How China’s Liquidity Squeeze Got Markets All Rattled

China’s repo market is a critical component of the country’s financial system. It’s where small banks can source short-term funding from cash-rich lenders and where the central bank can guide monetary policy by influencing the cost of borrowing. Which is why, in January -- with the economy fragile because of the pandemic and a holiday season approaching -- there was consternation when the People’s Bank of China drained so much cash that it engineered the biggest liquidity squeeze in almost six years. The development shone a light on the immense and competing forces that policy makers in Beijing must regularly juggle.

1. What’s the repo market like in China?

Repurchase agreements (repos for short) allow China’s state banks and big investors like mutual funds to make money by briefly lending cash that might otherwise sit idle. The country’s smaller banks and broker-dealers, which rely on wholesale funding, get needed financing by loaning out securities such as government or corporate bonds they hold in return. Daily trading volume averaged 3.9 trillion yuan ($604 billion) in the past year -- with some 15 trillion yuan worth of pledged repos outstanding. The most actively traded repos are the seven-day and overnight tenors, the latter being the preferred financing tool for buyers of sovereign debt. Interest rates of both are closely tracked because they are a good indicator of official monetary policy.

2. Where does the central bank come in?

The PBOC can influence the cost of borrowing overtly by changing the interest rates it charges via its daily open market operations. But there’s also a more discreet way: Managing the amount of cash entering or leaving the financial system by letting repo agreements mature, rolling them over or adding more liquidity. If the central bank offers less cash than the amount maturing that day, it’s essentially tightening liquidity. There are other ways to move short-term rates, such as boosting (or reducing) government bond issuance or injecting (or not injecting) medium-term loans, a routine that unfolds around the 15th of every month.

3. What happened to jolt the repo market?

The PBOC did the opposite of what was expected. In the weeks before the Lunar New Year holiday, citizens need more cash to pay for travel and gifts. This year, the seasonal surge in demand, albeit reduced because of pandemic restrictions, coincided with a deadline for companies to pay taxes. But instead of providing banks with funds to meet the increased need, the central bank actually withdrew liquidity. It was a far cry from the start of 2019 and 2020, when the PBOC flooded the financial system with cheap cash.

4. Why the reverse?

Because of growing concern that asset bubbles -- stoked by abundant liquidity -- were forming in the property, bond and equity markets. A central bank adviser in late January urged the PBOC to shift its policy focus this year to avoid further inflating prices. It’s a particularly sensitive issue for the Communist Party, with President Xi Jinping regularly opining that houses are for living in and not for speculation. The PBOC may have contributed to the excess by unleashing liquidity in late 2020 after a series of high-profile credit defaults had made banks less willing to lend. Those liquidity injections sent the overnight repo rate to a record low and encouraged the buildup of leverage in China’s financial markets. The fastest way to remove the froth is to make cash more expensive, and the quietest way to do that is to drain liquidity.

5. What happened to markets?

The repo market jammed up as some money brokers charged as much as 10% for overnight funding. Cash-starved investors dumped their most liquid holdings, triggering declines in popular stocks in Shenzhen, Shanghai and Hong Kong. The overnight repo rate surged to 3.3433% (surpassing China’s 10-year government bond yield) and overnight repo transactions -- a key indicator of leverage in the debt market -- tumbled by as much as two thirds by the end of January. Casualties included a popular bond carry trade, while the CSI 300 Index of equities slumped from a 13-year high, with margin debt falling from the highest levels witnessed since an epic stock market bubble burst in 2015.

6. Is there a middle path?

The central bank has started drip-feeding liquidity, helping to calm money markets and suppress interest rates. State media has also weighed in, telling investors to not worry. The whole drama showed that policy makers are serious about restraining a rapid debt buildup in the economy. But it also underlined that the PBOC faces a deft challenge of doing so without freezing the interbank market entirely -- a prospect that would damage confidence, risk destabilizing the financial system and jeopardize China’s fragile economic recovery from the pandemic.

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