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Chinese Market Flooded With Liquidity, Driving Borrowing Costs to Record Low

Chinese government recently pledged ample liquidity to invigorate the economy faced with slowing domestic demand and escalating trade tensions with the United States.

The People’s Bank of China (PBOC) injected a great amount of liquidity by means of targeted cut in reserve-requirement ratio (RRR), open market operation and the medium-term lending facility (MLF) since the start of July. The market has started to sense the change of the policy stance, with interbank borrowing costs, government bond yields and interest-rate swaps are hitting record lows.

The interest rate on pledged overnight repurchase agreement stays at a rarely-seen low level of 1.45 per cent on Thursday, after hitting 1.4 per cent one day earlier, the lowest level since 2015. Driven by lower borrowing costs, the volume of repurchase agreement surges to a new record high of 3.848 trillion yuan on Thursday, with the volume of overnight repurchase agreement reaching 3.43 trillion yuan.

The yield on one-year AAA-rated negotiable certificates slid to 2 per cent on Wednesday from 2.8 per cent a week earlier, dropping below the interest rate on one-year MLF. The last time this happened was in mid-2015 when Chinese central bank injected liquidity to prop up the stock market following the well-known market crash.

Since early July, the yields on negotiable certificates of deposit (NCD) have been tumbling. As of Wednesday, three-month AAA-rated NCD, a lifeline for small and medium banks, and six-month NCD both broke through the low point recorded during the last round of monetary easing. The yield on three-month NCD hit 2.0056 per cent, a new record low, only inches away from psychologically important 2 per cent.

The overnight Shanghai Interbank Offered Rate (Shibor) has dropped to lowest since July 2015.

The yield gap between government bonds and AAA-rated corporate debt has narrowed to the lowest since November 2016. Notably, the yield on AAA-rated corporate bond has dropped below the interest rate for the central bank’s open market operation.

Chinese yuan one-year interest rate swaps are trading near their lowest level since October 2016, signaling expectations that liquidity will remain ample for a while.

Money market interest rates have already retreated to the level in the fourth quarter 2016 before the authority kicked off a round of monetary tightening, according to China International Capital Corp.

How long the monetary easing will be in place will depend on how much the transmission mechanism of monetary easing to credit expansion can improve in the future, added Tan.

China said it will work to improve the transmission mechanism of monetary policy to support the real economy, according to the statement following a meeting of the Financial Stability Development Committee led by Vice Premier Liu He.

The ample liquidity comes after the central bank injected a great amount of liquidity via several channels, but because of inefficient transmission mechanism between monetary loosening and credit expansion, said Tan Hantuan, analyst with Guotai Junan Securities.

However, looking forward, the central bank’s hands may be tied when it comes to any further easing ambitions, given the risk of placing further pressure on the yuan.

“The central bank is likely to drain some liquidity from the market as it may not like seeing liquidity too high,” said Ming Ming, analyst with the CITIC Securities.

“That’s expected to be done in two ways, restarting selling repurchase agreement and replacing MLF with funds released through RRR cut,” said Ming.

The view was echoed by Tan, who said “since Tuesday the market has been expecting the PBOC to restart selling repurchase agreement, ” said Tan, “When borrowing cost in the market falls below policy rate such as the rate on MLF, banks will have the motive to buy repurchase agreement, leading some liquidity back to the PBOC. ”

The gap between one-year Chinese government bond yield and one-year US treasury yield has narrowed to about 15 basis points, placing more pressure on the weakening yuan.

“Therefore, if the PBOC doesn’t guide short-term interest rates lower by means of repurchase agreement, it’s likely to raise benchmark interest rate in September,” Tan added, “as soon as the real economy’s financing starts to recover, the authority is expected to tighten the liquidity again.”

 

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