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Coming Soon: Another Hike to China's Required Reserve Ratios
By Adam Wolfe
The People’s Bank of China (PBoC) almost certainly will have to hike the required reserve ratios (RRRs) for commercial banks in the next two weeks. Despite increasing the yields offered at recent PBoC bill auctions, the central bank has been unable to drain liquidity through open-market operations due to a wide differential with yields in the secondary market. In the coming weeks, a rather large amount of central bank bills and repos are set to expire, which will add to China’s excess liquidity. Given the jump in hot money inflows in Q4 2010 and the reported RMB500 billion rise in bank lending in the first week of January, the PBoC very soon will have to drain liquidity from the system with its only functioning tool. Although the PBoC will be reluctant to tighten monetary conditions ahead of the Chinese New Year on February 3, allowing the money supply to expand at its current trajectory would only necessitate more draconian measures after the holiday.
Drowning in Liquidity
Despite six RRR hikes and two interest rate hikes in 2010, China’s money supply growth was still excessive at the end of the year. China’s broad money supply (M2) increased 19.7% in 2010, well above consensus expectations (19%), though in line with RGE’s forecast (19.6%). After narrowing in the first half of the year, the differential between the growth rates of M2 and nominal GDP widened in H2. This surge in liquidity growth was mainly due to three factors: the return of hot money inflows, a jump in fiscal expenditures and continued credit extension, which defied the normal seasonal pattern. RGE estimates about US$1 billion of hot money poured into the economy every day in H2 2010. From May 2010 to November, China’s fiscal deficit nearly tripled (based on the trailing 12-month figure) as the government sought to achieve its deficit target for the year. New bank loans averaged RMB550 billion each month in H2, a 50% increase from the previous year.
Figure 1: Capital Inflows Jump (USD, bn, three-month sums)
Source: PBoC, Bloomberg, RGE calculations
In the final weeks of the year, the PBoC had to fight this surge in liquidity with one hand tied behind its back. It was not able to drain liquidity through open-market operations because the central bank was unwilling to increase the yields on offer to match those in the secondary market. The differential between the primary and secondary market is normally only a few basis points (bps)—despite state-ownership of the vast majority of the banking sector—but at the end of 2010 this spread widened to more than 100 bps. The PBoC was forced to suspend sales of three-year bills and reduce its normal three-month and one-year auctions to RMB1 billion each week. Luckily this was a period of relatively few bill and repo expirations, and the buyers’ strike only resulted in a RMB296 billion increase in interbank liquidity in the final six weeks of 2010.
With no ability to drain liquidity through open-market operations, the PBoC hiked RRRs three times in the final two months of 2010. This was in addition to a temporary RRR hike that the PBoC reportedly sprang on the largest banks in October. These measures pushed the RRRs for China’s largest banks to a record 19% and drained about RMB1.3 trillion in liquidity. However, as RGE argued in the 2011 Outlook, forcing banks to keep such a large portion of their deposits at the central bank, where they earn 1.62%, will only force them into riskier loans in order to defend their net interest margins.
Figure 2: Running Out of Room for More RRR Hikes
Source: PBoC. Note: This does not include temporary hikes to the RRRs of China’s six largest banks that the media reported but the PBoC did not publicly disclose.
In the first weeks of 2011, China’s liquidity problem has worsened. Despite raising the yields it offered on bills, the PBoC has so far been unable to drain liquidity through open-market operations, and the amount of bills and repos set to expire is increasing sharply. In the three weeks ending January 29, RMB510 billion will expire, up from RMB83 billion in the preceding three weeks. Banks are reported to have lent up to RMB500 billion in the first week of January, and the nondeliverable forward market is showing rising RMB appreciation expectations, which is likely to boost hot money inflows as well.
Figure 3 & 4: More to Mop Up (Expiring PBoC Bills/Repos and Net Weekly Operations, RMB, bn)
Source: PBoC, RGE
Although there has been some progress toward ending the buyers’ strike on PBoC bills, it continues to drag on. So far this year, yields on one-year bills sold by the PBoC have risen by 38 bps, reaching 2.72% at the January 11 auction, but the secondary market’s one-year yield is still about 40 bps higher. The PBoC was able to drain RMB60 billion with repos the same day, but it had to do so with 14-day repurchase agreements rather than the preferred 91-day repo. This may have been deliberate, so that the liquidity would be returned to the system ahead of the Chinese New Year holiday that starts on February 3, or it may have been due to banks’ unwillingness to buy longer-dated repos when they expect a rate hike. In another sign of progress, the PBoC plans to auction RMB3 billion in three-month bills at the January 13 sale, the largest offer in a month. Still, there is unlikely to be any significant drainage through open-market operations this week or next.
With the PBoC still fighting liquidity with one hand tied behind its back, it will have little choice but to hike RRRs soon. It may choose to do so in a dynamic way—with individual banks seeing their RRRs adjusted based on some metric of new loan growth, capital ratios and inflation—but there is no doubt about the direction of the coming move.
We expect banks’ RRRs to increase by 0.5 percentage point in the coming weeks, though we note that it may not be an across-the-board increase for all banks. This will drain a bit more than RMB350 billion from the interbank market, which will not be enough to offset the increase from hot money inflows, lending growth and expiring central bank bills. To end the buyers’ strike, the PBoC will have to continue to raise the yields it offers on bills and repos, and additional tightening measures can be expected after the Chinese New Year holiday. We expect that benchmark interest rates will increase 25 bps by the end of February. For a more detailed look at our monetary policy expectations for 2011, see “The Hangover: China Considers Policy Pills.”
Senior Analyst Rachel Ziemba contributed to this report.