Worst Cash Crunch Since June Signal of Economic Rebound

China’s brokerages are betting the biggest jump in money-market rates since June’s record cash crunch is a sign of strength in the nation’s economy rather than finance-industry weakness.

The central bank has refrained from injecting funds into the banking system since Oct. 17, driving the benchmark seven-day repurchase rate 138 basis points higher to 4.88 percent last week, the most in four months. Yet the one-year swap contract, the fixed payment needed to lock in the repo rate for 12 months, rose just 11 basis points to 4.08 percent, reflecting expectations for a gradual rise in borrowing costs. That’s well short of a 5.06 percent peak in June, when investors were concerned overstretched banks would default on payments.

This time round, the cash crunch is reflecting economic strength after gross domestic product expanded 7.8 percent in the three months through September, ending a two-quarter slowdown. The odds of a credit crisis are decreasing on expectations a Communist Party summit in November will take steps to scale back local-government debt and shadow banking, a Bloomberg survey indicated.

“Now that policy makers believe this year’s growth target can be met, the central bank thinks it may be time to make efforts to achieve its credit-growth target,” said Guo Caomin, a bond analyst at Industrial Bank Co. in Shanghai. If the PBOC doesn’t tighten as capital inflows return, then it’s actually loosening, he said.

Expansion Pressure

A steepening of the yield curve, which inverted for the first time on record in June, shows investors don’t expect the People’s Bank of China to risk slowing growth in the world’s second-largest economy with a repeat of June’s cash crunch. The government’s 10-year notes yielded 58 basis points more than one-year debt on Oct. 23, the biggest gap since May 15, ChinaBond data show.

The yuan has risen 2.4 percent this year and touched a 20-year high of 6.0802 per dollar in Shanghai last week. It closed down 0.02 percent at 6.0855 today. Credit-default swaps insuring China’s debt against non-payment were at 83 in New York on Oct. 25, down from this year’s high of 147 in June, according to CMA prices.

The pressure for monetary and credit expansion is high because of the nation’s wide trade surplus and as capital inflows increase, the PBOC said in an Oct. 16 statement posted on its website.

FX Reserves

Foreign-exchange reserves gained the most since 2011 in the third quarter, rising 4.67 percent to $3.66 trillion, a sign the government’s efforts to protect growth attracted money even as developing nations from India to Indonesia saw the exit of capital. Yuan positions at China’s financial institutions accumulated from foreign-exchange purchases climbed 0.5 percent, the most since April, to 27.5 trillion yuan ($4.5 trillion).

The PBOC has used open-market operations as the main tools to adjust money supply in the interbank market since July 2012. It halted bill sales in June after the seven-day repo rate surged to a record 10.77 percent. It started weekly auctions of reverse-repo contracts in late July to add short-term funds to the financial system, while locking up long-term liquidity by rolling over some maturing three-year notes. The average rate was 4.01 percent in the second half of this year, up from 3.85 percent in the first half.

“The increase in foreign-exchange inflows means there’s no longer a need to use reverse repos to release liquidity,” Chen Qi, a Shanghai-based strategist at UBS Securities Co., said on Oct. 24. “The PBOC’s displeasure with credit growth in recent months is obvious from its announcement last week. They’re fine-tuning their liquidity management now.”

Money Supply

The broadest measure of money supply, or M2, has exceeded the official goal of 13 percent every month this year, rising 14.2 percent in September. New yuan loans at 787 billion yuan topped the median estimate in a Bloomberg survey.

The average seven-day repo rate based on daily fixings from the National Interbank Funding Center dropped to a five-month low of 3.32 percent on Oct. 16. The PBOC suspended selling reverse-repurchase contracts the next day and on Oct. 22 and Oct. 24, driving the rate to 4.88 percent on Oct. 25, the highest since July 31.

Quarterly corporate tax payments contributed to the spike, and the repo rate will come down to about 4 percent after the end of this month, said UBS’s Chan. That level is the “new normal” and is considered reasonable by the PBOC, she added.

Seasonal Factors

The government is well aware of such seasonal factors and could have adjusted its liquidity management to avoid the surge, Zhang Zhiwei, chief China economist at Nomura Holdings Inc. in Hong Kong, said in an Oct. 24 report. That it allowed the rate to climb is a clear policy-tightening signal, he added.

Analysts surveyed by Bloomberg from Oct. 11 to Oct. 18 said the chances of a severe slowdown will decrease after the Communist Party meeting in November. Leaders will study reforms proposed by the State Council’s research arm, including changes to rural land ownership rules and adding “outside” investors to boost competition, China News Service reported Oct. 26.

“The depth and strength of the reforms will be unprecedented and will promote profound changes in every area of the economy and society,” said Yu Zhengsheng, a Politburo member, in the southern city of Nanning, according to a report by the official Xinhua News Agency.

‘Clear Framework’

Credit Suisse Group AG said the proposals by the Development Research Center are ambitious and exceed its expectations, while Nomura Holdings Inc. said the government’s effectiveness in implementing reforms remains to be seen.

“This report is particularly important, given its authoritativeness and a clear framework of reforms,” Yang Weixiao, a Beijing-based economist at Lianxun Securities Co., said. While the plan covers important aspects, it may send negative cues to the market if the policies announced after the meeting don’t live up to expectations, he added.

Authorities have signaled also that a deposit-insurance system and an easing of savings-rate limits are on the way. China started publishing a “loan prime rate” last week calculated from nine banks, adding a market-based benchmark as part of interest-rate liberalization.

“Liquidity will eventually ease even without targeted action from the PBOC,” said Siddharth Mathur, Singapore-based head of Asia currencies and rates strategy at Citigroup Inc. “This is merely another instance where seasonal liquidity tightness is not being preemptively offset by the PBOC’s open-market operations.”

— With assistance by Helen Sun, and Justina Lee

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