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.
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’
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.
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?
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.
IS IT THE RIGHT POLICY TO SQUEEZE THE BANKS?
We believe the PBoC should also bear some responsibility for the speculative banking behaviour. The rigid exchange rate policy, together with a rigid monetary policy, had caused large capital inflows up to April, which led commercial banks and firms to chase the interest rate and foreign exchange differentials among different products and between onshore and offshore markets. In fact, these activities have been occurring for a few years. In addition, the expected tapering of the US quantitative easing has led to slowing capital inflow in May or even capital outflow in June. Therefore, the PBoC’s monetary policy inaction in a rapidly changing environment should bear some responsibility in creating the liquidity squeeze in money markets.
We believe policymakers will need to be mindful of not undermining financial stability. Our understanding is that the PBoC is attempting to adopt a disciplinary approach and ‘let the market work’ without stepping in to resolve the tight liquidity conditions. On 13 June, the PBoC did not conduct any open market operations. However, the net injection of RMB92bn this week has failed to ease domestic liquidity conditions. We think that the jump in interest rates is signalling rising stress for China’s financial sector. If the policymakers do not act pre-emptively and decisively, the current interbank stress could degenerate into more significant problem.
The tight liquidity approach is useful to expose the frailties but it is not the ultimate solution. We believe financial reform should be accelerated as shadow banking activities can not controlled by tight liquidity conditions alone. Since the new leadership took power following March’s NPC meeting, the monetary authority (ie the PBoC) has failed to convince the market that it is undertaking a clear strategy to push forward overall monetary and financial reform. There has been no specific action for interest rate liberalisation, exchange rate regime reform and capital account liberalisation. We think that the daily routine of open market operations cannot substitute for a faster acceleration of structural reform. Further inaction by the PBoC could lead to larger risks to the financial system, a fast slowdown of the economy, significant loss of Chinese competitiveness, and large unemployment rate pressure this year.
SHOULD THE DISTRESS IN MONEY MARKETS CONTINUE FOR ANOTHER MONTH, A HARD LANDING RISK WOULD RISE SHARPLY
To some extent, the current distress in China’s money markets has a lot to do with the PBoC’s monetary policy operations. While the external and internal economic and financial environments have changed sharply, the PBoC’s monetary policy has remained unchanged since the beginning of the year. Meanwhile, the rigid exchange rate policy with large interest rate differentials had drawn large capital inflow into China up to April this year. As shown in the Total Social Financing chart above, large capital inflow has led to accommodative financial conditions, which in turn has also inflated a bigger property market asset bubble.
The subsequent falling capital inflow in May and even capital outflow in June due to the tightened capital control policies, together with other seasonal and regulatory factors, have tightened money market liquidity and led to surging money market rates. Indeed, the monetary policy inaction will also need to bear some responsibility for the current market situation.
China’s Monetary Policy
As pointed out before, China’s monetary policy stance should have turned more supportive of growth with falling inflation rate and decelerating growth prospects. In fact, other central banks in the region have cut interest rates and used intervention to ease the pressures of currency appreciation on export competitiveness. As such, we believe it will be difficult for the PBoC to maintain a relatively high policy rate and continue to allow the RMB to appreciate in the short run. If the new government does not want to push China’s economy into a hard landing and tolerate a growth rate less than 7.5%, China’s monetary policy will have to reverse course quickly. Otherwise, the very high money market rates will quickly lead to rising lending rates, which will pressure an already sluggish real economy, giving rise to a possible hard landing scenario. We believe the PBoC has already punished the commercial banks for their excesses in the past. It is therefore time for the central bank to restore confidence on China’s financial system by intensifying its efforts to ease money market conditions. Meanwhile, the PBoC will also need to fine-tune its monetary policy stance as suggested by the MPC. We therefore maintain our call that a rate cut of at least 25bps should be part of the fine-tuning process of China’s monetary policy in the near term.