On The Stealthy Doubling In Chinese 7-Day Repo Rates
Even as most investors are focusing on Europe, Libor, Euribor, Ted Spreads, the ECB, etc, many have noticed that over the past 10 days China's seven-day interbank rates have doubled from 1.8% to 3.2%. Is this latest episode of liquidity turmoil indicative that the PBoC is becoming less successful at communicating an "all clear" to the domestic (and international) markets? Or are there more troubling undercurrents in the sea of (previously) excess Chinese liquidity?
The primary driving force behind the BRIC (re)growth story of the past year has been the mirroring by China of the US excess liquidity policy, coupled with an extremely loose fiscal policy. Which is why every minor blip in any of the liquidity metrics in China tends to be analyzed under a microscope, due to huge implications on the commodity (and thus every other) trade. As the chart below highlights, in the last week, there has been a very disturbing move in the Chinese seven-day repo rate.
What may be the reasons for this surprising move? Bank of America's Ting Lu ventures one explanation:
Recent anomalies in China’s money market bewildered most investors who are trying to detect any small change in policy direction amid the European debt crisis. Markets became nervous about a possible credit seizure as China’s seven-day interbank rates doubled from 1.8% to 3.2% in 10 days. While some took the net injection of RMB224bn in May as a sign of policy easing, others cite the latest rise of the one-year PBoC bill’s yield at issuance as a sign of imminent rate hikes in June. However, we believe the ongoing mess in short-term rates tells us much more about the PBoC’s technical problems than its policy intentions.
The most immediate reason for the spike according to Lu, are imminent IPO and Convertible Bond issuances by the BoC:
To smooth short-term interbank rates, the PBoC has to forecast the demand and supply of funds. Though it might be hard to know the exact scale of hot money inflow or outflow (or conversion between USD and RMB by domestic residents), it should be relatively easy to know of IPOs and seasoned offerings in advance. The latest “unexpected” spike was largely driven by Bank of China’s RMB40bn offering in CBs, which could freeze RMB1.0tn during issuance.
The reason for the RMB40 billion Convertible Bond issuance, as BusinessWorld explains, is the desire by the BoC to shore up liquidity against "bad debt." Since this is something China has a lot of, we anticipate many more such liquidity lock-ups.
The problem, however, facing the PBoC is that such confidence restoring measures go directly against the ongoing desire to reliquify the market. As BofA further explains:
The PBoC intends to cap new loans at RMB7.5tn this year, but it got involved in a competition with CBRC on monitoring banks’ daily loan making. For the PBoC, RRR hikes and bill issuance this year became tools for both regulating bank loan making and smoothing short-term rates. But this multi-tasking flattened (or inverted) China’s yield curves to a degree that the PBoC is not comfortable with.
Indeed, as the chart below shows, the US is not the only country experiencing curve flattening, a bearish signal.
Further demonstrating the quandary facing the the PBoC is the increasingly erratic direction of recent liquidity injections and withdrawals: in this volatile environment, it is amazing 7 day repo rates have moved to only 3.2%.
Another very troubling trend is the drop in excess reserves held by banks: the commercial bank excess reserve ratio has dropped from 3.13% at the end of 2009 to 1.96% by end of Q1, 2010.
And the last factor leading to liquidity distrubances in Shanghai, completely independent of what may be happening in Europe, is the increasing volatility in RMB-USD forwards, courtesy of the groupthink moving from one near revaluation certainty, having hit a multi-year tight in late April, pushing back to January 2010 level as shortly as a month later.
With so much endogenous liquidity volatility occuring in China, it is no wonder Shanghai is at 52 week lows. It is only a matter of time before the broader market puts two and two together and links up the suddenly volatile liquidity environment in China to what is happening in the entire world. And as these things tend to be self-sustaining in feedback loops, keep an eye on the Chinese 7 day interbank rate, together with the European Commercial Paper and repo market, which, if history is any guide, is where the next liquidity shock will strike.