China central bank turns to liquidity firehouse

Having spent years outlining the move toward a price-based monetary framework and away from directly channeling credit, the People's Bank of China (PBOC) is turning to market-based liquidity measures to ease a pre-Chinese New Year cash squeeze and offset capital outflows stemming from its support for the falling yuan. Net injections totaling more than 1 trillion yuan ($152 billion) since mid-January add about the same as a 1 percentage point cut to banks' required reserve ratios -- the traditional way to boost liquidity.

The difference: RRR cuts are lasting, while injections via reverse repurchase agreements and new lending tools have set time periods. That gives the PBOC more power to manage liquidity by choosing whether or not to roll over funds as they come due. The newer liquidity tools also carry varying interest rates depending on the time period attached, helping create a yield curve the market can use for pricing other securities. That's important for a central bank balancing the need to avoid a short-term cash crunch with longer-term plans to rein in the pace of debt expansion.

Greater transparency is forming around the new approach too, with former Deutsche Bank AG economist turned PBOC researcher Ma Jun explaining the moves to Chinese media. The latest liquidity support is acting as a "substitute" for a RRR cut, Ma told state-run broadcasting network CCTV Wednesday. Overuse of RRR cuts may add too much pressure on short-term interest rates and would therefore be bad for stabilizing capital flows and the exchange rate, Ma said in a China Business News report published Thursday. "The PBOC is shifting monetary policy operations, from conventional RRR and interest-rate cuts to unconventional tools," said Fielding Chen, an economist at Bloomberg Intelligence in Hong Kong. "The PBOC hopes the latter can help to achieve two aims: target particular banks and thus help to facilitate rebalancing the economy; and help to build a benchmark yield curve."

Still, Chen said the new tools don't spell the death of the old. He expects two benchmark interest-rate cuts in the first half, and a couple of RRR reductions.

The PBOC's need to inject liquidity is a departure from the past, when vast trade surpluses, surging capital inflows, and efforts to keep the yuan from strengthening too fast meant the main effort was draining liquidity and forcing banks to lock away increasing proportions of deposits. While trade surpluses are still vast, the currency is now weakening and capital is heading for the exit.

Each time the PBOC steps in to support the currency, it spends some of its foreign-currency hoard to buy yuan, thereby draining funds. It's been doing the same in offshore markets like Hong Kong to plug an unwelcome discount with onshore rates that fans depreciation expectations. Liquidity injections help pump yuan back into the economy.

Then there's the Chinese New Year effect -- a cyclical spike in cash demand as 1.3 billion people plan trips and feasts for the week-long holiday. Huachuang Securities Co. estimates the pre-holiday demand for funds include residents' need for almost 2 trillion yuan, quarterly tax payments siphoning off 300 billion yuan, and the average monthly drain of about 700 billion yuan due to the decrease in foreign exchange positions.

The seven-day repo rate -- the cost of borrowing funds for seven days between commercial lenders -- suggests the PBOC's new approach is helping steady rates, with a corridor largely in place since late-August. The PBOC currently pays a 1.62 percent interest rate to commercial banks on the funds they have locked away with the monetary authority. By contrast, the PBOC sets repo rates close to the market level, with the three-month tool charges 2.75 percent.

That means the PBOC is giving money to banks at a higher price this time compared with a RRR cut. By doing so, it can keep liquidity flush and still avoid driving market interest rates too low -- a move which could trigger more capital outflows and compromise structural reforms aimed at gradually deleveraging the economy.