The People’s Bank of China moved to fix a severe liquidity crunch that threatened to cause widespread cash difficulties during the ensuing Chinese New Year by pumping in nearly 255bn yuan into its interbank market using reverse repo mechanisms.

It also opened a window to its Standing Lending Facility for the benefit of small and medium-sized banks located across 10 regions to help ease their liquidity problems.

People’s Bank of China’s liquidity support

The People’s Bank of China’s actions helped douse a massive rise in the seven-day repurchase rate – which fell over 100 basis points after the cash injection. On January 20, this rate had spiraled higher by 153 basis points, signalling aggravated liquidity problems and pushing the Shanghai Composite Index below the psychological 2,000 level.

“Such a response is not unusual as the People’s Bank of China has become notably more active in stabilizing liquidity conditions after the dramatic squeeze in June 2013,” says a SocGen Eco analysis research note.

Wealth management products the root of the problem

The crunch has been caused by a liquidity mismatch faced by Chinese banks on Wealth Management Products (WMP) that depended for their returns on reverse repo transactions. These effectively lent money to institutions such as trust companies that were not entirely regulated and ineligible to receive financing through normal banking channels. Interest rates charged on these arrangements were much higher and allowed banks to provide better returns on the WMPs.

The People’s Bank of China clamped down and imposed an investment ceiling of 35% on these transactions. Banks were meanwhile lending out on much longer terms, while WMPs were typically of tenures of 3 months or less. This caused a severe liquidity mismatch leading to interbank rates shooting higher.

Likely default not helping

The above problems are manifesting themselves in the case of the state-owned Industrial and Commercial Bank of China (SHA:601398) (HKG:1398), which had marketed a fund known as the China Credit Trust Co that in turn had invested most of the funds in an unlisted coal company which went into liquidation. A default of about 3bn yuan now looms large.

Teach them a lesson

The People’s Bank of China is known to have desisted from providing liquidity support in December to teach reckless banks a lesson by making them pay through the nose for interbank borrowing. However, the unfavorable publicity emanating from the imminent default, the ensuing Chinese New Year and the swooning Shanghai equity index may have forced it to extend the liquidity support operation.

“The real intention of the central bank is to stabilise market interest rates around a relatively higher level than in the past, so as to discourage risky lending behaviours while avoiding triggering systematic financial market risk,” observes SocGen.

People’s Bank of China takes to tweeting

Interestingly, the PBoC announced the fact of the liquidity action through a microblog posting on Sina Weibo (China’s Twitter).

 People's Bank of China Tweet

This action by the PBoC has been highly appreciated by the SocGen analysts.

“We do think that the central government has the resources and control to avoid a disastrous outcome, at least at this juncture, (referring to the China Trust Co. episode above) but the tricky part is managing market expectations. Hence, the PBoC’s effort to strengthen communication is of particular importance.”