MNI China Money Week: Tight Liquidity Conditions Set To Linger

     BEIJING (MNI) - The surprisingly long-lasting tightness of liquidity

conditions in the Chinese interbank market is expected to continue in coming

weeks as the People's Bank of China is seen reinforcing its intention to keep

liquidity tight but balanced.

     The PBOC drained a total of CNY330 billion from the interbank market via

reverse repos this week, a sharp reversal from the CNY110 billion injection last

week. Taking into account the CNY80 billion of treasury cash deposited into

commercial banks on Thursday, the PBOC drained a net CNY250 billion in liquidity

this week.

     The central bank explained on Friday that the market liquidity level is

moderate because of the treasury cash deposits, month-end fiscal spending and

commercial banks' withdrawing funds from the central bank in excess of those

needed to meet their reserve requirement ratios. 

     Nevertheless, the market was discomforted about the central bank's actions

this week. 

     "The news that the PBOC chose to drain liquidity from the market this

morning woke up our traders who were still in a happy weekend mood," an

interbank trader from a commercial bank based in Southern China said on Monday,

after the central bank drained a net CNY50 billion in liquidity that day. "The

impact on sentiment was quite big and we became cautious immediately." 

     The CFETS-ICAP money market sentiment index remained high throughout this

week, with the intraday readings averaging 61.5, compared with last week's 61.95

average. The lower the reading, the better the liquidity conditions.  

     The benchmark seven-day deposit repo (drepo) rate, which reflects the

borrowing costs of commercial banks in the interbank market, averaged 2.9021%

this week, slightly higher than last week's 2.882% average, hardly moving the

needle on liquidity. 

     The repo rate, which reflects the borrowing costs of all financial

institutions in the interbank market, averaged 3.7031%, higher than 3.6393% last

week. The widening spread between drepo and repo rates to 80.10 basis points

from 77.75 last week suggests that non-bank financial institutions' liquidity

conditions are worse than those for banks.

     The reason behind the recent tight liquidity conditions could be the banks'

low excess reserve ratios. According to estimates by China International Capital

Corporation (CICC), the excess reserve ratio fell to about 1.1% in July, the

lowest since the third quarter of 2013, when it was 0.8%.

     Analysts said the lower excess reserve ratios are due to a larger volume of

government fiscal deposits. Data released by the PBOC show that fiscal deposits

increased CNY1.16 trillion in July, the largest monthly gain since such data

began to be collected in 2005. Since fiscal deposits are held by the PBOC,

rather than by banks, a higher amount of fiscal deposits effectively drains

liquidity from the banking system.

     "The influence of the more than CNY1 trillion increase of fiscal deposits

should not be underestimated, since it is roughly the same as increasing the

required reserve ratio 100 basis points," CICC said in a report last weekend.

"In August, the PBOC's foreign-exchange purchase position rose to some extent,

and the PBOC has injected a net CNY152 billion so far this month [as of Aug.

18], but the effect of seasonal tax payments, required reserve payments and the

issuance of local government bonds will prevent the excess reserve ratio from

rising significantly from June to August," the report said.

     "A lower excess reserve ratio will cause banks to be more unwilling to lend

out money, which will cause higher fluctuations of liquidity for the whole

interbank market," as small banks and non-bank financial institutions rely on

big banks to lend them money, CICC said.

     The unusually large rise of fiscal deposits is caused not only by a higher

budget surplus -- which was CNY296.1 billion in July compared with a deficit of

CNY993.4 billion in June and a surplus of CNY200.2 billion last July -- but also

by an increase in local government bonds issuance, which totaled CNY845.3

billion in July, the highest monthly level since June 2016.

     Moreover, the largest part of the local government issuance, CNY646

billion, comprised new bonds, according to CICC, rather than those replacing

existing debts. 

     Replacement bonds tend to cause fewer liquidity problems, given the

Ministry of Finance requires local governments to pay off the old bonds within a

month of receiving money from the new issues. The payoffs cause money to flow

from the PBOC, where the bond proceeds are stored after auction, back to banks

in a relatively short time.  

     However, money coming from new bonds issued to finance new fiscal spending

often stay in the PBOC's accounts longer, which exacerbates liquidity problems.

     "There is no document stating how soon that money raised by a [local]

government to pay for a fiscal deficit needs to be spent," the CICC said. "This

explains why fiscal deposits went up in July, causing liquidity to tighten, and

so the situation did not improve in the short term."

     The PBOC has the capability to hedge the negative impact on liquidity

caused by the rise of fiscal deposits, but the PBOC's firm stance on keeping

liquidity "neither tight nor loose" has ensured that liquidity conditions have

not eased.

     "The continuous draining of liquidity from the market shows the PBOC does

not want liquidity to be loose," a Beijing-based interbank trader at a

commercial bank told MNI. "The previous expectations that loose liquidity

conditions would appear in mid-August were completely wrong."

     On Thursday and Friday, the PBOC said the current liquidity level was

"moderate" while draining liquidity from the market at the same time, showing

that the PBOC now has a higher tolerance for liquidity fluctuations.

     Qin Han and Liu Yi, analysts at Guotai Junan Securities, said the reason

the PBOC is not loosening liquidity is to prevent financial institutions from

increasing their leverage again.

     "When liquidity expectations were quite stable in June, many financial

institutions chose to releverage, which is against the PBOC's goal of

deleveraging," Qin and Liu said. "So the PBOC chose to increase the volatility

of the repo rate to prevent institutions from leveraging up, as increasing the

repo rate will have a large negative effect."

     Still, there are signs that the PBOC does not want liquidity to be too

tight -- nor the repo rate too high -- because it wants to avoid excessive

market stress. 

     First, the PBOC drained liquidity three straight days from Wednesday to

Friday this week -- which is very rare -- indicating its intention to stabilize

market expectations. Second, the PBOC said it would conduct open-market

operations to offset some of the impact of the rollover of special government

bonds on Aug. 29, showing that it is trying to massage liquidity conditions and

market sentiments. Third, traders said that China Development Bank, one of the

three Chinese government policy banks, started to lend out money in large

amounts on Tuesday afternoon to alleviate tight liquidity conditions on that

day, likely reflecting PBOC window guidance.

     Traders remain cautious about the outlook for liquidity conditions in the

short term.

     "The PBOC has made it clear in its announcements that it will maintain

liquidity conditions at a generally stable level," a trader based in central

China said. "So in the short-term I think liquidity conditions will remain tight

and balanced."

     However, some analysts argue there are a number of reasons for the PBOC to

relax liquidity conditions in the near future.

     "Liquidity is an important factor affecting short-term bond yields," Xu

Hanfei, Li Yuze and Liu Yu, analysts at China Merchant Securities, said on

Wednesday. "Bond yields are too high at the moment, meaning they cannot fulfill

the most important task of finance, as mentioned at the National Financial Work

Conference, which is to serve the real economy well." 

     The National Financial Work Conference was the high-level conference held

in mid-July, led by President Xi Jinping, which set priorities for China's

financial management.

     Ming Ming, an analyst at CITIC Securities, warned in a report that the

financial system now has a "low liquidity level" and that the structure of

liquidity is "not balanced," as big banks are on more solid footing

liquidity-wise than small banks and non-bank financial institutions. 

     Ming said it is important for the PBOC to "avoid the systemic risks induced

by the tight liquidity conditions of small and medium-sized banks and non-bank

financial institutions."

--MNI Beijing Bureau; +86 10 85325998; email: he.wei@marketnews.com

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

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

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