The People's Bank of China is likely to act to restrain a surge in short-term borrowing, analysts say.
Unexpectedly loose liquidity in China’s interbank market at a time of weak overall credit demand has pushed short-term repo market activity to historic levels, fueling concerns over financial fragility and likely prompting the central bank to reduce the size of its medium-term lending facilities next Monday, economists and analysts said.
Daily pledge-style repo trading volume totaled a record CNY7 trillion last Thursday, with 90% composed of overnight repos, after first breaking CNY6 trillion in July. Any sudden tightening of conditions, prompted by stronger economic data or capital outflows, could produce financial stress similar to that seen in 2013 and 2017, said Cai Hao, a researcher with the National Institution for Finance and Development at the Chinese Academy of Social Science.
The market’s “crazy performance” has been fed by an unexpected liquidity surge and the PBOC is unlikely to allow leverage to continue to build at such a rapid pace, Cai said.
However, the PBOC faces a delicate task in balancing weak credit demand with fiscal stimulus. It only drained CNY6 billion from the interbank market so far this month compared to CNY434 billion in July, despite keeping open market operations to a "mini" level in the past 12 trading days.
Analysts and traders will be seeking further signs of the PBOC's stance from next Monday’s MLF operation, when CNY600 billion is due.
Last month’s Politburo meeting, which downplayed China’s economic growth target, and rising tensions over Taiwan, have also fueled bullish sentiment in the bond market and encouraged a rush into short-term funding.
The PBOC may feel obliged to step in if the overnight repo rate (DR001) remains lower than 1%, or the 7-day deposit institutions repo (DR007) stays much lower than 2.1% for an extended period, in order to protect the guiding role of policy rates, said Ming Ming, chief economist of CITIC Securities. DR007 is now at 1.3%, 80 basis points below the 7-day open market operation rate.
Heavy short-term borrowing also increases the risk of a liquidity crunch and diverts funds from the real economy, Ming said.
Low repo rates have provided a feast for carry traders. DR001 has traded at around 1% in recent weeks, the lowest in 18 months, and the yield on AAA-rated one-year negotiable certificates of deposit slid to 1.92% last week, compared with 2.85% for the PBOC’s one-year MLF.
However, analysts predicted money market rates have probably hit bottom even though they should remain at a low level over the rest of the year as liquidity maintains ample.
Excess liquidity is being fed by fiscal stimulus taking place at a time of weak demand for credit, said Zhou Junzhi, analyst at Minsheng Securities. A CNY2-trillion local government borrowing spree peaked after their quotas of special revenue-backed bonds were largely sold in May and June, leaving funds, boosted by trillions of yuan in tax rebates, few places to go other than the interbank market, she said.
Restoring healthy demand for credit will be tough in the short term, as manufacturing and services sector activities remain constrained by pandemic restrictions and house buyers are afraid to add leverage, Ming said. Nor is there yet any sign of significant additional government borrowing which might sap liquidity, he added.
The PBOC is unlikely to try to drain much liquidity while weakness persists in the property sector, which is key for the financial system, local government revenues and social stability, Zhou said.
Depressed short-term yields may eventually fuel demand for longer-term debt, flattening the yield curve, said Yang Yewei, analyst at Guosheng Securities, predicting that the yield on 10-year Chinese government bonds would fall to around 2.6% from the current 2.7%.