China Crushes Leveraged Traders With Liquidity Withdrawals

(Bloomberg) -- China’s central bank is winning the battle against leverage, yanking billions of funds from the financial system and crushing a popular trade in the bond market.

The People’s Bank of China drained a net 150 billion yuan ($23 billion) of funds on Thursday using open-market operations, the largest such amount since October. That adds to its 178 billion yuan withdrawal from the past two days, and comes after the central bank unexpectedly mopped up medium-term liquidity earlier this month.

The moves have dried up activity in the country’s repo market, with the overnight rate seeing few quotes as of 3 p.m. Thursday. Traders said lenders were unwilling to offer large loans to each other, while non-bank financial institutions charged high rates. Some brokers offered overnight funds at a cost of 10% and seven-day cash at 5%, said the traders, who asked to not be named as they are not authorized to comment on the money market.

China’s one-year interest rate swaps -- a measure of expectations for future liquidity -– rose for the fifth session to 2.62%, in line for the highest since mid-December. The ChiNext index of stocks, where leverage is rampant, fell 3.6%. The CSI 300 Index closed 2.7% lower.

Excess funds in the banking system had juiced leverage in financial markets by driving China’s overnight repo rate to a record low of 0.59% in December. The cheap short-term financing enabled bond traders to make a killing buying sovereign debt with borrowed cash. Now the cost is above 3%, the highest since 2015.

With China’s 10-year government bonds yielding about 3.19% -- or less than 20 basis points above the overnight rate -- it leaves little room for traders to make money from the strategy. The gap was as wide as 263 basis points in late December.

Repos -- short for repurchase agreements -- are used by banks and brokers to borrow from each other to cover short-term liquidity needs. But China’s financial institutions were using the funds to buy sovereign notes, generating quick and low-risk returns. The so-called carry trade was so popular earlier in January that daily turnover in overnight repos touched a seven-month high.

Local media have sought to allay concern about a cash crunch, with the Securities Times this week urging investors in a front-page editorial to avoid reading too much into the central bank’s money-market operations. On Thursday, the China Securities Journal said the central bank will probably offer “necessary support at an appropriate time” to address any shortage before the weeklong Lunar New Year holiday, which begins in two weeks.

©2021 Bloomberg L.P.

With assistance from Bloomberg