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Repeats Story Initially Transmitted at 08:01 GMT Aug 25/04:01 EST Aug 25
     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