China’s Conflicting Priorities Amid Rare Money Market Distress – Reuters

SHANGHAI/SINGAPORE – China’s efforts to stabilize the yuan have been linked to recent turmoil in the money markets, as sources indicate that the government is navigating a significant economic slowdown.

On October 31, a typical month-end demand for cash escalated into a frenzy, driving short-term funding rates up to 50%. Authorities are now investigating this incident. Six market participants highlighted a combination of factors that led to widespread uncertainty and panic across trading desks in Shanghai and Beijing as the day progressed.

To address the situation, the People’s Bank of China (PBOC), along with its associated entities, intervened by directing lenders, extending trading hours, and engaging in discussions with financial institutions to stabilize the markets.

Among the contributing elements were the usual month-end liquidity demands, cash hoarding ahead of a major government bond sale, and the reluctance of major banks to lend due to governmental directives aimed at preserving the yuan’s value.

"It was an accident," remarked Xia Chun, the chief economist at a wealth management firm, describing it as an unintended outcome of the government’s stringent financial regulations. He noted that banks were hesitant to lend, which pushed non-banking entities into a tight spot as they sought funds from each other in the afternoon hours, resulting in skyrocketing borrowing rates.

For the first time, the reasons behind the spike in interest rates and subsequent market disruption have come to light. Participants have warned that the vulnerabilities exposed could persist as long as capital outflows put pressure on the financial system.

Due to the sensitive nature of the topic, most market participants requested anonymity while discussing the events. The PBOC confirmed that the China Foreign Exchange Trade System (CFETS) was investigating "abnormal" trading activity from that day, specifically involving accounts that repeatedly borrowed and lent money at excessively high interest rates.

Short-term funding mechanisms, such as overnight repurchase agreements, are vital for the operations of banks, insurance companies, and other financial institutions, as they significantly influence foreign exchange movements and liquidity in the market.

Disruptions in these markets pose risks to financial stability, a reality underscored by China’s recent approval of a substantial sovereign debt sale. This move involved increasing the size of bond issuance while adhering to a pre-set schedule, a decision that some believe has contributed to market tensions.

Typically, the PBOC would counterbalance the cash drain from increased bond issuance by injecting additional liquidity into the banking system. However, concerns over worsening pressure on the yuan—down over 5% against the dollar this year—have led to a cautious approach from the central bank.

During the trading session that Tuesday, the surge for short-term funding became chaotic. Repo rates between banks, which usually remain stable, skyrocketed from 2% to as much as 8% on October 31.

At 4 p.m., state banks that typically provide last-minute funding were reportedly absent, forcing a handful of desperate borrowers to accept exorbitant rates between 30% and 50%, levels not seen since past banking crises. By the end of the day, positions remained unresolved and trades incomplete.

One fund manager described the atmosphere on the trading floor as tense, with participants wary of uncertainties. They stressed that in such an environment, borrowing at high rates becomes a rational choice to avoid defaults.

In response to the turmoil, the PBOC instructed state banks to lend additional funds. Meanwhile, major clearing houses reopened at 6 p.m. in a bid to quell the crisis, leading to a resolution of the turmoil by 8:30 p.m.

At a subsequent meeting the next day, the PBOC expressed concern over market behaviors that were "disturbing the market" and urged institutions to refrain from emotional decisions. The CFETS also mandated that traders maintain a 5% ceiling on repo transactions and warned those involved in high-rate deals would need to justify their actions to regulators.

As stability returned and overnight rates fell below 3%, many analysts believe the immediate danger has passed, although the underlying tensions linked to the yuan’s management persist.

China’s economic recovery post-COVID has been disappointing, compounded by global interest rate rises that have prompted capital flight and put additional pressure on the yuan. Despite these challenges, efforts have been made to stabilize the currency, including interventions by state banks and new regulations to curb speculative behavior.

Nevertheless, there remains a cautious outlook, with many expecting continued tightness in liquidity so long as the currency faces upward pressure. Broad dollar weaknesses have recently aided the yuan, yet at a current exchange rate of 7.28 to the dollar, it hovers close to its 16-year low set in September.

Experts warn that a failure to adjust the current patterns of liquidity provision could lead to further instability in the financial system, leaving it vulnerable to future shocks.