China is finding itself in an increasingly more untenable situation, trapped on one hand by its sliding currency (and declining reserves), which as noted earlier it has manipulated higher by forcing overnight unsecured rates to spike, in the process punishing "speculators" and other shorts...
... and on the other, by a banking sector that finds itself desperately in need of liquidity, unable to endure the PBOC's monetary interventions, and on the verge of a liquidity crisis comparable to what Chinese banks suffered in the summer of 2013 when overnight rates briefly shot up above 20% as China pushed aggressively with a failed deleveraging campaign.
All this came to a head late last week when as Caixin reported late on Thursday, interbank lending froze on Thursday after many commercial banks suspended interbank operations amid tight liquidity conditions. Caixin adds that major institutions such as securities firms and fund managers, suddenly found themselves in a liquidity vacuum after banks, including the big four state-owned banks, became reluctant to make loans.
The magazine added that liquidity had become a major factor affecting the market after the central bank increased the cost of capital through open market operations in the past month, something we highlights three weeks ago in "The Market's Next Headache: China's (Not So) Stealth Tightening."
The latest liquidity freeze forced China's central bank to immediately extend hundreds of billions of yuan in emergency loans to financial firms on Friday and "ordered" some of the country’s biggest lenders to extend credit as well, as it moved to ease a liquidity crunch and continuing debt selloff.
On Friday, the PBOC tapped an emergency lending facility it created in 2014 to extend 394 billion yuan ($56.7 billion) in six-month and one-year loans to 19 banks. That pushes the net amount extended through the facility to 721.5 billion yuan so far in December, a monthly record, according to Beijing-based research firm NSBO. The central bank also injected a net 45 billion yuan into the money market on Friday, following a net 145 billion yuan cash infusion on Thursday.
The PBOC also ordered a few large banks to extend longer-term loans to nonbank financial institutions, while China’s securities regulator asked brokers tasked with making a market in bonds to continue trading and not shut any companies out of the market, according to Mr. Zheng of Dongxing Securities.
“The whole market is scrambling for liquidity and the PBOC is ready to do more to calm the market,” said Arthur Lau, head of Asia ex-Japan fixed income at PineBridge Investments in Hong Kong.
According to the WSJ, Investors and analysts said that the PBOC’s moves—which ended up pumping around 600 billion yuan ($86.3 billion) into the markets and financial system in two days—have helped calm some of the jitters.
“These policy interventions have helped tremendously in pacifying the mood,” said Zheng Lianghai, fixed-income analyst at Dongxing Securities in Shanghai.
It is unclear if the "pacified mood" will last: as a reminder, last Thursday, China briefly halted trading in bond futures after a record bond market crash send China's 10Y yield plunging by the most on record, wiping out over a year of gains.
One day later, China suffered its first failed Bill auction since introducing a Primary Dealer system, which theoretically should have made "failed auctions" a thing of the past, over investor concerns of spiking short-term rates. On Friday, the yield on China’s 10-year government bond jumped about 0.1 percentage point to 3.33%, while yields on the interest-rate sensitive two-year government bond and the 30-year bond, which responds to inflation expectations, rose even more.
According to the WSJ, year-end factors are exacerbating liquidity concerns, among them banks storing up cash to prepare for an expected rush to move money abroad in the new year, when Chinese foreign-exchange quotas for individuals reset. Banks are also preparing for an early Lunar New Year in 2017, when Chinese traditionally give gifts of cash.
Yet some market-watchers say that a host of factors—from rising global rates to the central bank’s attempts to deflate China’s asset bubbles—could hit the country’s $9 trillion bond market, where yields hit record lows this year. If the bond selloff accelerates, some analysts fear China could see a market crash like the one that hit stocks last year.
Indeed, the jitters go deeper than seasonal factors. Increased prospects for inflation—and a more hawkish Fed—come as Chinese regulators have already started to tighten short-term borrowing conditions in recent weeks to cool overheating Chinese markets. Over the past year, speculators have borrowed from money markets to fund investments in bonds and other financial products.
So while the PBOC can easily pump liquidity, it could come at the expense of further devaluation in the Yuan, which last week saw its lowest print on record, just shy of the key 7.00 level. A weakening Chinese currency, which has fallen 7.2% against the U.S. dollar this year, has also kept the pressure on officials to tighten monetary policy and stem capital outflows, however it is these same tight conditions that have led to the banking freeze, putting the PBOC in a quandary: does it focus on the banks, or the Yuan.
Meanwhile, the country’s foreign-exchange reserves plummeted by $69 billion in November to $3.052 trillion, putting reserves at their lowest level since March 2011. Officials are ramping up their capital controls to keep the yuan from fleeing overseas by cracking down on overseas acquisitions by mainland companies and limiting how much money multinational companies can move out of the country and into their global operations.
As the following table lays out, while China still has a substantial liquidity buffer left, a worst case scenario could see China running out of liquid US holdings in just around 15 months.
Chinese banks are also being pushed by new domestic regulations to bolster capital levels, and some are rushing to boost their cash positions by selling bonds before the year-end deadline, analysts say.
Further complicating matters, was the announcement by a top economic official on Saturday that China must do more to deflate a property bubble that expanded this year by "strictly" controlling speculation while also stepping up the fight to rein in excessive corporate borrowing, suggesting further monetary tightening is on deck.
"We need to give a higher priority to preventing and controlling financial risks," Yang Weimin, deputy director of the Office of the Central Leading Group on Finance and Economic Affairs, said Saturday at a forum in Beijing. "We need to defuse a flurry of risks, contain asset bubbles, and improve oversight to ensure there won’t be a systemic financial risk."
Yang spoke a day after China’s top policy makers said they plan prudent and neutral monetary policy next year to sustain a steady expansion with breathing room for reforms. Preventing and controlling financial risk to avoid asset bubbles will be a priority, officials said in a statement Friday after the three-day Central Economic Work Conference.
"Houses are built to be inhabited, not for speculation," the post-meeting statement said. It proposed using finance, land, taxation, investment and other instruments "to establish a fundamental and long-term system to curb real-estate bubbles and market volatilities," according to a report Saturday from the official Xinhua News Agency. Yang, who helped draft Friday’s statement, sits on the Communist Party’s elite financial and economic panel led by Xi that is shaping policies to help support growth. The director of the panel’s general office is Liu He, one of Xi’s top advisers which likely means that China's top priority at this point will be withdrawing further excess liquidity from the market in a gradual attempt to restore affordability to China's housing market.
The question is whether China can do that while avoiding a hard landing for the banking sector, which once again finds itself desperate for liquidity, yet while can also ill afford further capital outflows, which would result from additional liquidity injections by the central bank.
As stated earlier, this suggests that the PBOC will soon have to make an unpleasant choice: deflate the housing bubble, and avoid an acceleration in capital outflows, or preserve the viability of China's creaking banking sector and continue with massive "emergency" liquidity injections.