No central bank likes to be caught off guard for one of its primary duties, especially when a breakdown happens to quickly after a recent one. Hence the troubles of the People’s Bank of China as year-end approaches. Six months after a monumental lock-up in its money markets, the central bank is facing similar troubles in calming the situation. What gives?

(If you don’t want context, skip down below)

It’s complicated for sure but basically boils down to how the PBOC is losing control of monetary policy onshore and is struggling to reassert control. And a lot of this has to do with China’s very unique monetary situation.

Some background first. The PBOC is not like many central banks managing an economy of its size. First, the currency is essentially fixed, so its role focuses more on currency management than interest rate targeting. Then because of China’s many regulated interest rates, its interest rate decisions do not reverberate through the economy – this is not an economy based on the market price of money. More one where savings was funneled into banks who then made lending decisions for many reasons, some politically motivated and others not (and the all-powerful State Council makes the ultimate decisions on monetary policy, the PBOC only makes recommendations). But the key thing is that level of interest rates has not typically played an important role. For that reason, changes in banks’ reserve requirements (RRR) have been far more important than interest rate announcements, because RRR hikes have been a primary means of absorbing the liquidity coming into the economy from FX inflows that add to local money supply (and vice versa – outflows mean cutting RRR to keep liquidity relatively equal if not looser). That’s why the relationship between China’s FX reserves and RRR is so strong.

Perverse incentives arise. First and foremost, Chinese households – seeing deposit rates held down on purpose – want a better return on their savings. Likewise banks want better ways to glean funding from all that savings and are happy to pay a certain premium in return to get the money. Throw some bad assets that need funding and then you have something called “wealth management products” (WMPs) - and related trust products - that close the circle: households stash their cash in higher-yielding semi-deposits, banks getting funding for these dodgy assets (even through the trust company middlemen) and everyone’s happy. Except the PBOC.

You need to understand the role of WMPs (good explanation here from Oliver Barron at Forbes). These ingenious devices, not too different from a CDO, wrap together a bunch of different assets – including the crazy property debt racked up by local governments after the 2009 stimulus splurge, which created many of the current credit troubles – into a single vehicle that has a shelf-life far longer than the funding invited, which tends to have money market-type maturities. Caijing estimated in May last year that WMPs and the assets of trust companies totalled about 12-15% of formal bank assets or no less than one-third of China’s GDP. That has probably only grown in the meantime. No wonder the funding problems keep occurring at the half-year of June and December. Some banks are balancing a highly volatile mix of funding needs (covering the gap of funding not covered by deposits with interbank borrowing) that gets exacerbated at these key calendar points – or perhaps deposit flows have become so volatile from the WMP competition that banks are struggling to manage. So some are desperate enough to grasp at double-digit rates if necessary. By almost all accounts, the PBOC, very aware of the situation and wanting to cut back on this credit creation that challenges its role as chief credit moderator, has tried to crack down on this behavior through punitive rates – hence the June crunch where it deliberately held back on providing liquidity until the last moment. Something similar is playing out now. As our story from earlier this year suggests and the market seems to reflect, China Minsheng Bank is one to watch. This is why social financing - including some shadow banking elements including outright bank lending - has become the main PBOC measure of credit growth. That has frustrated its attempts to rein things in. We (Divyang Shah and myself) did a regression of what the social financing growth trajectory would have looked like if credit growth had been before the 2009 stimulus package. As you can see below, credit growth has ballooned in ways that is still frustrating the PBOC for all the reasons mentioned above. 

The PBOC could easily inject more liquidity in a more direct fashion but appears to not want to do so, at least not until it has inflicted the most pain on those relying on the interbank market too much to fund chunky/funky lending elsewhere. It’s something of a game of chicken as our reports have suggested this week: the central bank is clearly pushing some banks to the brink without wanting to push them over. Some reports have said that the PBOC has misjudged on inflows back into the banking system at year-end from local governments usually making last-minute deposits for fiscal spending that didn’t happen this year with the crackdown on local governments. Perhaps so, but the PBOC could still just pump in some temporary liquidity via the normal broader channels rather than the very selective SLOs that favor some banks over others. We’ll see on Tuesday. But given that this is playing out again six months after global markets and central banks were surprised with what transpired in China’s money markets and Beijing seemed to catch unwanted attention on the subject, the PBOC must have the backing of the State Council with its response. Along with the fact this fits with the crackdown on corruption and the ill-gotten gains achieved during the previous administration. 

What some of the reports this week have missed is that the PBOC has engineered something of a market-led tightening of policy without touching its usual tools. As I wrote on FX Buzz last week (shameless plug: on Thomson Reuters Eikon only), the local bond and IRS yield curves make this very clear. Both curves have completely flattened since the squeeze earlier this year, which would seem to a reflect that since then, the cost of money in the market has gone up beyond even recent 7-day repo rates. You can look at this multiple ways, but the message is pretty clear. If you had no idea who the country and central bank was looking at this chart, you would have thought there had been a pretty significant tightening campaign this year, especially by modern G5 QE standards. That’s a pretty fair conclusion: 2-year bond yields are up 124 bps and 10-year yields 99 bps in a year when the China bears were worried about a hard landing, and some were looking for stimulus.

China and the PBOC have tightened policy and will keep policy tight, maybe even tighten further if the FX hot money inflows continue. Fake trade invoicing has returned as a problem that adds to the PBOC’s liquidity management challenges. 

But China has many means to handle these challenges. I think as the post has mostly made clear, it also has its own opaque way of dealing with challenges. The PBOC is not going to risk a shock to confidence by putting a bank out of business. Yet it has to change behavior, and engineering these targeted squeezes in interbank markets at key calendar liquidity points seems its best way of getting its message across for now.

China’s economic management is pretty savvy and has a lot of tools at its disposal, so I’ve never favored the hard-landing camp’s simplistic view. But things are in flux and this is a story that bears close watching. To really boil it down, China has tightened policy and may tighten further. The risks to EM markets are pretty clear, especially with Fed QE tapering laying the groundwork for actually tightening (Chinese imports have cooled with global trade). Deposit-setting liberalization is China’s ultimate means of squeezing the shadow banking system and bringing those deposits back into the open banking system, so that may progress more quickly than expected. 

More to come on this story for sure. Happy holidays!