MNI China Money Week: Market in Party Mood as PBOC Loosens

--Financial Institutions, Particularly Small Banks, Releveraging While They Can

     BEIJING (MNI) - Chinese financial institutions are quick to spot an

opportunity and rarely let one pass. They wasted no time taking advantage of the

central bank's relaxation of liquidity conditions in June to ease market jitters

about a seasonal cash crunch, and another temporary loosening in mid July. As

cash was pumped into the interbank bond market and interest rates started to

edge down, they jumped back onto the leverage dance floor. 

     The tell-tale signs were everywhere - notably a jump in issuance of

Negotiable Certificates of Deposit (NCD) by banks in the interbank market, and a

surge in loans from deposit-taking banks to non-bank financial institutions,

which were mostly channelled into purchases of asset management products.

     Although Chinese regulators have continued to pursue their campaign to

deleverage the financial sector, they've also sought to strike a balance between

curbing the worst excesses and "maintaining stability" in the financial markets

to avoid any potential for volatility that could spin out of control. Many

financial institutions have been betting on the shifting sands of this balancing

act, leveraging up when stability is in the ascendant and liquidity rises to

engage in the profitable arbitrage opportunities this throws up. 

     "We had to seize the day," a trader from a city commercial bank on China's

east coast told Market News. "We couldn't pass up this opportunity when market

interest rates were comparatively low. We were seriously limited in April and

May when the regulatory environment was so tough."

     Although the Chinese leadership has set its sights firmly on curbing the

growth of leverage in the financial sector and pushing banks to lend to the

so-called "real economy", it recognizes this cannot be done overnight. The

People's Daily, the mouthpiece of the ruling Communist Party, noted earlier this

month in a commentary on financial regulation that deleveraging can not be

accomplished in one stroke because the financial sector has a natural tendency

to add leverage. Although the authorities need to prevent systemic risks, they

have to guide money away from the financial sector and into the real economy at

a controlled pace, it said.

     The PBOC was unexpectedly generous to the interbank market last month, with

traders describing a market in carnival mood as it feasted on the central bank's

liquidity injections. The PBOC pumped roughly CNY620 billion into the market

from June 1 to June 19 through open-market operations and its Medium-term

Lending Facility. Although the PBOC drained that amount and more from late June

until early July, it turned the taps on again from July 11, adding CNY510

billion last week alone via OMO, the largest weekly net injection since mid

January. 

     Regulators eased up on some of the deadlines and controls they had

previously imposed on banks and financial institutions, and the end-June

hoarding of cash to meet the central bank's Macro-Prudential Assessment also

passed, which helped pump up the party atmosphere. 

     The average rate on the benchmark seven-day repo, which reflects the cost

of borrowing among banks in the interbank market, fell by almost 90 basis points

over the course of June, closing at 2.5% on June 30 compared with 3.44% on May

31. The rate on Friday was still relatively low and last at 2.8057%. 

     "As money-market rates went down and liquidity was good, a lot of

institutions started to borrow money to buy higher yielding bonds," said a

trader with a state-owned bank in Guangdong province. "City commercial banks and

smaller banks especially were doing this."

     Another trader with a bank in northeast China said his bank had added

leverage to try and scrape back lost profits. "We've been under a fair bit of

pressure. With money-market rates down, if we didn't take this chance it would

be really hard for us to pay out the high yields we've promised on our wealth

management products. A lot of smaller banks have to rely on making money off the

thin margins they make on interest-rate spreads." 

     Banks' net issuance of NCDs, which generates interbank liability, surged to

CNY373.9 billion in June after showing negative growth of CNY333.3 billion in

May and an increase of only CNY115.7 billion in April. Net issuance of NCDs this

month as of July 26 has been similar to June's figure at CNY352.4 billion,

according to Wind Information, a Shanghai-based financial data provider.

