Markets

Christopher Langner is a markets columnist for Bloomberg Gadfly. He previously covered corporate finance for Bloomberg News, and has written for Reuters/IFR, Forbes, the Wall Street Journal and Mergermarket.

Among financial geeks, the repurchase market is seen as the lifeblood of a monetary system. Without it, banks can't really operate.

China's seized up on Tuesday, prompting the People's Bank to perform an emergency cardiac massage. Other regulators in Beijing may want to look on closely, because they may be called upon to undertake a similar maneuver shortly.

To understand what happened in Asia's largest economy, it's important to know how banks operate. Every so many hours, institutions tally up how much cash is coming in the doors and how much is going out. Unlike in the textbooks, this never nets out at zero. Enter the repo market. Banks with excess cash lend it to those that are short at a friendly interest rate. The borrrowing bank also deposits some securities in treasury for the lending institution as a guarantee it will return the money tomorrow.

That kind of arrangement happens even when the central bank is the creditor. Remember when the U.S. Federal Reserve said Lehman Brothers Holdings Inc. didn't have collateral to be used for additional liquidity when it let the investment bank collapse back in 2008?

Bankers are a suspicious lot by nature, and they suspect each other more than anyone else. When a rare default happens, they start hoarding cash, even if they know they can get their money back by selling some of the securities that were pledged. That's what's happening now in China.

China's central bank on Tuesday injected hundreds of billions of yuan into the financial system after some smaller lenders failed to make debt payments in the interbank market, people familiar with the matter said. The interest rate on overnight borrowings soared 78 basis points from a week ago to 3.28 percent, making the yield to borrow for a single day higher than the 3.14 percent five-year Chinese government bonds pay.

Madness
China's repurchase rate curve has taken an odd shape, with the cost of two-week money rising steeply to become now pricier than six-month cash
Source: Bloomberg
* Snap shot as of 9:37pm EST, March 21, 2017

That should normalize after a few liquidity injections -- after all, nothing's more comforting than knowing the central bank has your back. This time, however, it may be more complicated, particularly if the missed payments are the start of a trend.

On Tuesday, it also transpired that the China Securities Depository and Clearing Corp., which oversees exchange-traded notes, plans to allow financial institutions to use only AAA-rated company securities as collateral for short-term loans. (In China, banks tend to be a bit more generous than their Western counterparts, which typically only accept their own government's debt as collateral.)

They're All Good
Of the some 9,240 Chinese corporate bonds rated by Lianhe, almost 95 percent have a grade of AA or higher, which qualified them for repo under the old rules
Source: Bloomberg

One of the most recent times regulators tightened repo regulations was in December 2014, and the bond market pretty much froze. Then, banks were told they could only accept bonds rated AA or higher. That's since become something of a moot point: Thanks to the financial discipline of Chinese borrowers, about 95 percent of corporate debentures can be used as a guarantee for interbank borrowings.

The new requirement means at least half of these securities will no longer qualify. Whether that played a part or not in this week's interbank defaults isn't clear. But you can bet it will in future.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Christopher Langner in Singapore at clangner@bloomberg.net

To contact the editor responsible for this story:
Katrina Nicholas at knicholas2@bloomberg.net