China’s central bank is experimenting with more delicate tools to support bank liquidity and lending, showing an apparent reluctance to resort to blunter monetary policy instruments such as cutting the amount of cash banks must hold as reserves despite abundant signs of weakening growth.
The central bank surveyed primary dealers about demand for 28-day reverse bond repurchase agreements on Wednesday, traders said, as policymakers seek alternatives to another cut in banks’ required reserve ratio (RRR).
It was the first time the People’s Bank of China (PBOC) has suggested it might use such a long-term instrument to inject liquidity into the interbank market.
As recently as two weeks ago, money market traders and economists widely believed the third RRR cut of 2012 was imminent, as evidence mounted that the world’s second-largest economy was slowing more sharply than expected.
But the current consensus is that the PBOC has decided to rely on reverse repos to ensure that banks have the liquidity necessary to support the flow of new loans and bond issues. The PBOC began issuing reverse repos regularly in May.
“My baseline scenario is that the authorities’ focus in 2012 is not on growth but in cleaning up the excesses that materialised from the 2009-10 stimulus,” said Tim Condon, head of Asian economic research at ING in Singapore.
“They simply don’t want to do anything that will risk rekindling the area of excess that they are trying to clean up. And therefore I see the 28-day repo as kind of a fine-tuning measure, that they don’t want to actually make a permanent injection via a RRR cut.”
China’s economy grew at its slowest pace in more than three years in the second quarter, and a factory survey last week showed China’s manufacturing sector contracted at its sharpest pace in nine months in August. Earlier data showed that exports, bank loans, and industrial output all grew more slowly than expected in July.
Why no RRR cut?
While the PBOC has used 28-day forward repos to withdraw liquidity, it has relied exclusively on seven-day and 14-day reverse repos for liquidity injections in recent years. In 2005, 21-day reverse repos were used on a small scale.
Extending the maturity of reverse repo operations offers an apparent compromise between shorter-term liquidity injections and an RRR cut.
Traders had complained that even if the volume of reverse repo fund injections is large, such operations have limited potential to bring down interbank rates. The short duration created uncertainty, since the market could never be sure whether the repos would be rolled over on maturity.
Beyond the issue of duration, however, traders are divided about the central bank’s fundamental motivation for choosing reverse repos over an RRR cut.
Some speculate that central bank is reluctant to take any major easing steps prior to the Communist Party congress likely to occur in October or November, when the Party will unveil its next generation of top leaders. The precise dates are not yet decided.
Such reluctance could reflect divisions within the leadership about how to balance the need for monetary easing with the risk of re-inflating a housing bubble and fuelling investment in industries such as steel and cement already sagging under the weight of overcapacity.
But other disagree, noting that RRR cuts have traditionally been viewed as a technocratic decision that the PBOC is free to make without consulting the State Council, China’s cabinet.
An alternate theory is that the shift to reverse repos represents a longer-term effort by the PBOC to re-tool monetary policy to bring it in line with advanced economies.
In the United States and European Union, central banks use short-term repos to achieve an explicit short-term rates target. Quantitative tools such as reserve ratios play little role.
Guiding the market
Traders point out that, unlike an RRR cut, reverse repos allow the central bank to explicitly guide interbank rates via the auction yield. This essentially sets a floor on the rate at which banks will lend to each other for a given duration.
“An increased number of tenors in PBOC reverse repos will make it easier for the central bank to adjust short-term funding costs,” said a trader at a major Chinese state-owned bank in Beijing.
“Signs are that the PBOC is recently strengthening its guidance of money market rates via its reverse repo rates. Its intention for now appears to be maintaining the stability of short-term funding costs.”
Even as the central bank has increased the volume of its fund injections in recent weeks, it has guided the rate on its seven-day reverse repos from 3.30 per cent on July 12 to 3.40 per cent for the past two weeks.
That suggests that while the central bank aims to ensure that banks have the funds they need to lend, they do not want the benchmark seven-day repo interbank rate to plumb the depths of 2009-10, during which it rarely exceeded 3 per cent and was often below 2 per cent.
By contrast, an RRR cut is a blunter instrument that simply floods the interbank market with funds and lets banks sort out the price at which they will lend.
China was forced to increase the RRR for much of the last decade as a way to sterilize the massive foreign exchange inflows created by its huge trade surpluses.
But the trade surplus has fallen sharply in recent years, and China suffered its first capital account deficit in the second quarter this year.
With the reserve ratio still high at 20 per cent, China must still eventually unwind it to more reasonable levels. But the more balanced flow of capital into and out of the country suggests that the RRR will play a less important role in monetary policy in the future.
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