China’s short-term liquidity has eased. The seven-day repo rate has come back down by 4%, while SHIBOR of maturities less than 1 month have come down significantly, but rates for 1-month and above remain more of less unchanged. Liquidity has eased up to 2 weeks, but not longer.
It is not usual practice for the PBOC to keep injecting liquidity through open market operations for extended periods of time, and it is perhaps even more unusual for such injections to have so little impact on interbank rates. At the same time, we observe that the rates for reverse repo have not changed much either, while PBOC still refuses to cut reserve requirement ratios (against all the hopes the market had) or benchmark deposits and lending rates.
So it does not appear to us that the PBOC is willing to ease more despite the slowing economy because of inflation concerns and real estate market resilience. At the same time, there is a little liquidity problem, which is probably more than just a quarter-end and pre-holiday cash crunch:
The problem, of course, has been the persistent money outflow and FX accumulation, which automatically tighten liquidity in the Chinese banking system. This has been a major theme for almost a year now. As a result, FX reserve accumulation has stopped.
So has the balance sheet expansion. Not only has it stopped, the size of PBOC’s balance is actually falling relatively to the size of the Chinese economy.
We often hear analysts and economists telling people that there is nothing to worry about regarding capital outflow, because China has US$3.2 trillion FX reserve. This, however, ignores the impact of a shrinking FX reserve on Chinese liquidity. The PBOC does have US$3.2 trillion of fire power, if you like, to prop up the currency in the unlikely event of massive capital outflow, but the success of it will come at the expense of domestic liquidity. As the charts above show, the PBOC might have cut interest rates twice, but they are at the same time performing quantitative tightening, albeit against its own will. Sooner or later, it will necessitate the use of other tools (on top of routine use of reverse repo) to ease liquidity, such as outright bond buying, or perhaps guiding a depreciation of the Chinese Yuan and hope that inflows will appear again.
And the latter option appears to be what the PBOC is actually using. The chart below shows the daily market price of onshore USDCNY and the PBOC daily fixing. After months of setting the daily fixings persistently higher than what the market thought Chinese Yuan should be, PBOC is now setting Chinese Yuan at weaker rates than the market. The divergence is getting particularly obvious since the Fed announced QE-Infinity. At some point, perhaps (or perhaps not), it will necessitate PBOC FX intervention again, essentially to print Chinese Yuan in order to bring the price closer to the fixing.
For the time being, however, the potential positive impact on liquidity through this channel of base money creation is not felt. With the euphoria regarding QE3 fading in some markets, and the Eurozone Crisis back in focus, it is not clear how large and for how long the positive impact of QE-Infinity on Chinese liquidity can be.