China’s money market is likely to see more interest rate volatility as financing activities consume ever-greater volumes of liquidity, the People’s Bank of China has warned.
The bank warned in its fourth quarter monetary policy report that growing bank assets and “off-balance sheet innovations” are eating up increasing amounts of liquidity, and this explains periodic bouts of tight liquidity despite expanding M2.
“The more active the financing activity, the more banking system liquidity is digested, leading to rising liquidity demand,” it said in the report released at the weekend.
Market participants will “need to tolerate reasonable money rate volatility,” the PBOC said.
In a section of the 59-page report, the PBOC attempted to explain why money market rates have become more volatile, pinning some of the blame on overstretched banks which have borrowed short to lend long, making them more sensitive to changes in liquidity availability.
The extraordinary growth of Chinese off-balance sheet financing activities has triggered global concerns about systemic crisis. Chinese bank assets have more than doubled since the end of 2009 to CNY148 trillion (US$24.3 trillion), nearly three times last year’s GDP.
The government has attempted to rein in the extremes of shadow financing, though PBOC efforts to control these activities via its provision of market liquidity haven’t been successful, market analysts have said.
The PBOC report said last June’s liquidity crunch, in which short-term interest rates surged to record levels, was the result of short-term factors such as corporate tax payments and “reflected a “conflict” between the overly-fast growth of liquidity demands and the moderate supply.”
The bank’s report didn’t make reference to a decision by the authorities in June to deliberately withhold funding to the market in order to push financial institutions to deleverage, something that market participants believe caused the spike in rates.
The PBOC did acknowledge that its attempts to “adjust the price of financing” can increase the correlation between liquidity availability and the cost of that funding and said that “the central bank will improve the balance of liquidity management and interest rate changes.”
Analysts expect the PBOC to continue to push financial system deleveraging this year as part of the new Chinese leadership’s overhaul of the economy. The bank noted that interest rate reform is also likely to lead to higher and more volatile rates while noting that the economy’s ongoing reliance on debt and investment to fuel growth means financing costs will rise.
“The Chinese economy’s reliance on debt and investment, the high investment model and the overconcentration of resources in real estate and other sectors mean it is easy for debt levels to increase and it’s very likely that small and medium-sized companies will be squeezed, increasing the difficulties of financing and raising finance costs,” it said.
“The massive local financing-construction model has strengthened in recent years, increasing the potential for risks to the economy’s performance,” the report said.
The PBOC said it will step up monitoring and the prevention of risk related to wealth management products and interbank market trading activities, step up its monitoring of local government debt and “explore market mechanisms to solve local government debt problems.”
The seven-day repo rate averaged 5.2390% in Saturday market trading, down on Friday’s 5.4325% but up from 4.9887% ahead of the Chinese New Year holiday. Interbank market traders said the increase in rates reflects uncertainty about the PBOC’s policy intentions now that the holiday, with its peak cash demands, is over.
The seven-day is well below the record 25% hit in intraday trading last June, though traders remain on edge, in part because of uncertainty about how hard the PBOC intends to push its clean up of the market this year.