- PBoC calms China's money market
- De facto tightening nevertheless a result
- Further pressure on China's economy
- PBoC could yet reverse and loosen


By Greg Peel

Unlike conventional monetary policy in the US, Europe and Australia, note Commonwealth Bank's foreign exchange analysts, China's policy is not delivered via single official cash rate target. Rather, the People's Bank of China uses a collection of tools and regulations to set monetary policy. These include benchmark lending and deposit rates ranges, reserve requirement ratios (RRR) for banks, and open market operations (OMOs) which influence short term rates and the interbank rate (Shibor).

Monetary policy is adjusted frequently with China's money supply in mind, and the PBoC acts spontaneously as the need arises rather than on scheduled dates following policy meetings as occurs in the developed world.

China's broadest measure of credit growth, known as total social financing (TSF), has risen 58% year on year, CBA notes. This does not reflect loose PBoC policy but rather a lift in loans to non-bank financial institutions which are mostly tied to wealth management products offering investors higher interest rates than bank deposits. Without large deposit bases of their own, these non-banks rely on the Shibor market for funding. This is what the world calls China's "shadow banking" system. Shadow banking has allowed TSF to grow a-pace against Beijing's policy intentions.

A central bank, such as the Reserve Bank of Australia, normally sets a target rate for overnight cash (ie the current RBA rate of 2.75%) and then adds or withdraws funds daily from the banking system as needs be to maintain the right credit demand-supply balance at that rate. Similarly, the PBoC manages the Shibor rate through such OMOs. Last week the PBoC nevertheless decided to clamp down on shadow banking by not injecting funds into the system, hence a resultant credit squeeze sent Shibor sky-rocketing to an intraday peak of 25% compared to previous "normal" levels of around 3%.

Such a squeeze is reminiscent of the US experience leading up to, and particularly immediately after, the fall of Lehman in 2008. Hence comparisons have been made in global commentary. However, credit dried up in the US, and the rest of the developed world, because banks and institutions suddenly became wary of each other's liquidity, not because the Federal Reserve was not injecting funds. On the contrary, funds were very quickly injected, leading to the TARP and QE1.

Such a credit squeeze can not only bankrupt financial institutions, such as Lehman, but freeze an economy. Money being passed back and forth between banks not only reflects financial market transactions but the day to day flow of corporate payables and receivables.

JP Morgan's economists believe the PBoC underestimated the impact its actions would have. While the central bank insisted there was no shortage of liquidity at the aggregate level, there is a big difference between the credit requirements of China's big banks, which have substantial deposit bases, and China's small and non-banks, which do not. While Shibor transactions only represent a small percentage of China's banking system, the rate spike not only threatened to bring down many small banks but also the corporate clients relying on overnight credit. Meanwhile, the big banks, representing the bulk of liquidity, have little need to access Shibor and hence offered no buffer.

Calm was nevertheless restored yesterday after the PBoC ? no doubt a little spooked by what it had caused ? issued a statement intended to ease the liquidity squeeze. And in so doing, calm a nervous world.

The statement assured that the central bank had now injected liquidity to some financial institutions and that it would use OMOs and other tools to maintain stability in the banking system. At 1.5trn renminbi, aggregate bank excess reserves are around double what is considered sufficient. The bank will ensure stable growth in credit and improve credit allocation, and ensure credit support to sectors such as manufacturing, services, agriculture and small-to-medium enterprises. And the PBoC will strengthen market discipline in the Shibor market.

In other words, "Oops, sorry".

The Chinese money market has now duly calmed down and Shibor has fallen to around 5%. JP Morgan suggests, nevertheless, that the PBoC has damaged its global reputation and undermined its efforts to establish an interest rate transmission mechanism in China with a stable benchmark, such as Shibor. No doubt Beijing would like to see Shibor one day rival its developed world template Libor, the London interbank overnight rate, which is used as a basis for rate setting across the globe including in the US.

The PBoC had also previously reiterated a neutral monetary policy stance, but has actually orchestrated de facto monetary tightening, JP Morgan believes. While interbank rates have fallen, they are unlikely to fall as low as they were previously now that shadow banking activities will decline. Higher rates will then be passed on to borrowers, putting more pressure on an already weakening Chinese economy.

The world entered 2013 expecting more monetary loosening from the PBoC under the new regime in order to support a slower growing Chinese economy and head off any "hard landing" risks. Such de facto tightening means the opposite.

CBA does not nevertheless believe China's economy will sharply slow further as a result of Shibor tightening. While China's closely watched manufacturing purchasing managers' index (PMI) has slipped into contraction, the analysts do not see this indicator pointing to a sharp correction. And if necessary, the PBoC can always jump in and loosen Shibor up again, and/or cut the RRR and/or benchmark lending rates.

CBA further believes that now that the world has come to understand what went wrong in China last week (few outside Shanghai had ever heard of "Shibor" previously), fears will recede. It is also likely China's own stock market will recover after falling 24% from its February peak. Base metal prices, which have traced a similar path, may also enjoy a rebound, suggests CBA.

The analysts thus expect the Aussie dollar to recover to around US$0.96 by year-end. Thereafter the Aussie should resume its depreciation, they suggest, as levels above 96 are unlikely given renewed strength in the US dollar and the challenges faced by the Australian economy as it attempts to transition away from mining as the primary driver. The growth path for Australia's economy will depend on strength or otherwise in net exports, household consumption, residential investment and business investment outside resources, the analysts note.