MNI China Money Week: Traders See Deleverage Warning From PBOC

--Shift in Liquidity Management Strategy Seen Aimed at Wrong-Footing

Institutions 

     BEIJING (MNI) - As Chinese traders returned to work on Monday after a

week-long public holiday, the main topic of conversation was whether the central

bank was changing its strategy for managing money market liquidity.

     On Sept. 30, the last trading day before the Golden Week holiday, even

though it was a Saturday, speculation spread through the market that a

commercial bank with a good reputation for internal controls had defaulted on an

interbank loan. The interbank trading system, which normally closes at 5:00 pm,

remained open for an extra half hour but the bank failed to pay back the loan by

5:30 pm, traders said.  

     The one-day deposit repo (drepo) rate, which reflects only the borrowing

costs of banks rather than all financial institutions in the interbank market,

rose to 2.9518%, the highest since Aug. 29, while the seven-day drepo jumped to

3.1622%, the highest since the end of April. Traders said some financial

institutions paid interest rates as high as 10% for two-month funds.

     Liquidity conditions at the end of September were unusually tight for a

quarter end, especially given the approach of a major public holiday when cash

demand usually spikes and institutions compete for funds. The PBOC withdrew

CNY360 billion yuan from the interbank market through open-market operations in

the week before the break and drained a net CNY180 billion in open-market

operations on Oct. 9, the first trading day after the holiday. 

     "Liquidity conditions were as tight [on Monday] as they were on Sept. 30,

and big banks were unwilling to lend money until 4:00 pm, which finally managed

to calm the market," an interbank trader at a rural commercial bank told MNI on

Monday. "I knew Sept. 30 was going to be tight, but I never expected it to be

that tight. I expected today would be better, but it was still very tight. I was

crying bitter tears," he said. 

     "It's become impossible for anyone apart from the PBOC to predict liquidity

conditions," the trader said.

     That may well be the point. The interbank market has become used to a

quarterly pattern that sees liquidity conditions tighten at the beginning and

middle of the final month of a quarter before relaxing at the end of the month

when the dash for cash is over. But September was different, and on Sept. 30 the

CFETS-ICAP money-market sentiment index, which closed at 47 the previous day,

spiked from an already unusually high 60 to 77 by 4:00 pm, the first time

closing sentiment was higher than opening sentiment since July 10, and the

highest closing reading since the index became available on March 16.

     The "central bank mother," as the People's Bank of China is affectionately

known in the market, is firmly in control of the liquidity levers that turn the

wheels of the interbank market and has become much more adept at fine-tuning

liquidity and responding to the needs of the market since a devastating cash

crunch in June 2013 sent money-market rates soaring and roiled global markets. 

     So traders were surprised to see the mini panic in the market on Saturday.

One hypothesis doing the rounds is that the PBOC's deliberate tightening of

liquidity was part of a strategy to break the market expectation that liquidity

would be loosened at the month-end and quarter-end. 

     "Many interbank traders have been lulled into believing that liquidity

conditions will naturally loosen as the quarter-end approaches, so some of them

do not actively prepare," Tongye Zhangsan, a widely read interbank market

blogger wrote on Oct. 1. "Those traders would not borrow in advance expensive

money [with longer duration] to get past quarter-end, rather they will simply

roll over overnight money and wait until money becomes cheaper to borrow." 

     The PBOC is now trying to break that expectation by wrong-footing

institutions that have been playing that game.  

     "The quarter-end relaxation of liquidity motivates financial institutions

to leverage up again, which goes against the theme of financial deleveraging,"

Huachuang Securities said in a report this week. "The PBOC could correct market

expectations [as they did in tightening liquidity conditions in April and July

after quarter-end], but the process of draining liquidity can be quite long, so

financial institutions would still benefit from loose liquidity during the

draining process." 

     "The best way for the PBOC to prevent financial institutions from

leveraging up is to reinforce market expectations for slightly tight liquidity

conditions, which will curb their appetite for increasing debt," the Huachuang

analysts wrote. 

     The PBOC announced on Sept. 30 that starting Jan. 1, 2018, banks that meet

certain criteria for lending to support the government's inclusive finance

strategy will have their reserve requirement ratio cut by as much as 1.5

percentage points. The liquidity mini-squeeze before and after the week-long

holiday may have been an attempt to warn financial institutions against assuming

that the reserve requirement ratio cut announcement meant the PBOC was relaxing

its monetary stance, according to Huachuang Securities.    

     "Until the work of financial deleveraging and cleaning up financial

excesses has finished, the PBOC will maintain a prudent and neutral monetary

policy stance," Huachuang said.

     Liquidity conditions improved as this week progressed. Deposits flowed back

into the banking system after the holiday and the PBOC refrained from

substantial drains of liquidity via open-market operations after Monday's hit.

The benchmark seven-day drepo rate fell from 2.9706% on Monday to 2.8299% on

Thursday. The CFETS-ICAP money market sentiment index fell from 63 at Monday's

close to 37 on Thursday.

     "Conditions are very good now and it is quite easy to borrow money, which

has really eased market concerns about tight liquidity," an interbank trader at

a rural commercial bank in central China said on Wednesday. "At around 3:00 pm

today, overnight money flooded the trading screen -- traders were begging to

lend money out," he joked.

     On Friday, the PBOC injected CNY498 billion via its Medium-term Lending

Facility (MLF), lifting market confidence as there were rumors that the PBOC

would not roll over the CNY439.5 billion in MLF instruments that matured Friday

and next week. Short-term liquidity conditions are expected to remain relatively

loose.

     But the good times may not last long, as two factors are likely to have

negative impacts on liquidity.

     The Ministry of Finance announced its plans for government bond issuance in

the fourth quarter, indicating a net supply of CNY200 billion to CNY250 billion

in October, according to Lianxun Securities estimates, the highest since the

WIND information system data became available in 1997. That will lead to a

transfer of money out of the banking system into government coffers. 

     Tax payments also loom on the horizon. October traditionally sees large

payments to the government as companies pay their business income and

value-added taxes. According to Lianxun Securities, average October tax payments

over the last five years have been in a range of CNY500 billion to CNY600

billion, suggesting this month could see a similar and very likely a bigger

amount shift out of the banking system into government accounts. Considering the

big impact on liquidity of tax payments in previous months, the impact in

October will likely be even larger.

     "Liquidity conditions are very likely to become tight in the last 10 days

of October as the tax payments begin," the interbank trader said.

     Analysts shared similar cautious sentiments. 

     "Investors should not be too optimistic about liquidity conditions in

October," Huachuang Securities analysts said. "We could see even tighter

conditions than in previous Octobers." 

     The yield on one of the most-traded China Government Bonds that matures on

Aug. 3, 2027, rose from 3.65% on Monday to 3.6650% on Friday.

     The yuan strengthened against the U.S. dollar this week. It last traded at

6.5796 on Friday compared with 6.6470 on Sept. 29.

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

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

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