On The Paradox Of Concurrent Chinese RRR Hikes And OMO Liquidity Injections (And A SHIBOR Update)

About two weeks ago we brought attention to the curious case of surging Chinese SHIBOR. Today we update on the short and longof it (literally). Indeed since the first post, the short end has dramatically tightened. However, just as importantly, the long-end continues to drift wider. As the chart below demonstrates the 1 Week SHIBOR has plunges from north of 6% to the mid 2% range in about ten days. However, both the 1 and 3-Month rates continue to be sticky and are well above recent averages. This will certainly portend continued liquidity scarcity in the months ahead. And speaking of, interest rates, we would like to bring attention to the seemingly paradoxical and contradictory action being taken by the PBoC, which on one hand has been hiking the Reserve Ratio Requirement (liquidity withdrawing) while concurrently adding liquidity via net liquidity injections through Open Market Operations. As Morgan Stanley's Steven Zhang suggests: "The PBOC’s purpose appears to be to substitute RRR hikes for PBoC bill issuance and repos with a view to enhancing the effectiveness while keeping the cost of liquidity management low." Yet even so, Zhang confirms that the end result will be one of incremental tightening, no matter how much the PBoC wants to moderate liquidity extraction. "Even if the spreads between reference and interbank spot yields were to narrow to acceptable levels, we don’t believe that the scale of open market operations would be restored to normal levels. In this tightening cycle, liquidity management will largely become a one-way operation - withdrawal." In other words, look for more pain in the Shanghai Composite over the coming weeks as mainland investors realize that the inflation party is, indeed, coming to an end (and that to Bernanke's chagrin, all attempts at exporting inflation to China will henceforth rebound with a magnified impact).

But first, here is SHIBOR and the divergence between the short and long end.

As for the far more relevant issue of a seemingly schizophrenic approach to liquidity management, here is what Zhang has to say regarding net liquidity injections via OMO on one hand, and withdrawals via RRR hikes, on the other:

PBOC Open Market Operations: After four consecutive weeks of floor-level bill issuance (RMB 2 bn per week of RMB 1 bn each for 1-Yr and 3-M bills) with suspension of repo sales, total issuance rebounded to RMB 92 bn (RMB 4 bn of PBOC bills and RMB 88 bn of repo sales) last week. However, given RMB 111 bn of redemptions (RMB 66 bn of bills and RMB 45 bn of repos) over the same period, net liquidity injection (through OMOs) extended into the eighth week.



Reference yields continued to rise: The PBOC raised the reference yields for the third consecutive week, after which 1-Yr and 3-M rates had risen by 37.8 bps and 44.6 bps to 2.722% and 2.259%, respectively, over the period. However, given the significant spreads with  interbank spot rates (48 bps and 69 bps for 1-Yr and 3-M bills, respectively) (Exhibit 3), the recent hikes in reference yields seem far from sufficient to revive market participants’ interests in PBOC bills and repos, in our view. Even if the spreads between reference and interbank spot yields were to narrow to acceptable levels, we don’t believe that the scale of open market operations would be restored to normal levels. In this tightening cycle, liquidity management will largely become a one-way operation - withdrawal. In this context, the RRR would be superior to OMOs based on cost considerations (e.g., interest rate paid on required reserves is only 1.62%) and  effectiveness (locking about RMB 350 bn of liquidity for every 50 bps of RRR hike). This is the reason behind the seemingly contradiction that the PBOC has hiked RRR for four times within two months but simultaneously continued to inject liquidity through OMOs. The PBOC’s  purpose appears to be to substitute RRR hikes for PBoC bill issuance and repos with a view to enhancing the effectiveness while  keeping the cost of liquidity management low.

As a result, the latest RRR hike, while seemingly still innocuous, is starting to have a substantial impact on investor behavior and interpretation of formal policy:

RRR hike again: On Friday 14, PBoC announced a 50 bps RRR hike effective Jan 20, the fourth rise in two months. This is in part a response to the reportedly aggressive credit expansion by Chinese banks so far this year, in our view. Moreover, this RRR hike should help to absorb the liquidity released from OMOs after the previous hike (Dec 20) and tackle the rising redemption pressure in the coming weeks given the paralyzed OMOs. This RRR hike, together with the rate hike made on Christmas Day, also indicates that China's monetary tightening will be front-loaded, reflecting Chinese authorities' intention to keep inflation expectations in check up front. China's monetary policy will be characterized by "tightening to keep inflationary pressures in check", "front-loaded tightening", and  "non-transparent monetary policy implementation", in our view. We reiterate our call for caution over the next 3-6 months, as the risk/reward balance does not look favorable in view of the rather strong policy headwinds.

In conclusion, Morgan Stanley believes that over time the liquidity balance will increasingly shift to the liquidity withdrawal side of the equation.

Out of consideration for cost and effectiveness, we believe that RRR may continue to play the key role of liquidity management if the trend of one-way operation (withdrawal) of liquidity management continues. In this context, the swaps between RRR and PBOC bills & repos would continue in form of repeated RRR hikes to be accompanied with consecutive liquidity injections through OMOs. Besides the  conventional RRR hike, we expect Dynamic Differentiated RRR to become a primary monetary policy tool in 2011.

And after all, who can blame China: unlike the US, they at least are starting to see the adverse consequences of inflation predicated by loose central bank monetary policy which has already claimed numerous lives in Africa, and soon likely, elsewhere.