China's Found a New Way to Pump Record Credit Without the Side Effects

  • Policy makers continue turning away from older benchmark rates
  • Mid-term funds inject liquidity for three months to one year

Why Money Keeps Flowing Out of China

China is increasingly managing the flow of credit with more finely-tuned instruments than its old method of changing how much of their deposits lenders must keep locked away.

Banks’ required reserve requirements haven’t changed for almost a year. Instead, the central bank has used short-term lending channels to add almost six times as much funding than would have been added by lowering banks’ RRRs by half a percentage point.

With the new tool playing its part in stabilizing the economy -- data Friday is estimated to show a 6.7 percent expansion for 2016 -- the People’s Bank of China is switching its focus to risk management. Another advantage of targeted lending: it adds funds without signaling broad easing that adds to downward pressure on the yuan and fuels further capital flight.

The PBOC pumped in a net 270 billion yuan ($39 billion) through open-market operations on Tuesday, the most in a year, data compiled by Bloomberg show. That followed last week’s 305.5 billion yuan of MLF operations, the main short-term lending tool used to meet banks’ medium-term cash demand. Analysts said the efforts can help stabilize liquidity before the week-long Chinese New Year holiday at the end of this month.

The PBOC increased the total outstanding of its Medium-term Lending Facility last month to a record 3.46 trillion yuan. That compares with the 600 billion yuan that economists estimate was added to the banking system after the last required reserve ratio cut in February, when it was lowered by half a percentage point. Bank deposits stood at 155 trillion yuan in December, greater than U.S. gross domestic product.

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By moving away from traditional tools such as cutting bank reserve requirements and using funds tied to specific duration and interest rates, the central bank can use those to help rein in excessive leverage by pushing up specific borrowing costs for lenders.

The mid-term lending program is the central bank’s way of adapting as the economy evolves, according to Tommy Xie, an economist at OCBC Bank in Singapore. As economic activity moves away from export-led growth, less capital is flowing in, which effectively reduces the central bank’s reserves and in turn decreases the central bank measure of liquidity supply.

Monetary Base

"The PBOC has been resorting to MLF to make up the loss in monetary base since the first quarter in 2016," said Zhou Hao, an economist at Commerzbank AG in Singapore. "The difference between a RRR cut and MLF is that the latter has pushed up borrowing costs, which shows the policy makers’ intention to reduce leverage and prevent financial risks."

Another factor policy makers are considering is how different tools affect the yuan. Recent depreciation pressure has made cutting the reserve ratio impossible for policy makers, Zhou said, effectively leaving mid-term lending as their best option.

The reserve ratio of funds that banks must lock away has been kept on hold since the last cut in February. While that ratio is one of the highest in the world, RRR cuts still remain unlikely because producer prices are rising at the fastest pace in five years, said Larry Hu, head of China economics at Macquarie Securities Ltd. in Hong Kong.

Compared with traditional RRR cuts, the MLF tool has the following advantages:

  • MLF gives the PBOC more command of the amount and duration of funds banks hold
  • Banks pay interest on MLF funds, which means those borrowing costs can be raised as a tool to deflate bubbles and reduce leverage
  • Unlike RRR cuts, MLF operations expire in three months to a year, which means banks can’t use the funds as freely as they would if they held less reserves
  • MLF puts less downward pressure on the yuan

Still, there are costs. Banks can’t plan long-term for funds raised from MLF operations and may even need to hoard liquidity if they don’t know when the PBOC will extend new financing, said Ding Shuang, chief China economist at Standard Chartered Plc in Hong Kong.

"Financial institutions love RRR cuts more than the MLF, which offers more expensive liquidity that can push up lending cost in the real economy," he said, adding that the central bank will be more inclined to cut the reserve ratio when pressure on the yuan eases.

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— With assistance by Heng Xie, and Yinan Zhao

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