Ratland China’s central bank faces tricky balance to support liquidity

The People’s Bank of China has taken steps to ease financial conditions after interbank rates doubled in the second half of the year, reflecting the challenge it faces in navigating a return to normal monetary conditions.

The central bank supplied more liquidity than the market anticipated in mid-December via its medium-term lending facility, through which it provides one-year loans to the banking system. The scale of a reverse repo operation in late December — another way of injecting cash into the system — also exceeded expectations, analysts said.

The moves to ease banks’ access to funding come after conditions tightened over the second half of the year as China’s economic recovery gathered pace. They also illustrate the pressure facing the central bank as it grapples to control leverage across a rapid but uneven economic recovery without excessively constraining the flow of money to businesses and households.

“The policymakers want a smooth transition from the past stimulus to a normalised policy,” said Chaoping Zhu, global market strategist at JPMorgan Asset Management. The central bank is now trying to “stabilise the market rate to prevent a sudden dry-up of liquidity” from occurring, he added.

While China has not unleashed monetary loosening on a scale comparable with the US and Europe, it did cut lending rates last year. The MLF rate remains at 2.95 per cent, its lowest level since it was introduced in 2014.

But the three-month Shanghai Interbank rate, an important benchmark for lending in China, rose from 1.4 per cent in May to more than 3.1 per cent by late November, its highest level in almost two years, with analysts pointing to the PBoC restricting short-term liquidity in the system.

The rate has fallen slightly over recent weeks, but remains elevated at 2.8 per cent. Shorter term rates have also followed a similar trajectory.

Banks typically require more funding at the end of the year, but the PBoC’s approach also comes after jitters spread through Chinese financial markets following a series of bond defaults last month. At the end of November, it added Rmb200bn ($30.4bn) in a surprise injection through the MLF.

Concerns over the creditworthiness of some borrowers compounded existing concerns about overall high levels of leverage in China. JPMorgan estimates that the country’s ratio of debt to economic output has risen 27 percentage points to 306 per cent in 2020, based on all government, corporate and household borrowing.

The government has already taken steps to limit leverage in the property sector after house prices rose sharply.

Dariusz Kowalczyk, an economist at Crédit Agricole, said the PBoC’s role in previously pushing up interbank rates “definitely reflects the logic of trying to limit leverage”.

But he added that the central bank was under pressure after deflation unexpectedly appeared in November, which in effect increases real interest rates.

“I don’t expect a cut in official rates, but I think they will try to keep their liquidity conditions a little bit better,” he said. “The problem of leverage will be very challenging for them.”