The complexity of the situation shouldn’t be underestimated.
That’s a quote from the PBoC emphasizing just how difficult the Chinese central bank’s job has become. “China will give higher priority to balance between tightening and easing and keeping the monetary policy neutral,” officials said, in a statement following the quarterly meeting of the monetary policy committee.
It would be difficult to overstate how precarious the balancing act has become since the August, 2015 move to begin a controlled devaluation of the RMB. Indeed, I can scarcely count the number of short posts, articles, and lengthy missives I’ve penned this year about Beijing’s impossible juggling act.
This month, we got the most recent manifestation of China’s never-ending game of “Whack-a-mole” when efforts to curb speculation and tighten liquidity in money markets ended up conspiring with a surprisingly hawkish Fed to trigger a bond market meltdown. The situation was exacerbated by at least two high profile scandals involving supposedly fraudulent seals and paperwork tied to entrusted bond deals.
Over the past several weeks, Chinese money markets have experienced a good deal of turmoil. On Thursday for instance, seven and 14-day repo rates exploded after the PBoC sucked hundreds of billions in liquidity from the system.
Note that the central bank is also extending the tenors (and thus raising the cost of liquidity) of its open market operations. Here’s an illuminating breakdown:
(Charts: SocGen)
What’s particularly interesting to watch is the 7-day repo rate which, as SocGen notes, has “breached 2.5% – the upper-end of a longstanding trading range netting out spikes — more often since September than in previous months.”
Here’s a 30,000 foot view:
(Chart: Bloomberg)
…and here’s a zoomed in look with volatility indicators…
(Chart: SocGen)
As you can see, things are getting more unpredictable as the 7-day rate sees more frequent spikes.
Another important concept to grasp is the difference between the interbank rate and the more widely traded benchmark rate. Here’s SocGen with some color:
In its latest quarterly monetary report the PBoC mentioned that the 7-day repo (DR007) used among depository institutions in the interbank market could help “cultivate” a market benchmark rate. This 7-day repo (DR007) requires rates products — CGBs, PBFs, PBoC bills — as collateral and is traded among depository institutions only, whereas the benchmark 7-day repo (R007) is traded among a wider base of market participants and allows a wider choice of collateral. DR007 has been tracking R007 closely with less volatility. With lower counterparty/credit risks it is not surprising that DR007 is slightly lower than R007. That said, 36% of the widely-used repos (R007) are done using CGBs as collateral and another 51% using financial bonds. The difference in levels between R007 and DR007 should not be big.
(Chart: SocGen)
Right. So essentially, the interbank and benchmark rates are diverging more than they should because the market is becoming more hesitant to lend against anything other than than the highest quality collateral.
All of this is only going to get worse as counterparty risk multiplies and as the PBoC tries to strike an impossible balance between tightening money market liquidity and keeping the spigots open so as not to choke off growth and/or prompt too much deleveraging too fast.
When it comes right down to it, there’s mayhem bubbling just beneath the surface and if you learned anything from 2008, let it be that money markets are where to look when it comes to assessing the severity of the problem.
