PBoC Struggles to Cope with China’s ‘Bottom Up’ Rate Liberalisation…

China’s 7-day bond repo rate traded at an average of 8.2% on Friday, nearly double its level a week earlier. Interbank borrowing rates also surged, although not to the double digit levels seen in June. After markets closed, the PBoC announced that it had injected a total of Rmb300bn via special liquidity operations (SLOs), and in a sign of panic, has even used social networking service Weibo to declare its actions, rather than waiting a month as usual. In one way, both this spike in interbank rates and the one in June reflect incompetent PBoC technical management of a fast evolving financial market, as bank deposits disperse in a ‘bottom up’ form of interest rate liberalization. 

The bank will provide more liquidity this week to cap rates if needed to calm the year-end liquidity squeeze; while durations of a month and less have surged, those three months to one year have remained much flatter (albeit liquidity is overwhelmingly at the short end). However, Chinese financial markets are evolving rapidly via the shadow sector and competition for deposits is becoming intense, making it harder for the PBoC to micromanage the supply of liquidity. The PBoC hasn’t yet moved to a monetary policy framework targetting benchmark rates, as in developed economies.

On the operational level, the PBoC was complacent because it expected the central government, which has more than RMB4trn of commercial bank deposits and has traditionally allocated a large amount of that to local governments in December, to follow the usual script. That pattern appears to be much more muted under the new regime of official frugality. The key underlying structural issue is deposits have been fleeing the banking system for higher yielding wealth management products and online money market funds, reducing transparency. Additionally, the pressure on banks to secure deposits is always intense at the end of the year when they have to satisfy the regulatory requirement that their outstanding loans total no more than 75% of deposits on their balance sheets. The central bank crackdown in H1 on speculative forms of financing which used the interbank market and WMPs to fuel a property and investment bubble has been successful; monthly total social finance growth peaked back in March and had halved by July.

New total social financing in November stood at RMB1.23trn and total outstanding RMB loans were up 14.2% y/y, the same as overall M2 growth. However, total credit in the economy will grow almost 20% this year.Raising the cost of capital is the only effective way to encourage companies to borrow and invest more efficiently, as part of still very early stage efforts to restructure the economy away from its credit-intensive model that the government admits is unsustainable. The volatility in credit markets this year is a signal of just how difficult and disruptive that process will be.

Both now and in June, the bank refused to inject liquidity until signs of stress were generating panic headlines. The difference is that shadow finance has been reined in since Q2, so using interbank rates as a crude weapon to beat excess credit growth into submission makes even less sense, but also that the 1-year bond yield has been trending higher for months and has reached an almost decade high. It seems that more by default than design, China is now irreversibly shifting to positive real funding costs which will further pressure headline growth rates next year but also boost rebalancing momentum.  Overall, the diversification of China’s deposit markets and rising funding costs are healthy developments medium term but while the immediate money market squeeze will subside, I’ve always maintained that the Chinese economy would ultimately suffer a ‘margin call’ in slow motion from its own bank depositors as they conducted their own version of the global reach for yield.

Ultimately, the onset of demographic decline will see total deposits within the bank and shadow sectors peak through mid-decade as savings start to be run down. In the near-term, while interbank rates will subside and Chinese financial stocks rally into early 2014, 5-year generic credit default swaps look cheap at under 70bps and an increasingly desirable hedge for many investors in 2014, as these episodes of credit market instability are likely to recur and place the spotlight again on the challenge of stabilising overall systemic leverage growth.