Last week's credit squeeze in China was a stark reminder of continuing stresses inthe financial sector, Xie Yu reports from Shanghai
Traders sighed with relief on Tuesday, after cash rates in China's money market eased inresponse to fresh liquidity from central bank open market operations.
But the volatility isn't over — indeed, it will be a regular feature in the future, experts warned.
"Seasonal factors contributed to the recent tight conditions, but they're not the fundamentalproblem," said Xu Gao, chief economist and head of economic research at China EverbrightSecurities Co Ltd.
It seems the central bank is trying to use high rates to force financial institutions to cut credit tocertain sectors, including property and local governments, in the face of inflated asset prices,Xu said.
But China's capital market isn't entirely rate-sensitive, and it will experience frequent "liquiditycrunches", especially at the end of months or quarters, he added.
The continuing process of interest rate liberalization is making it even harder to price capital,and that intensifies rate volatility, said Chen Li, chief China equity strategist with UBS SecuritiesCo Ltd.
The People's Bank of China, the country's central bank, suspended open market operations inlate November. That was well before money market rates surged last week.
The seven-day repurchase rate, a gauge of liquidity in the financial system, increased 100basis points to a six-month high of 7.6 percent in Shanghai last Friday, compared with 7.22percent during the June crunch.
On that day, the PBOC injected 300 billion yuan ($494 million) to targeted recipients, but themove didn't calm fearful investors. The seven-day repo rate finally declined on Tuesday whenthe central bank resumed reverse repos.
Sitting on about 20 trillion yuan of reserve deposits, which can always be released into theinterbank system, the central bank is more than capable of keeping a liquidity squeeze fromturning into something more severe, analysts said.
"What happened this time and back in June actually resulted from the PBOC's hands-offpolicy," said Xu.
The authorities have been worried about asset price bubbles and funds being diverted fromwhere they are needed.
Also, the PBOC has been urging banks to better manage liquidity, cut their off-balance-sheetloans and match the maturities of assets and liabilities.
"I think the PBOC keeps warning banks about using cheap official funds to finance the shadowbanking sector," said Vivien Li, a money market trader with a midsized bank in Shanghai.
The central bank understands that the goal can't be achieved instantly, and it will make surefinancial institutions don't run out of cash. But that's not the same as engineering an easing infunding conditions, Xu said.
During the squeeze in June, there were rumors that a Chinese bank had defaulted on a loan toanother bank. Ahead of its recent initial public offering in Hong Kong, China Everbright BankCo Ltd disclosed in its prospectus that two of its branches had failed to pay 6.5 billion yuan ofinterbank loans due on June 5. The payment was later made.
A just-released report from the Chinese Academy of Social Sciences said the debts of thenation's local governments may have reached almost 20 trillion yuan.
The official statement from the Central Economic Work Conference earlier this month defined"controlling and defusing" local government debt risks as "an important economic task".
However, that remains a tough task. Higher interest rates will contribute to slower growthbecause they "will damage investment, particularly for highly leveraged companies such asproperty developers" and local government financing vehicles, said Zhang Zhiwei, chief Chinaeconomist at Nomura Holdings Inc.
The outcome also depends on whether the PBOC's current operations can achieve the goal ofdeleveraging, Chen with UBS Securities said.
"Medium- and long-term interest rates remain elevated in China's capital market. Somecompanies will be forced to cut leverage and eliminate capacity, but not the ones that areinsensitive to the cost of capital," Chen said.
For example, some government-guaranteed programs may not be affected by tight credit at all.
The latest squeeze was a reminder of the stresses in China's financial sector.
"Chinese banks now rely more on the interbank market for funding because of increasedcompetition for deposits — the result of bottom-up interest rate liberalization and pressure fromrolling over nonperforming loans," Wang Tao, chief China economist with UBS AG, said in arecent note.
Based on the experience of other countries that have conducted interest rate liberalization,cash rates — especially short-term rates — often fluctuate violently in the early stages. Andthat's exactly what's happening in China, Chen said.
"I do not think any bank in China is short of cash. But at the current stage of interest rateliberalization, when the cost of capital is unstable, no one is sure how much money is ‘enough',"he added.
Seasonal factors, including tax payments, contributed to the market upheavals in June andDecember, but a more important factor may be capital outflows from saving accounts and intowealth management products, said Chen.
Commercial banks are changing their business models and pursuing high-yield businesses toboost efficiency, which is greatly increasing their capital risk and operating risk.
Certain high-yield "innovative" financial products are drawing capital out of the banking system,destabilizing the short-term dynamics of capital supply and demand.
Many high-yield wealth management products are draining traditional bank deposits.
These wealth management products are often timed to mature near the end of a quarter, sothe funds flow back into on-balance-sheet deposits for regulatory reporting purposes.
Banks often borrow short-term funds to finance these payouts, since the loans, bonds andother assets underlying the products may not have matured.
"Duration mismatch risk in the money market is pushing short-term volatility to high levels," saidXu.
Duration mismatch refers to a situation where the values of assets and liabilities don't have thesame sensitivity to changes in interest rates.
Most economists believe that the PBOC doesn't plan to loosen policy.
"By adopting a tighter monetary approach to the interbank market, China's central bank kept atight leash on liquidity directed into the shadow banking system," Mike Werner, senior analystat Sanford C. Bernstein & Co, said in a recent report.
Werner noted that China's shadow banking sector is growing at its slowest pace since 2011,when the nation shifted to a tight monetary policy to fight inflation.
Generally speaking, the era of loose liquidity has ended, said Chen.
The US Federal Reserve Board announced last week that it will taper its quantitative easingpolicy.
A "modest reduction" was announced in monthly asset purchases from $85 billion to $75 billion,with another $10 billion trimmed from mortgage-backed securities and Treasury bonds.
"The speed of scaling back is moderate and the impact on China will be limited," said Chen.
However, with the cost of capital going up globally, any cash crunch in China could becompounded, he added.