     The outstanding amount of NCDs issued by city and commercial banks rose by

CNY200 billion in June to CNY3.83 trillion, while that of joint-stock banks was

CNY3.56 trillion, unchanged from May, according to data from Tianfeng

Securities, indicating that it's been small and medium-sized lenders who have

been the most aggressive in taking on more debt to buy products with higher

yields. 

     Non-bank financial institutions (NBFI), including funds and securities

companies, have also been leveraging up. Banks' claims on other financial

institutions, which includes loans to NBFI, purchases of asset management

products from NBFI, and trust and entrusted investments, rose by CNY1.4 trillion

in June to CNY28.5 trillion, the biggest monthly increase in value terms since

January 2016 and snapping a two-month decline. 

     Another indicator of leverage in the interbank market, the outstanding

amount of bonds used as collateral in repo agreements, rose to a record CNY5.26

trillion at the end of June, up CNY770 billion from May, after the amount

declined over CNY990 in April, according to Wind.

     The value of bonds deposited at the China Central Depository & Clearing

system rose to CNY46.43 trillion in June from CNY45.68 trillion in May,

according to data from the China Central Depository & Clearing Co. Data for July

is not available yet. 

     "The increase in bonds pledged as collateral and at the depositary

indicates that the leverage ratio in the bond market is rising due to the

recovery of the bond market in June and the sluggish issuance of bonds in the

primary market," Ji Linghao, a bond analyst with Huachuang Securities told MNI.

     The question now is how long the carnival will last. With the PBOC firmly

in control of the party, the market is searching for clues as to whether it will

turn the volume down or switch the music off altogether.

     The National Financial Work Conference (NFWC), where top policy makers map

out financial reform and regulation, met in mid July and the PBOC held a

follow-on meeting this week, where it stressed the need to continue to implement

a "prudent and neutral monetary policy" and maintain "basically stable

liquidity" in order to create the appropriate monetary environment for President

Xi Jinping's supply-side reforms. The message received by the market is that

liquidity won't be loosened much but it won't be tightened too much either. 

     "From the stance the authorities have shown in several important meetings

recently, the PBOC may not further tighten regulations for the financial sector

since it will focus more on maintaining stability and preventing risks, so the

current 'neither tight nor loose' situation will continue," said the trader in

eastern China. 

     Others say the PBOC's liquidity injections are just a short term

phenomenon, given the focus of the NFWC on curbing financial risks and

deleveraging. There's also uncertainty over how tough financial regulation may

get in the wake of the establishment of the Financial Stability and Development

Committee to oversee regulation. 

     "The authorities' determination to deleverage has not changed, so the theme

will still be tightening, " Huachuang Securities' Ji said. "The recent

releveraging is obviously going in the opposite direction to what regulators

want, so these financial institutions who have leveraged up again need to be

careful." 

     The PBOC's generosity continued this week, with a net injection of CNY141.5

billion via its open market operations. On the monthly basis, the net OMO

injection by July 28 reached CNY232.5 billion in July, much more than the

CNY106.7 billion in June and CNY69.5 billion in May, indicating the central bank

is not tightening liquidity. 

     "Although the PBOC left the liquidity injection unchanged in Tuesday and

Wednesday, the liquidity situation is not very tight. Seven-day capital is in

short supply, since institutions are preparing for cross over to the next

month," a Beijing trader in a join-stock bank told MNI. "The liquidity situation

will remain at a neither tight nor loose level, as the PBOC's intention will be

just to hedge the maturity of reverse repos," he said. 

     The average rate on the benchmark seven-day repo - which is in effect the

drepo, the cost for banks, rather than all financial institutions, to borrow

from each other in the interbank market - was last at 2.8057 Friday afternoon

from a closing rate of 2.9099 the previous Friday.

     The yuan exchange rate continued to strengthen, guided higher by the PBOC,

as the U.S dollar index fell. The yuan appreciated by around 0.3% against the

greenback this week, the third consecutive weekly gain, and was last trading at

6.7487 per dollar. For the month so far, the Chinese currency has strengthened

by 0.46%, the fourth month of appreciation in a row. 

--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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