China’s Yield Hike Signals Gradual Tightening of Excess Liquidity

SHANGHAI: A surprise increase in the interest rate on a central bank three-month bill sale signals the start of a gradual tightening of excess liquidity that will eventually lead to higher policy rates, says Reuters.

On Thursday, Jan 7 the People’s Bank of China’s (PBOC) pushed up the yield on its three month bills by 4.04 basis points, sending markets from stocks to metals reeling on worries the move was a precursor to tighter policy that could temper demand from the world’s third-largest economy.

Many analysts played down the likelihood of any imminent increase in benchmark lending and deposit rates. But they said the auction result does herald an upward crawl in money market rates to absorb some of the huge liquidity in the financial system.

It also points to the deployment of other tools to tighten liquidity at the margins — likely starting with an increase in the yield on its benchmark one-year bills for the first time in five months when they are auctioned on Tuesday.

“While the rise is very small, the move is best seen as an early stage of interest rate increases,” said Wensheng Peng and Jian Chang with Barclays Capital in Hong Kong.

“Increases in money market rates owing to higher central bank paper rates should help to dampen asset market speculation and, at the margin, reduce banks’ incentives to lend owing to increased opportunity costs,” they said in a note to clients.

LENDING TARGETED

Traders now see bill and bond yields being nudged up by an average of 20 to 25 basis points in the first quarter, before the central bank moves into an even tighter stance.

“The primary target of the move is lending. The PBOC is also eyeing a huge amount of bills and bond repurchase agreements that will be maturing in the first quarter,” said Yang Yongguang, a senior money market analyst at Guohai Securities in Shenzhen.

A total of 1.27 trillion yuan ($186 billion) in central bank bills, 500 billion yuan in 91-day repos and 131 billion yuan in 28-day repos will mature this quarter, Reuters calculations show, putting the central bank under pressure to drain the funds.

The central bank has mopped up funds from the money market in each of the past 13 weeks, draining a combined 850 billion yuan ($124 billion) since mid-October, but nearly 80 percent of that has been in 28-day and 91-day repos, meaning most of those funds are now starting to get recycled back into the system.

As it looks to chip away at that mountain of cash, the PBOC will probably raise the yield on its one-year bills by 4 to 5 bps in next week’s auction, from the 1.7605 percent it has kept it at since August, traders say.

It is seen continuing to raise bill yields by a few basis points each week to eventually raise them a cumulative 15 to 20 basis points, traders said. But because bill and bond yields in the secondary market are already high, their upside will be capped at 20-25 bps in the first quarter, they said.

The indicative one-year central bank bill yield on the secondary market rose 2.44 bps to 1.9500 percent bid on Friday, Reuters Reference Rates show. That is already 18.95 bps higher than the PBOC’s one-year auction yield this week of 1.7605 percent.

GRADUALISM

The central bank’s move to push up the three-month bill rate instead of its one-year bill rate suggests the PBOC is targetting short-term liquidity more than long-term liquidity for now.

That gives the PBOC the kind of policy flexibility it has outlined in statements in recent weeks to that it can wait for more data with which to gauge the strength of the economy’s recovery and inflationary pressures.

“By rolling funds into next quarter, the government has an easy time keeping money in the market for the rest of the year, in case of a weakening of the economic recovery,” said a senior dealer at a major Chinese state-owned bank in Beijing.

“But the market expects the economy to show solid signs of a full recovery in the second quarter, with inflation also rising, and that will be the time for real policy tightening.”

Policy tools expected to be used in the second quarter mainly include frequent use of one-year bills instead of repos, a resumption of issuance of three-year bills, higher bank reserve requirements, different reserve requirements for different banks and higher interest rates paid out on reserves.

The clear purpose of these measures will be to lock up money longer term, traders said. Outright increases in benchmark lending and deposit rates will probably only follow in the second half, when the recovery is expected to be on a more solid footing, many analysts say.

The rate rises could be brought forward though if inflation or inflationary expectations pick up. Annual consumer inflation was a modest 0.6 percent in November, but is expected to have picked up in December.

China will also eventually let the yuan start to rise again against the dollar, though that will wait until at least the second quarter, a Reuters poll showed this week. Any rise will also be modest as central planners wait for exports to recover. Still, a gradual shift to outright interest rate increases is not without its pitfalls.

“This may end up inviting banks to lend even earlier due to the prospect of stronger tightening, creating a vicious cycle in which the PBOC will be forced to step up its tightening efforts throughout the year,” said Yang with Guohai Securities. – Reuters

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