China’s Money Markets Experience Liquidity Crisis Due to Government Debt Sales

Bloomberg — A brief liquidity crisis shook China’s money markets earlier this week, illustrating how the country’s tightly managed financial system is under strain from a deluge of government debt sales.

On Tuesday, interest rates on overnight interbank loans shot up to 50% in isolated transactions for non-bank institutions, worsening a usually mild end-of-month funding crisis. A confluence of factors, from capital requirements for banks to tax payments and large sales of government bonds, were behind the surge in demand.

A person close to the People’s Bank of China told Bloomberg News on Tuesday that borrowing costs will likely retreat to normal levels as liquidity remains plentiful. Interbank rates fell sharply the next day and the PBOC even withdrew cash from the markets, suggesting it views Tuesday’s chaos as a one-time disruption.

What happened

1. Why did borrowing costs for non-bank institutions skyrocket this time?

Money market rates rose in late October as banks came under pressure to meet regulatory requirements, companies faced taxes and China’s central and local governments sold a record amount of bonds. One bank trader then said that demand for cash was too high for the big banks, the main providers of finance, to meet.

Liquidity conditions tightened further on Tuesday. Nonbank institutions, from stockbrokers to asset managers, which are known for aggressively using interbank lending to bet on bonds, were likely to be caught off guard.

2. What are overnight repurchase agreements and what are they used for in China?

Overnight repurchase agreements, or repos, are a money market loan that uses public or corporate debt as collateral. They are the most popular financing tool for leveraged bond bets in China.

3. Who are non-banking institutions in China and where do they get funding from?

Non-banking institutions are all financial companies other than commercial lenders. They include securities companies, insurance companies, fund houses and trust companies. They can access short-term financing in the country’s vast interbank market or on its two stock exchanges.

4. Why do they tend to suffer more from liquidity restrictions?

It is often much more difficult for non-bank borrowers to obtain financing in the interbank market, because their asset holdings are primarily made up of higher-yielding but lower-rated corporate bonds. The reduced appetite for these types of bonds as collateral for loans usually translates into higher borrowing costs.

When there is a seasonal increase in demand for cash, such as at the end of a quarter or month, the reserve of funds dominated by commercial lenders is further reduced for their non-bank counterparts.

5. How does the PBOC typically respond to a cash squeeze?

In the past, the Chinese central bank has resorted to liquidity injections through open market operations or over-the-counter guidance to big banks, or a combination of both, to calm frayed nerves.

State media also often intervene. On Tuesday, China Central Television blamed unnamed financial institutions for disrupting the market.

China also reopened its interbank trading platform at 6:00 p.m. local time on Tuesday, about an hour after its normal closing time, to give market participants more time to settle transactions.

6. Will it be repeated?

Analysts warn that similar liquidity scares may occur again in the coming months, however brief, as Beijing raises 1 trillion yuan ($137 billion) through sovereign bonds to finance more stimulus. Provincial governments are also preparing for another 1 trillion yuan refinancing program.

“As bank balance sheets become clogged with all this public debt issuance, nonbank and leveraged investment firms will likely continue to suffer,” Adam Wolfe, an economist at Absolute Strategy Research, wrote in a note. “So we continue to expect more liquidity support from the PBOC, including a cut to banks’ reserve requirement ratio.”

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