Photographer: Qilai Shen/Bloomberg

China's Central Bank Faces a $600 Billion Test

  • More than 3 trillion yuan of MLF loans to come due this year
  • Collateral pressures will rise, Citic economist Ming says

People’s Bank of China Governor Zhou Xiaochuan’s shift toward new tools to steer the economy has swollen a targeted lending program to such a level that outstanding funds are now worth more than the annual output of the Malaysian and Danish economies combined.

The Medium-term Lending Facility has increased to 4.1 trillion yuan ($594 billion), with 3.2 trillion yuan coming due from April to December this year, according to data compiled by Bloomberg. About 2 trillion yuan matured in the same period last year.

While the monetary authority has shown a willingness to roll over the funds, with new loans extending maturities in each of the first three months of 2017, the ballooning amount illustrates the challenge Zhou faces as he tries to reduce leverage in the financial system while keeping the monetary base big enough to avoid a credit crunch.

The PBOC kicked off its latest tightening cycle in August after monetary loosening helped fuel an unprecedented, 11-quarter bond rally. The authority has been shifting its focus to controlling borrowing costs for short- and mid-term funds, rather than benchmark interest rates that have a broader, less controlled effect. Introduced in 2014, MLFs come in tenors of three, six and 12 months.

“The PBOC may extend MLFs to longer tenors to ease the pressure” on money market rates, said Liu Dongliang, a senior analyst at China Merchants Bank Co. in Shenzhen. “The central bank can also keep rolling over these operations” because the focus on deleveraging reduces the likelihood of a cut to the amount of money banks must lock away as reserves.

The use of MLFs has grown even as the PBOC tightened lending in open-market operations, driving up costs and extending tenors. The tools give policy makers room to raise money market rates and cut financial leverage without putting excessive pressure on the yuan and risk exacerbating capital outflows.

In the older era of generous inflows and trade surpluses, China used the required reserve ratio to maintain currency stability. Now, as uncertainty over trade increases and foreign reserves decrease, the MLF and other lending tools have eclipsed required reserves as a key channel to inject funds.

"The central bank didn’t cut reserve ratios when capital flowed out, leaving behind debt that’s paid back by all kinds of short- and mid-term liquidity tools," said George Wu, who worked as a PBOC monetary policy official for 12 years. "The large amount maturing in the second half increases the possibility of market volatility."

Market swings would increase if banks and other financial institutions weren’t sure whether the PBOC would roll over the loans, or if major lenders reduce their lending to smaller ones.

The large amount of MLF also makes open-market operations more difficult, potentially making the financial system more vulnerable, said Wu, now chief economist at Huarong Securities Co. in Beijing. The PBOC is aware that relying on newer liquidity tools may create communication challenges for the central bank’s signals to markets, he said.

One way to help ease money-market volatility would be for the PBOC to widen the field of primary dealers that trade directly with the central bank from the current 48, which would dilute the influence of major state-owned banks, according to Wang Yifeng, an analyst at China Minsheng Banking Corp.’s research institute in Beijing.

That is similar to a call from Xu Zhong, chief of the PBOC’s research bureau, who said more dealers can help curb speculation and ease the hurt smaller financial institutions endure when there’s a liquidity shortage, according to an article posted on the PBOC’s website in March.

While economists forecast China’s growth will hold up at 6.8 percent in the first three months of the year, full-year expansion will slow to 6.2 percent in 2018. In addition, potential trade conflicts with the U.S. and domestic property-purchase curbs may be a drag on growth in the second half of 2017. 

If growth slows, asset prices stabilize and pressure on the yuan eases in coming months, cutting reserve ratios will be a natural move, Huarong’s Wu said. The PBOC can also provide momentary support using its Temporary Liquidity Facility, he said.

Cutting bank reserve requirements could help reduce money market swings in the short term but wouldn’t steer financial institutions away from relying on short-term funding structures to financing longer-term assets, according to Andrew Polk, director of China research at Medley Global Advisors LLC in Beijing. "The interbank market needs a bit of volatility" to make that reliance less attractive, he said.

Banks pledge central government bonds and other high-rated debt as collateral to obtain medium-term funding. One potential complication of using those newer instruments is that lenders don’t have enough of those securities, according to Ming Ming, a former PBOC monetary policy official and head of fixed-income research at Citic Securities Co. in Beijing.

“Collateral pressures will rise,” he wrote in a recent report. “The central bank will be restricted if it wants to increase open-market operations and MLF. Expanding the list of qualified collateral is fundamental, and local government debt may be an option.”

— With assistance by Yinan Zhao, Xize Kang, Helen Sun, and Zheng Wu

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