By Saikat Chatterjee
HONG KONG (Reuters) - A three-week cash crunch in China's money market has led to a sharp rise in borrowing costs, sent Chinese stocks to four-year lows and spilled over into global markets.
WHAT CAUSED THE CRISIS?
- The crackdown on currency speculation by China's forex regulator in late April was the biggest reason for the sudden tightening in onshore money market rates.
The State Administration of Foreign Exchange (SAFE) tightened limits on banks' abilities to bet their own money on the yuan's appreciation, aiming to discourage firms from using dollar loans as a means to speculate on yuan gains.
The changes suggested China had grown frustrated over speculative capital inflows driving up the value of the yuan. The net impact of this was a sharp drop in foreign exchange purchases by the banks in May and June, leading to a drying up of liquidity. (For a related chart, click on: http://r.reuters.com/pev95t)
- A secondary factor is the snowballing effect of a broad regulatory crackdown on banks' wealth management products (WMPs) and transactions between banks' on and off-balance sheet funds since the start of the year.
By forcing banks to use more of their own funds to purchase off-balance sheet credit assets, regulators have reduced their liquidity and left them increasingly vulnerable in the event of a cash squeeze.
- Other factors behind the squeeze were seasonal. There was extra demand for cash from companies at the beginning of June because of a holiday and a postponed corporate tax payment coming due, according to UBS. Banks had underestimated the demand for liquidity in this period.
WHY IS THE CENTRAL BANK ALLOWING THE MONEY MARKET TIGHTNESS?
In some ways, this crisis has been one of the People's Bank of China's (PBOC) own creation. By stepping aside and allowing banks to scramble in the money market for liquidity it is sending out a clear message to banks: rely on good old-fashioned deposits to fund loan books rather than fickle money markets.
Many small and medium sized banks hold hundreds of billions of structured wealth management products that generate coupons of up to 10 percent per annum, but which are leveraged and funded by short-dated PBOC liquidity.
With Beijing well aware of the risks in these existing products, the central bank was intent on teaching these banks a lesson in risk management.
Indeed, in the early days of the cash squeeze, when interbank rates rocketed to 15 percent and higher on some deals, banks begged the PBOC to ease money market conditions. Their pleas fell on deaf ears.
The PBOC's campaign is directed at the smaller banks who are particularly reliant on the short-term money market for their liquidity needs. Despite a 75 percent loan-to-deposit ratio, many of these smaller banks run ratios that are effectively much higher levels by issuing wealth management products and other methods.
WHAT HAS BEEN THE PBOC RESPONSE, AND WHAT DOES IT SIGNAL?
After saying little in the first two weeks of the crisis and denying reports that it had injected funds into some banks, the central bank seems to have relented this week.
Tuesday's announcement that it had helped some banks and was ready to act again as the lender of last resort for those caught in a short-term squeeze clearly indicated to the market that it was relenting on its harsh stance.
The benchmark seven-day repo rate, a measure of the rate at which banks lend to each other, opened down about a quarter of a point around 7.20 percent on a weighted-average basis on Wednesday. That is still well above the long-run average of 3 to 4 percent, though below a peak of 15 percent or higher at the height of the crunch.
That chimes with the consensus view the PBOC would be reluctant to prolong the crunch for too long for fear of stifling growth. China's GDP growth rate is already at the floor of what the country's leaders have deemed tolerable.
WHAT CAN THE PBOC DO TO ALLEVIATE THE CRUNCH?
Having punished overextended lenders with the unexpected liquidity crunch, the central bank said on Tuesday it would provide cash to institutions that support the real economy.
In practice, the easing of overnight and 7-day lending rates on Tuesday and Wednesday suggest it has already begun to relax its grip on money market liquidity and thus ease the crunch.
It said on Tuesday it had given cash to some institutions facing temporary shortages and would continue to do so if needed after Chinese shares plumbed to their lowest levels since 2009.
It has an arsenal of weapons to boost interbank liquidity. The bank conducts open market operations (OMOs) every Tuesday and Thursday -- where it has been a net injector of funds in the last three weeks and where it can sharply step up the pace of fund injections.
- It has enhanced the use of OMOs by introducing short-term liquidity operations (SLOs) earlier this year, which help in filling the gaps between the regular operations. This tool is used on a discretionary basis and unconfirmed reports earlier this month were rife that it was injecting funds via this method into the market.
It could also cut banks' required reserve ratios (RRRs), the amount they must hold on deposit at the central bank. The PBOC has used this route to neutralise capital flows and control liquidity. It has stayed at 20 percent since May 2012 even though inflation has declined.
In the longer term, the PBOC may look to other measures, such as improving prudential regulations, to try to stamp out the kinds of reckless behaviours that this money market squeeze was engineered to punish.
(Additional reporting by Lawrence White; Editing by Alex Richardson)
