Repo Rate Foretold China's Reserve Move

SHANGHAI—The timing of China's latest decision to ease conditions for bank lending came as a surprise to the markets.

But to anyone alert to the liquidity squeeze in the interbank market, in particular the sharp rise of the benchmark short-term interest rate, Saturday's announcement of a lower reserve requirement for banks was less of a shock.

In the week before the People's Bank of China's announcment, the weighted average rate on seven-day repurchase agreements, or repo—the most widely used funding instrument in China's interbank market—had surged, signaling that the country's banks were uncomfortably short of funds.

Early Friday the rate hit 7%, its highest level in a month, up 3.37 percentage points from a week earlier—mainly due to a five billion yuan (US$794 million) share offering by China Communications Construction Co., as depositors hoping to subscribe pulled a total of 180 billion yuan from the banks.

That matters for the real economy because the repo rate represents the cost of capital for China's banks, and is passed along to their borrowers.

The Chinese central bank has proven to be skillful in adjusting liquidity, controlling the ups and downs of the repo rate through its regular open-market operations and use of the reserve requirement ratio.

In 2009, with the global economy on the brink of crisis, the central bank sought to encourage investment by flooding the financial system with liquidity. The repo rate fell to 1% in the opening months of the year, which was key to pushing the banks into their stimulus lending spree.

In 2010, with the focus on controlling inflation, the central bank started to withdraw liquidity, sending the repo rate higher, a trend that continued—with some bumps—through 2011 and into 2012.

Looking back at Saturday's move with the benefit of hindsight, the surge in the repo rate provided a heads-up. The PBOC on Friday provided another signal of the urgency of easing liquidity conditions, using an unscheduled open market operation to inject cash into the system. By Friday's close, the seven-day repo rate was down to 5.31%.

Saturday's cut in the reserve requirement ratio is intended to do the rest of the job.

"We weren't expecting an imminent cut, but it didn't come as a big surprise either," UBS economist Wang Tao said of the reserve-ratio reduction. "In recent days, interest rates rose quite a bit in the interbank market, showing that liquidity is very tight."

The seven-day repo rate is increasingly seen as a key measure of liquidity conditions in China's financial system, and a more sensitive indicator of the direction of monetary policy than the rather static fixed-deposit and lending interest rates. Traded by banks, insurers, brokerage firms and fund-management companies, it also serves as a benchmark reference rate for pricing fixed-income derivatives such as interest-rate swaps.



Central bank operations aren't the only mover of China's money-market rates. China's banks are constantly buffeted by forces that add to or subtract from their capacity to lend. Moves by the PBOC are often seen as shifts toward either tightening or loosening. In reality, they are more often attempts to counteract the external shocks that knock money markets off course.

The current account is typically the main source of fluctuations. A current account surplus in most months of the year means extra funds coming into the banking system, requiring the central bank to raise the reserve requirement to soak up additional liquidity. Between August 2003 and June 2008, it raised the ratio to 17.5% from 6%, a series of increases that was as much about counteracting the inflow of funds from a growing current-account surplus as about tightening policy.

Speculative capital sometimes finds a way to evade the government's controls, and that also affects liquidity in the banking system. Analysts blamed capital outflows at the end of 2011 for drying up bank funds and forcing the central bank's hand on lowering the reserve requirement.

Initial public offerings can also have a marked impact. China's equities are typically priced low to ensure a bounce on the first day of trading. That leads to a rush to subscribe, as in the China Communications Construction case, with tens of billions or even hundreds of billions of yuan leaving the banking system as depositors chase the hot stock.

For most investors, keeping track of all the ins and outs of China's capital flows is not worth the trouble. But the seven-day repo rate provides a short cut. If it surges, some combination of forces is draining the system of liquidity. If it dips, banks are flush with cash.

To be sure, the repo rate doesn't always reveal what the central bank has in mind. It stayed little changed in the run-up to the last reserve-requirement cut in late November. And at the end of December, when banks' surging year-end cash demand pushed the seven-day repo rate up by 2.59 percentage points in a week, the central bank refrained from acting.

But analysts say that's a reminder to keep other factors in mind, rather than an excuse to ignore the repo rate's clues to the policy outlook.

"Any sharp increase in the interbank seven-day repo rate might be a catalyst for the final introduction of a cut in banks' reserve-requirement ratio, but economic fundamentals are still key to determining such crucial easing measures," said Zhang Junjie, a bond analyst at Ping An Securities.

Source: http://online.wsj.com/article/SB10001424052970204909104577236414128744998.html?mod=WSJASIA_hps_LEFTTopWhatNews