China’s interbank rates have continued to remain elevated for the third week in a row. Although the statement from the Monetary Policy Committee over the weekend suggests that the People’s Bank of China (PBoC) may need to “fine-tune” its monetary policy, on Monday the PBoC again warned the commercial banks that relief will not forthcoming and that they will need to manage well their liquidity conditions before the end of first half of the year. It appears the standoff between China’s commercial banks and the central bank will continue, and that elevated money market rates will persist for a while.

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Therefore, the natural questions are: ‘How long will this liquidity squeeze last?’; and ‘How will high interbank rates affect the real economy? says ANZ Research in a note out today’

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HOW LONG WILL THE LIQUIDITY SQUEEZE LAST?

As we approach the end of the first half of the year, we believe the following factors will tighten interbank liquidity conditions further in the coming weeks:

First, it appears maturing central bank bills and repos for July will be as big as CNY291bn, with most of which (RMB160bn) maturing in the middle of the month. Meanwhile, another RMB258bn of funds will mature in August. If the PBoC does not react to the currently very tight monetary conditions and continue to only issue a small amount of bills, the liquidity squeeze will not ease before the middle of July.

Second, commercial banks are facing the half-year evaluation of their loan to deposit ratio by the China Banking Regulatory Commission (CBRC). Traditionally we tend to see a volatile interbank rate leading into the end of the half-year. It is likely that the current liquidity squeeze will drive interbank rates even higher this week.

Third, the State Administration of Foreign Exchange (SAFE) issued a Notice on Strengthening the Management of Foreign Exchange Inflows on 5 May 2013. Under the new rule, banks are required to maintain a minimum net foreign exchange position based on a formula. In order to satisfy the required loan to deposit ratio in foreign assets, Chinese commercial banks are require to purchase foreign exchange up to USD150bn, which will further tighten their RMB-based balance sheets.

Fourth, the CBRC will also look into enforcing its No 8 document that was introduced in March. According to this new regulation, non-standard investments shouldn’t exceed 35% of a bank’s total issued wealth management products (WMPs) or 4% of the bank’s total assets at the end of the previous year. Non-standard investments include assets that aren’t traded on the inter-bank bond market or stock exchanges, such as trust loans, bills of exchange, accounts receivables and other credit products. While the banks have started to downsize these non-standard investments, they still need time to wait for these assets to mature. In the meantime they still need to finance them via WMPs or inter-bank borrowing. The market thus believes that many banks, especially medium and small banks, will have to borrow intensively to roll over the assets before the end of June.

Fifth, many of the wealth management products are due at the end of the month. Rating agency Fitch estimates that CNY1.5trn is due by the end of 30 June.

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All this suggests that the current tight liquidity conditions are going to last till past mid -July.

Contingent on PBoC’s future policy, the historically high interbank rate will continue to last for another two to three weeks. If this were to happen, we believe the risk increases of a disorderly deleveraging process in China’s financial markets, badly impacting real sectors of the economy.

HOW DID THE CURRENT LIQUIDITY SQUEEZE START?

It appears that overall credit conditions were relaxed until May. Total social financing, an aggregate measure of credit extended to the economy, increased by more than 50% from the year earlier. In addition, foreign assets held by financial institutions, a measure of capital inflow, went up by CNY1.58trn. It seems that the banking system is filled with abundant liquidity. So how did the liquidity squeeze come about?

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THE FOLLOWING FACTORS HAVE CONTRIBUTED TO THE CURRENT SITUATION

  • Seasonal and festival factors: As a rule, Chinese corporates need to submit tax payments for last year before the end of May, and the commercial banks tend to hoard cash before the holidays. However, liquidity conditions didn’t ease significantly after the Dragon Boat holidays (10-12 June) as has normally happened. In addition, it seems that the market believes that liquidity conditions won’t ease even after the end of June, as the IRS rates continue to pick up, and the Ministry of Finance failed to sell 9-month government bonds during the week. However, we do not think the seasonal and festival factors are the key drivers of the abnormal surge this year because the markets should have factored them in.
  • Cracking down of non-genuine trade led to a sharp fall in capital inflow: The Chinese authorities tightened regulation to limit export over-invoicing, which could have reduced capital inflows. China’s exports collapsed in May after a surge in the past two quarters, reflecting the authorities’ efforts to crack down on over-invoicing and round-tripping activities that seek financial gains on large offshore and onshore interest rate differentials and RMB’s appreciation. In addition, commercial banks need to buy more USD positions before the end of June due to the new regulation by SAFE. (Under the new rule, banks are required to maintain a minimum net foreign exchange position based on a formula). As a result, the commercial banks need to reserve more RMB funding (to purchase USD at a proper timing) than normal, which has further tightened the market.
  • An allegedly missed payment led to an interbank freeze: It has been reported that an interbank payment (of RMB6bn) between two prominent onshore banks failed to be made on time on 6 June because of tight liquidity conditions, which has increased risk aversion and the cash-hoarding sentiment. While both banks denied this report, including an e-mailed statement that relationships were good and that “all liquidity indicators… are good”, onshore commercial banks have remained quite cautious in the past week in order to avoid liquidity squeezing. As of today, there has not been any official explanation on the development of this apparent “default” case. In fact, a lot of commercial banks are reviewing their credit lines with their counterparties, which could result in difficulties if market volatility continues to rise.
  • The PBoC would like to deter banks from using interbank borrowings to finance and leverage their off-balance-sheet assets.

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