PBOC Battling Bubbles Seen Keeping Rates Elevated: China Credit

China’s money markets are signaling that the central bank has little room to switch focus to reviving a flagging economy from containing asset bubbles.

The seven-day repurchase rate sank to a 22-month low of 2.22 percent today, a day after the People’s Bank of China sold 28-day repos at 4 percent. The one-year swap, the fixed cost to receive the seven-day repo, was a record 2 percentage points higher than the benchmark on March 7. The gap was 190 basis points today.

“China is walking on a wire when it comes to monetary policy and that wire is getting thinner and thinner,” said Zhou Yanwu, a research director at Beijing-based ResearchInChina. “All the PBOC can do is try to balance well so that it’s not braking a high-speed car too abruptly or fueling a bubble that’s already too big.”

Official data over the weekend showing the steepest slide in exports since 2009 and the slowest inflation in 13 months added to pressure on PBOC Governor Zhou Xiaochuan to review his bank’s “prudent” monetary policy. Goldman Sachs Group Inc. predicted the repo rate will rise to 4.25 percent by year-end and even higher if there is a resurgence in “opaque bank credit.”

China’s $6 trillion shadow-banking industry, which includes trust companies and lenders’ wealth management products, was rated as the biggest challenge for China in a Bloomberg News survey of 29 economists before the annual National People’s Congress meeting started March 5. Bill Gross, who oversees the world’s biggest bond fund at Pacific Investment Management Co., in February dubbed China the “mystery meat” of emerging markets, saying nobody knows the extent of its problems.

Strike Balance

Premier Li Keqiang faces challenges in achieving the 7.5 percent economic growth target he set for this year. Exports fell 18.1 percent last month from a year earlier, while economists in a Bloomberg survey had expected a 7.5 percent gain. The manufacturing Purchasing Managers’ Index slipped to a seven-month low of 50.2 in February and a private PMI report signaled a contraction, falling below the dividing line of 50.

“China’s interest-rate policy needs to strike a balance between managing the economic cycle and containing financial fragility, including from opaque bank credit that is moved off the formal loan book,” Goldman Sachs Hong Kong-based analyst MK Tang wrote in a note yesterday. “We are watchful for signs of a possible resurgence in opaque bank credit, as this would be a major swing factor for interest rates.”

Flush Liquidity

The PBOC sold 100 billion yuan ($16.3 billion) of 28-day repos at 4 percent yesterday, the biggest issuance of such contracts since June 2011. A range of 3.8 percent to 4 percent is seen by policy makers as the floor of the “desired zone” for money-market rates, according to Standard Chartered Plc.

“We don’t really think the flush liquidity conditions will be sustained,” said Becky Liu, a Hong Kong-based rates strategist at Standard Chartered. “If money-market rates stay as low as the current levels, it’s not supportive of their plan -- that they still want the banking system to go through a deleveraging and they don’t want to inflate the shadow-banking bubble.”

Caps on the savings rates that lenders can offer have led to an exodus of funds from the banking system into higher-yielding products. Flows may reverse once deposit rates are liberalized, a move PBOC’s Zhou said yesterday would happen in one to two years, and credit risk plays a greater role in investment choices. The yield on 10-year government bonds declined four basis points this year to 4.52 percent as of March 11, ChinaBond data show.

Default Risk

China had its first onshore bond default after Shanghai Chaori Solar Energy Science & Technology Co., a solar-panel maker, last week failed to pay interest on notes due March 2017. A 3 billion yuan China Credit Trust Co. product that lent money to a collapsed coal miner averted a default on its principal in January after being bailed out. A similar product issued by Jilin Province Trust Co. has missed five interest payments, Shanghai Securities News reported last month.

“If none of the firms are allowed to default, people will think the government is backing them so they can keep buying such investments,” said Yao Yang, director of the China Center for Economic Research at Peking University. “On the other hand, the government cannot allow a lot of defaults, which could cause panic in the economy.”

The PBOC also has the option of using other policy tools, including the reserve-requirement ratio for major banks that it has kept at 20 percent since its last reduction in May 2012. The authority should consider cutting the ratio once or twice in the event of a cash squeeze as trust products and local government debt fall due, Zhang Monan, a researcher at China International Economic Exchange Center, wrote in the Shanghai Securities News yesterday.

Last Lever

As the economy slows, the Chinese currency has fallen 1.3 percent in the past month, Asia’s worst performance, according to data compiled by Bloomberg. It’s strengthened 35 percent since a dollar peg ended in July 2005, leading gains in emerging markets. The spot rate fell 0.06 percent to 6.1436 per dollar as of 11:31 a.m. in Shanghai.

The yuan’s exchange rate becomes “the obvious remaining policy lever left to pull” for China to support its economy, Richard Iley, a Hong Kong-based economist at BNP Paribas SA, wrote in a March 3 note.

“Any genuine attempt to rein in excessive credit growth is quietly being shelved as growth momentum continues to ebb,” Iley said. The yuan will probably need to depreciate further to loosen financial conditions to steer growth, he said.

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