• An aggressive campaign to rein in lending activities in China’s interbank market is creating pricing irregularities in the financial system. Money market rates and bond yields have risen above key bank loan rates, while the government yield curve has taken an unusual shape. 
  • The central bank is in a bind. Raising benchmark rates would at least restore some of its rate-setting authority but would also drag on the economy. Conversely, easing policy to help lower market rates would undermine the leadership’s deleveraging drive. 
  • We expect the bank to stand pat for now but this will be a difficult month. Current pricings may be unusual but the risks of doing too much outweigh those of continuing to muddle through.

The cost of borrowing wholesale funds in the Chinese interbank market now exceeds the amount banks charge on lending those funds out to borrowers, as the government’s deleveraging campaign rolls on. Something has to give, but we do not think the People’s Bank of China will be in a hurry to move while the leadership considers curbing credit activities in the interbank market a policy priority.

Key money market rates, such as the Shanghai Interbank Offered Rate and yields on negotiable certificates of deposit, exceed the loan prime rate — the rate commercial banks give their best clients (see chart).

Yields on five-year, AAA-rated medium-term notes and enterprise bonds have risen above the lending rate for the equivalent tenor, for example, while the government bond yield curve recently took on a strange, double-humped shape, indicating a severe liquidity shortage that has strangled trading in key tenors (see chart). This pricing is even more extreme than during the chaos of the June 2013 liquidity crunch.

Rising money market rates are having a real economic impact as banks across China raise their lending rates. Small lenders are charging as much as 30 per cent more than the PBoC’s published rates. Average loan rates were already rising in the first quarter as lenders struggled to maintain their net interest margins. We would expect this trend to have continued into the current quarter (average lending rates are published in the weeks after the quarter-end) (see chart). The percentage of first-time homebuyers having to pay the benchmark rate or above for a mortgage surged to 72 per cent in May from 58.9 per cent the previous month, according to the latest FTCR China Real Estate Index, the biggest month-on-month move since the survey began.

No following the Fed

This is no accident but a deliberate campaign to deny liquidity to parts of the financial system in order to force a clean-up. Given the political will underpinning the campaign, we do not expect the central bank to step in unless it gauges heightened risk of a systemic break. These strains are only set to increase as the end of quarter approaches because banks typically hoard deposits at such times to prepare for regulatory checks. 

With market rates rising above benchmark rates, the central bank may feel pressured to keep up with policy rate increases, or risk a challenge to its rate-setting authority. But higher bank borrowing costs would be extremely negative for meeting official growth targets and for keeping defaults under control.

Instead, incremental signalling moves, such as adjustments to rates for its various funding facilities, are the more likely near-term policy choice for the central bank. But this is a balancing act for the PBoC, which will try to ease liquidity conditions where appropriate; the bank has indicated it is preparing for a tight June by providing more funds through its Medium-term Lending Facility and 28-day reverse repurchase agreements. 

We therefore see less cause for the PBoC to follow the US Federal Reserve should it raise rates again in two weeks. The PBoC raised rates on its funding facilities after the Fed’s March hike, arguing that it needed to maintain a spread between US and Chinese rates to keep the exchange rate stable. The central bank is concerned that too narrow a gap would reduce the attractiveness of renminbi assets and drive capital outflows. The increase in domestic yields has done much to maintain that gap, reducing the need for the PBoC to move in tandem with the US (see chart). 

No reserve cut

An alternative policy choice for the bank is to try to lower market rates by releasing more liquidity into the system with a cut in the reserve requirement ratio (RRR). 

The fall in the excess deposit reserve ratio, which measures the discretionary reserves that banks can choose to store with the PBoC, highlights liquidity strains and has fuelled calls for a cut (see chart). Sheng Songcheng, an adviser to the PBoC, said last month that the bank could act if the excess reserve ratio falls too low, without specifying a level. We believe the PBoC has more patience, however: the excess reserve ratio fell below current levels in the second quarter of 2011 but the PBoC did not cut the RRR until December of that year. In addition, a cut would undermine the government’s message on deleveraging. 

In the event of truly heightened systemic risk, we have no doubt that the PBoC would act, but for now will resist doing so.

FT Confidential Research is an independent research service from the Financial Times, providing in-depth analysis of and statistical insight into China and Southeast Asia. Our team of researchers in these key markets combine findings from our proprietary surveys with on-the-ground research to provide predictive analysis for investors.
Copyright The Financial Times Limited 2018. All rights reserved.

Comments have not been enabled for this article.