How China’s Liquidity Squeeze Got Markets All Rattled

China’s repo market is a critical component of the country’s financial system. It’s where small banks can source short-term funding from cash-rich lenders and where the central bank can guide monetary policy by influencing the cost of borrowing. Which is why, in January -- with the economy fragile because of the pandemic and a holiday season approaching -- there was consternation when the People’s Bank of China drained so much cash that it engineered the biggest liquidity squeeze in almost six years. The development shone a light on the immense and competing forces that policy makers in Beijing must regularly juggle.

Repurchase agreements (repos for short) allow China’s state banks and big investors like mutual funds to make money by briefly lending cash that might otherwise sit idle. The country’s smaller banks and broker-dealers, which rely on wholesale funding, get needed financing by loaning out securities such as government or corporate bonds they hold in return. Daily trading volume averaged 3.9 trillion yuan ($604 billion) in the past year -- with some 15 trillion yuan worth of pledged repos outstanding. The most actively traded repos are the seven-day and overnight tenors, the latter being the preferred financing tool for buyers of sovereign debt. Interest rates of both are closely tracked because they are a good indicator of official monetary policy.