MNI China Liquidity Survey: Unexpected Tightness Spooks Market

--Survey Respondents Say Liquidity Conditions Worsened in August

--July-Aug Results Suggest Worst Liquidity Conditions in 3-Year Survey History

     BEIJING (MNI) - The Chinese central bank's campaign to force the financial

sector to deleverage and its policy of keeping interbank market liquidity "tight

but stable" are starting to bite and traders are unhappy - not just with the

lack of funds but with the People's Bank of China's communication with the

market.

     The "central bank mother," as the PBOC is nicknamed, turned into the wicked

stepmother this month, as its squeeze on the availability of money that caused

the market such grief in July continued in August. The central bank has made it

clear for several months that it will pursue a prudent and neutral monetary

policy, keep liquidity "tight but stable" and money-market interest rates stable

as it pushes financial institutions to reduce their leverage. But the pressure

its policies are putting on the interbank market is becoming difficult for many

to bear, especially smaller banks who are more dependent on wholesale funding.

     For the second month in a row, none of the 19 traders who took part in the

Market News International monthly interbank survey reported an improvement in

liquidity conditions, while 18 respondents reported a deterioration, only

marginally fewer than the full house of 19 last month. Taking the July and

August results together, traders are reporting liquidity conditions are at their

worst since the survey began in May 2014.

     MNI gauged the opinions of 19 traders with financial institutions operating

in the interbank market, the country's main platform for trading money-market,

bond and currency instruments, and the main funding source for financial

institutions. Interviews were conducted from August 16-18.

     "We've been kneeling down and begging for money this week," a trader with a

commercial bank in eastern China told MNI. "I can't remember such a bad

situation in August."

     A trader with a joint-stock bank in Guangdong province said liquidity

conditions were so tight that even some large joint-stock banks had been forced

to go to the interbank market to borrow.

     On top of tax payments and banks' preparing cash to pay their reserve

requirement obligations to the PBOC, the commercial-bank trader said he believed

the root cause of the liquidity shortage was banks' low excess reserve ratios,

especially the large lenders who provide most of the liquidity to the interbank

market. With excess reserves low, banks are more conservative and more cautious

in managing their liquidity.

     "In its second-quarter monetary policy report the PBOC said the ratio fell

sharply because of a change in the clearing payments system, but I don't agree

with that -- the system was upgraded a long time ago but the ratio has fallen

rapidly in recent months and that's a result of the deleveraging campaign and

tighter regulations," the trader said.  

     Another trader with a small bank in northern China said the central bank

was tightening after loose liquidity conditions in June and early July pushed

many financial institutions to releverage. "Now the PBOC is trying to rein that

in again," said. "But the whole system is fragile -- if the PBOC stops or

reduces injections or if there's anything to disturb the equilibrium, the

liquidity situation would get intense immediately." 

     "I also think that traders were feeling optimistic about liquidity and the

market because the economic data have been weaker, but the PBOC has poured cold

water over that," he said. "We're going to have to be more careful."

     The PBOC had earned plaudits from traders over the past 18 months for

improving communications with the market, giving clearer guidance as to its

policy intentions and explaining its decisions. But the MNI survey shows a

significant turnaround in sentiment this month, with the percentage of traders

saying PBOC guidance was worse surging to a record high of 42% from zero in the

previous two surveys. The percentage of respondents who said guidance was better

fell to 15.8%, the lowest since September 2016.

     "The PBOC is always telling us that the liquidity situation is stable, but

the reality is it's not stable at all," complained one trader with a commercial

bank in a large city in eastern China. "But we traders feel like we're riding a

roller coaster. The first two weeks this month, it was fine although liquidity

was not as loose as in July. Then suddenly, it got crazy tight. The PBOC

increased injections, but it was far from enough."

     In the first two weeks of August, the PBOC drained a net CNY70 billion

through open-market operations, but as liquidity deteriorated and repo rates

jumped, it pumped in a net CNY110 billion last week and another net CNY112

billion through its Medium-term Lending Facility (MLF) on Aug 15.

     Although the value-weighted average rate of the seven-day drepo, the

benchmark rate gauging the liquidity in the banking sector, has held steady in a

range of 2.7% and 3.0%, the rate spiked as high as 6.5% in intra-day trading on

Wednesday last week and 6% on Thursday, according to Wind, a shanghai based

financial data provider, highlighting the shortage of money. 

     "The market was very nervous, if the PBOC hadn't made these injections no

one would have been lending," said a trader with a city bank in an eastern

province. "But on Thursday afternoon at around 3:30 pm, the big banks suddenly

started to lend, so we guessed that the PBOC must have given them money."

     A trader with a small bank in northern China noted that the spread between

the seven-day drepo (deposit repo) rate and the seven-day repo rate has been

widening, indicating that non-bank financial institutions are having even more

difficulty getting funds.

     The rates of seven-day repo, gauging the liquidity in both bank and

non-bank institutions, remained in a range of 3.0% to 4.1% so far this month.

The spread between seven-day drepo rate and the same duration repo rate widened

as large as  113 basic points on Thursday, from a 94 basic points at end of

July, according to Wind.  

     The drepo rate, which the PBOC has been promoting as the benchmark

money-market rate since the third quarter of 2016, reflects the borrowing costs

of only depository financial institutions -- mainly banks -- when using

government bonds and quasi-government bonds as collateral. The repo rate

measures the borrowing costs of all types of financial institutions that use a

wider range of collateral, including government bonds and corporate bonds, and

tends to be higher and more volatile. The PBOC prefers the drepo because it says

the rate better reflects liquidity conditions in the banking system.

     "The seven-day drepo really doesn't reflect the reality of what's going on

and I think it's being dressed up to look better than it is in order to calm

both the market and expectations," said the trader with the state-owned bank in

Guangdong province. "It looks like the PBOC has decided that it doesn't want the

volume-weight average price of the drepo to go higher than 3% and if it does

then it will provide liquidity."

     In terms of the outlook for the seven-day repo rate over the next two

weeks, traders' views were similar to last month, with the biggest proportion of

respondents, 42%, seeing rates rising, while just under a third saw them staying

the same and just over a quarter expecting a decline.

     Market sentiment has also turned negative on the economy, with the

percentage of respondents in the MNI survey who said economic conditions have

deteriorated jumped to 63% from 26% in the previous survey, with only 10.5%

seeing an improvement, down from 42% in July's poll.

     "The expansionary phase of the economic cycle has ended as the re-stocking

process has finished," said a trader with a large state-owned commercial bank in

Shanghai. "Funding costs are rising and that's going to be a problem for the

real economy and it's going to hurt industrial profits."

--MNI Beijing Bureau; +86 (10) 8532 5998; email: marissa.wang@marketnews.com

--MNI Beijing Bureau; +44 203-586-2244; email: nerys.avery@marketnews.com

--MNI BEIJING Bureau; +1 202-371-2121; email: john.carter@mni-news.com

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