank bond buying. The PBOC has issued repeated warnings against the bond rally over financial risk concerns, and a newspaper it manages said the monetary authority could step in to sell bonds if demand for the haven assets continues to rise.

In another sign of the PBOC’s unease with the bond bull run, Pan said the central bank is monitoring bond investments by non-bank financial institutions closely as those who hold large amounts of medium- to long-term bonds could face interest-rate risks. Central banks should learn a lesson from the collapse of the Silicon Valley Bank, and correct any pile-up of financial market risks in a timely fashion, he said.

Many economists argued China wouldn’t embark on QE in the short term, as interest rates are still well above zero and market demand for government bonds is strong.

“It is encouraging for the PBOC to bring forth the discussion of sovereign bond trading. QE or not, the potential participation of PBOC is likely to improve market liquidity,” said Wee Khoon Chong, a senior Asia-Pacific strategist at BNY Mellon in Hong Kong.

Pan signaled there is more room to ease monetary policy as other economies are pivoting to cut rates this year. The appreciation momentum of the dollar is weakening, which will help keep the yuan stable and expand the room for China’s monetary policy, he said.

He also fueled speculations the LPR will be lowered in coming months by saying that some banks’ quotes of the rate significantly deviated from the actual best lending rate they offer to clients. The PBOC will work to improve the quality of such quotes to better reflect the lending market’s rate levels, he said.

  - Bloomberg