The PBOC’s New Tightening Tool: Measured but Meaningful

The PBOC’s New Tightening Tool: Measured but Meaningful
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The PBOC’s New Tightening Tool: Measured but Meaningful

When the People’s Bank of China (PBOC) raised repo rates in mid-March, the increase was small ‒ 10 basis points ‒ and it marked the second hike this year to tighten monetary conditions. Despite a lack of fanfare, though, the latest repo rate hike signals significant developments in China.

On 16 March, the PBOC hiked the seven-day reverse repo (repurchase) rate from 2.35% to 2.45% and raised the whole liquidity facility curve by 10 bps (including seven-day, 14-day and 28-day reverse repos and the standing and medium-term lending facilities). The PBOC’s tightening came right on the heels of a 25 bp rate hike by the Federal Reserve.

In its statement, the PBOC cited the Fed’s hike and improving exports as the global catalysts for the rate increase and pointed to dropping real rates, strong credit expansion and property reflation as the domestic factors. In general, the PBOC considers rising money market rates and tighter liquidity helpful in its effort to “deleverage and curb the property bubble.” Certainly, the hawkish shift also helps to support the yuan’s crawling peg against the U.S. dollar as the Fed continues to raise U.S. interest rates.

With this second tightening in 2017, Chinese policymakers have clearly shifted from “growth” mode to “stability, risk management” mode; indeed, in early March, China lowered its official growth target to 6.5% from 6.5%-7.0%.

It is also becoming clear that the PBOC is adopting a new approach to raising rates. In past tightening cycles, it has routinely hiked bank deposit and loan rates, typically by 25 bps in each move. This time and in a similar move in February, the PBOC instead lifted repo/money market rates and by only 10 bps each time.

Does this mean the PBOC’s rate hikes are less effective than before? And what are the broader implications for China’s economy and global markets?

Why raise China’s repo rates?

Certainly, hiking the benchmark bank deposit/lending rates by 25 bps is a stronger move and has bigger signaling effects than a 10 bp boost in repo rates. Yet, in the fragile and uncertain macro environment, particularly if China’s Consumer Price Index (CPI) remains below the PBOC’s 3% target, the central bank may prefer the flexibility and tentative tightening of lifting money market rates rather than using a blunt tool like hiking bank deposit rates.

It can also be argued that repo rates are effectively becoming China’s new policy rates.

After five years of explosive expansion and deregulation in China, wholesale funding has become much more important. Currently, 25% of banking system liabilities consist of various forms of wholesale funding, including repos and certificates of deposit (CDs). As a result, hiking rates for reverse repos and liquidity facilities is actually a very effective way of tightening monetary conditions.

Since the PBOC hiked repo rates by 10 bps in February, the rate on banks’ negotiable certificates of deposit (NCDs), which account for 4% of banks’ liability funding and total some 7 trillion yuan outstanding, has jumped 75 bps to 4.40%. This liquidity tightening is working through the financial system to push rates higher on bank loans and mortgages, albeit with a lag.

Implications for investors

The PBOC’s tightening cycle is clearly negative for the Chinese government bond (CGB) market. Maintaining the yuan’s crawling peg against the U.S. dollar is likely to continue to constrain monetary policy; the PBOC still faces the “trilemma” of trying to maintain a stable exchange rate, independent monetary policy and free capital flow all at the same time.

Over 2017, we therefore expect the PBOC to continue the gradual tightening shift by hiking repo rates another 30 bps (in three moves of 10 bps), bringing the seven-day repo to 2.75%. This should tighten monetary conditions over time, slowing economic growth and commodities momentum into the second half of this year.

Isaac Meng is an emerging markets portfolio manager in PIMCO’s Hong Kong office.

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