Q&A: Cash crunch in China

December 22, 2013 6:33 am

Q&A: Cash crunch in China

By Simon Rabinovitch in Shanghai

At the end of Friday the People’s Bank of China, the central bank, responded to rising money market rates by announcing it had injected more liquidity into the system. With investors on edge as Chinese markets reopen on Monday, will last week’s injection be enough to calm fears that China is set for a cash crunch or will there be more?Why are people concerned about a “cash crunch” in China?

For the simple reason that money market rates shot up to unsustainably high levels over Thursday and Friday of last week, indicating that banks are hoarding cash and are extremely reluctant to lend to each other. The seven-day bond repurchase rate, a crucial gauge of short-term liquidity, traded at an average of 8.2 per cent on Friday, nearly double its level a week earlier, a dizzyingly fast rise. Interbank borrowing rates also soared, climbing to heights last seen during China’s cash crunch in June when rates hit double-digits. As that episode showed, lending to the “real economy” of companies and households need not be affected by short-term turmoil in the interbank market, but it would be very worrying if it were to persist much longer.

What’s the cause of the cash crunch?

The immediate trigger for the tightness is the central bank itself. Over the past half month, it has steadfastly refused to inject any money into financial markets via its regular open-market operations. Traders have complained that this tightening stance is inappropriate in late December because of a seasonal rise in the demand for cash: banks face regulatory pressure to book more deposits at the end of the year at the same time as companies withdraw more money for their operations. Moreover, with savers shifting out of traditional bank deposits into alternatives such as wealth management products, the end-of-year competition between banks for cash has become even fiercer.

Is the central bank punishing misbehaving banks?

The central bank has been steadily guiding up interest rates in the interbank market over the past half year. It has made clear that it does not want banks to rely on cheap short-term liabilities in the interbank market to finance risky longer-term assets, many of which are grey-area “shadow” loans to property companies and local governments. By making short-term rates both higher and somewhat more volatile, it is trying to force banks to do a better job of matching their interbank assets and liabilities. But letting money market rates surge to 10 per cent is emphatically not part of the central bank’s strategy. So, many analysts believe that it has miscalculated. It expected the finance ministry to disburse a large volume of funds in the final weeks of December – as it has done in past years – to meet budgetary commitments, but failed to anticipate the far-reaching consequences of President Xi Jinping’s campaign to rein in wasteful spending. Chinese financial markets are also becoming more complex as interest rate liberalisation gains momentum. This makes it difficult for the central bank to predict the supply of and demand for cash, and it has yet to move to a monetary policy framework where it focuses on benchmark rates, as is the norm for central banks in developed economies.

What is the central bank doing about it?

One thing is certain: the central bank does not want to see a severe cash crunch. It took the highly unusual step last week of conducting “short-term liquidity operations”, giving cash-strapped banks an emergency dose of credit (the banks pledge assets such as bonds for the cash and promise to buy them back them after a few days). It has twice used Weibo, China’s version of Twitter, to announce its moves hours after conducting them, rather than following its own rule of waiting one month to confirm SLOs. After markets closed on Friday, the central bank announced it had injected a total of Rmb300bn ($49bn) via SLOs. This is a huge injection of liquidity, though some traders have complained that a standard infusion via open-market operations – which are more transparent and are available to all banks – would have been more effective than these behind-the-scenes manoeuvres.

What is going to happen this week?

With open-market operations scheduled for Tuesday and Thursday, and the precedent now set for emergency cash injections, it would be astonishing if the central bank did not step in to provide more liquidity this week if the cash crunch continues. But the central bank is wary of overreacting because it has reason to believe that the extreme tightness will subside after the Chinese lunar new year in early February. Looking at interbank borrowing rates, while durations of one month and less have shot up, those from three months to one year have remained much flatter. This is an indication that the cash crunch is more an end-of-year scramble for money than a fundamental breakdown of the Chinese financial system.