Bank of America Merrill Lynch’s global rates teams has interesting note out on Friday regarding Chinese repo rates.
As they point out, the seven-day rate currently implies something of a liquidity crunch in the market. While much of this is naturally down to the routine dash for cash ahead of the Chinese New Year, the rate rise has, nevertheless, been pretty significant and sharp when compared to previous years:
According to the analysts the surge may be down to the fact that the market was awaiting a PBoC reserve requirement ratio cut (RRR) which never happened. Indeed, rather than a cut, the PBoC has instead declared itself willing to engage in reverse repo operations to help out liquidity (much like the ECB).
If you’re confused by the reference to ‘reverse repos‘ rather than standard repos, that’s down to the PBoC classifying the repo deal from its own point of view rather than from the point of view of its counterparties.
But just like in Europe and the US, the ‘reverse repo’ involves the PBoC accepting collateral from banks in exchange for liquidity. The type of collateral accepted, meanwhile, includes central government bonds, PBoC bills and agency bonds.
And here’s the thing. According to the BoAML analysts some banks might not have enough of that sort of collateral to be able to engage heavily in such PBoC repos:
Due to the large size of reverse repo and required collateral, institutions need to source large quantities of these bonds to secure repo liquidity funding. Cleary, small and medium sized national banks will experience more difficulty in getting the benefit of the liquidity provided by a reverse repo operation for lack of collateral. Their inventories of these bonds are low in the first place due to the yields these bonds offer and also the higher loan to- deposit ratio leaving less money on the table to buy these debt instruments.
So what’s behind the policy? After all, why not just cut the RRR to help out liquidity rather than focus on reverse repo operations, which may or may not be helpful to all the banks in question?
The analysts suspect it could be because the PBoC is trying to avoid sending out the wrong signal about inflation while trying to gain control over “unofficial” rates and liquidity.
As they note:
The liquidity is clearly very tight. We have been arguing for the PBoC to ease liquidity and raise rates at the same time so that it does not send an easing signal before inflation is truly at bay. So far, the PBoC has shown great restraint in cutting RRR, despite capital outflow putting further strain on the liquidity situation. One interpretation for this stance is that the PBoC is trying to gain control over the “unofficial” rate if it cannot really control the “official” deposit/lending rate decision.
The past one way inflow has caused the PBoC to lose control over monetary policy.
Its intention to raise rate and RRR are not easy to implement because of the wider message it sends to the market. Now with the cross-border flow more balanced, it can use both repo, and reverse repo operations to manage the 7d repo rate under the liquidity management operation.
In other words, since the PBoC is much less of a hostage to one-way cross-border inflows than it used to be — as they’ve become more balanced — they can finally utilise the repo market as a real-time policy tool.
In the old unbalanced flow days, repo ops were, after all, restricted by the PBoC’s top prority, which was sterilising renminbi liquidity (the result of its dollar intervention policy).
But by turning to reverse repos as a liquidity measure now, the analysts think the PBoC may be attempting to have its cake and eat it.
After all, boosting liquidity through the repo market, rather than changing its RRR or official rate policy, presents the illusion that the PBoC is still standing firm on inflation, while also dealing with the market’s underlying liquidity issues.
As the analysts conclude, that now only leaves the market to determine what exactly the PBoC’s target level for the repo rate might be:
The 7d repo rate is an “unofficial” rate for the PBoC to control. But, if, as we argued, that the PBoC has the intention to manage this “unofficial” rate, what should be the fair level? In principle, the 7d repo is a secure short-term borrowing rate; thus, it should be compared to the overnight deposit rate, currently at 0.5%. But we believe this would be a mistake. Given the PBoC’s stronger bias to fight inflation compared to the State Council, which tries to balance the interests of many other ministries, we believe the right target should be the 1y deposit rate (3.5%) with the floor at 3m deposit rate (3.1%). Despite the global weakness and the domestic slowdown, the 7d repo has seen a difficulty to break the 3% level, and liquidity has been withdrawn rather than injected by the PBoC when the repo rate was at that low if we factor in the trade and FDI in getting the true picture of cross-border flows’ impact on liquidity.
Whether this policy proves too punishing for China’s small and medium-sized banks, which lack the required collateral to gain traction from PBoC reverse repos, we’ll have to wait and see.
Related links:
A central bank is only as good as its target - FT Alphaville
The Chinese funding risk is everywhere - FT Alphaville
The PBoC and that RRR decision – FT Alphaville