Traders and treasurers in China have been spooked by a liquidity squeeze that has prompted unprecedented rises in interbank rates. While some sources attribute this to the traditional increase in demand for cash ahead of the Chinese New Year, as migrant workers withdraw money to take home to their families, the unusual severity of the squeeze has other sources saying that the Chinese authorities have badly mismanaged the situation.
The People’s Bank of China, the central bank, has been battling aggressively to control inflation in China, its primary weapon being increases in the reserve requirement ratios (RRR) – the amount of cash banks must hold. These increases have the effect of draining liquidity from the system and together with the seasonal extra demand for cash from individuals have contrived to drive up money market rates sharply. On January 25 the benchmark interbank rate jumped a record 242 basis points to 7.69%, a three-year high.
Market criticism of the PBOC’s handling of the situation focuses on a number of issues. First, the timing of the most recent RRR increase on January 20 has been called into question given that cash demands for the New Year were peaking, with the sources that Euromoney spoke to reaching a rough consensus that about Rmb600 billion ($91 billion) is likely to be withdrawn from banks ahead of the celebration. Together with the estimated Rmb350 billion of liquidity drained by that 50bp RRR increase this put too much of a strain on banks’ cash positions, forcing the PBOC to backpedal and reinject Rmb300 billion of cash into the system via reverse repo agreements.
The second criticism of the PBOC’s behaviour is more systemic: that overuse of one inflation-fixing tool, increases in the RRR, is threatening to destabilize the attempted repairs because it is not balanced by appropriate matching use of the other most effective tool, increases in interest rates. Interest rates have been raised but not fast enough – China still has negative real rates.
The period immediately after the February 3 Chinese New Year will be crucial. If interbank rates gradually climb back down following the festivities, as they have tended to do in recent years, all will be well and it will be possible to attribute the problems in late January to a slight wobble in the timing of the PBOC’s interventions.
If, as some fear, those rates do not substantially decrease, concerns that there are more systemic problems in China’s money markets will be justified. As Michael Pettis, professor of finance at Guanghua School of Management in Peking University, points out in a newsletter, money markets are the basic plumbing of the financial system and their malfunctioning can often be the first warning sign that something is rotten within. Those who recall the seizing up of the money markets in the US at the start of the recent global crisis can attest to that.
The PBOC does, of course, face an enormous challenge in trying to control China’s inflation rate. While it could improve matters by offering more transparency to the market about the timing and nature of its interventions, the central issue raised by the late January liquidity scare is somewhat out of its hands. That is the question of whether these events were a blip caused by an unfortunate combination of circumstances or a symptom of growing unease about the nature and direction of China’s growth.
