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China's Road to Greater Financial Stability
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Chapter 5. Systemic Liquidity, Monetary Operations, and Financial Stability in China

Author(s):
Udaibir Das, Jonathan Fiechter, and Tao Sun
Published Date:
August 2013
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This chapter considers the various ways in which domestic liquidity, monetary policy operations, and financial stability intersect in China. It highlights how the operations and facilities of the People’s Bank of China (PBC) influence liquidity and eventually financial prices, as well as the role they could play in mitigating a crisis. The chapter also discusses other stability and efficiency aspects of liquidity management in China, as well as some of the main implications for liquidity management of advancing financial liberalization.

Overview

Historically, China’s financial system has been highly liquid, reflecting the impact of persistent foreign exchange inflows. With ample liquidity, banks following a relatively conservative business model, and with access to high-quality collateral, the prospect of a near-term liquidity crisis has been limited. China has not faced any systemic banking crisis since the restructuring in the early 2000s, including during the period of heightened global stress following the collapse of Lehman Brothers in 2008. However, one lesson of the global financial crisis is that even abundant central bank liquidity can be insufficient to prevent a systemic liquidity crisis (IMF, 2010). Indeed, such crises can result directly from friction in the functioning of markets (market liquidity) or an inability of institutions to meet their short-term funding needs (funding liquidity), possibly due to counterparty risk. Moreover, in the case of China, liquidity has always been unevenly distributed throughout the system and liquidity conditions have recently tightened, making the ongoing management of liquidity increasingly important.

This chapter focuses on the interaction of liquidity management and systemic liquidity risk in China (Box 5.1). While aggregate central bank liquidity cannot prevent a liquidity crisis, the central bank’s operating framework, interacting with well-functioning financial markets, will limit this systemic risk. Beyond documenting the current institutional set-up and functioning of money and fixed-income markets, the chapter also describes some changes that will strengthen both aggregate and institutional-level liquidity management in all environments, irrespective of the amount of aggregate liquidity. These changes can ensure the management framework is not only aimed at withdrawing liquidity during periods of significant liquidity surplus but also flexible enough to provide timely and targeted liquidity in the event of a local or general liquidity shortage resulting, say, from an unexpected reversal of capital inflows or a rise in counterparty risk.

Box 5.1What Is Liquidity?

Three concepts of liquidity are relevant to systemic liquidity management.1 The first, aggregate liquidity, is the extent of liquid funds the central bank supplies to the financial system. The second is market liquidity, which relates to the depth, breadth, and resilience of markets, so that parties may trade an asset on short notice, at low cost, and without affecting its price. The final concept is funding liquidity, which refers to the ability of a solvent institution to raise funding on short notice and make agreed-upon payments in a timely manner. In developed financial markets, under normal market conditions, market and funding liquidity risk are low, provided the central bank ensures aggregate liquidity to the banking system that is consistent with economic and financial stability, since funds cycle through the banking system and move to where the greatest shortage is. However, systemic liquidity risk can arise due to information asymmetries across market participants and incomplete markets (e.g., poorly functioning hedging markets), irrespective of the amount of aggregate (central bank) liquidity.

This chapter measures the aggregate liquidity position of the banking system using the concept of its structural liquidity position, which reflects the impact of exogenous factors beyond the People’s Bank of China’s (PBC) control on funds available to the system. Specifically, based on the stylized balance sheet depicted in Table 5.1.1 (bold elements in the table), structural liquidity is defined as S = NFABNGOVK. When this is positive, the banking system has a structural liquidity surplus with respect to the central bank, meaning that it has no need to obtain (net) funding from the central bank.

TABLE 5.1.1Stylized People’s Bank of China Balance Sheet
AssetsLiabilities
Net foreign assets (NFA)Bank notes in circulation (BN)
Net domestic assets (NDA)Government deposits (GOV)
Minimum reserve requirements (MRR)
Excess reserves (XR)
PBC paper (B)
PBC capital (K)
Note: PBC = the People’s Bank of China.

A structural liquidity surplus does not, per se, eliminate the risk of a systemic crisis. Indeed, during periods of market or funding liquidity stress, a vicious link between market and funding liquidity can occur as limited funding prompts “fire sales” of assets, which in turn limits the ability of institutions to raise funds as collateral values fall. As a result, liquidity channels can propagate a financial crisis as the deterioration of either market liquidity or funding liquidity leads to a systemic liquidity crisis irrespective of the extent of aggregate liquidity if counterparty risk becomes important. Indeed, empirically, funding and market risk are often correlated, with market liquidity conditions highly correlated across markets and funding liquidity conditions correlated across institutions. Given the financial instability generated in such a crisis, there is a role for the central bank to provide liquidity in a way that breaks this vicious cycle.

1Nikolaou (2009) provides an excellent summary of the literature on the meaning of liquidity and the interaction between these three types of liquidity.

The nature of the potential liquidity strains faced by Chinese banks highlights the critical role of the PBC operations and framework in mitigating liquidity stresses, and suggests some necessary reforms. Unlike large Western banks pre-Lehman, many Chinese banks have lower exposure to funding and especially market risk. They have large—and historically stable—deposit funding, a negative loan-deposit gap, limited leverage and exposure to derivatives, and predominantly hold high-quality securities that can easily be collateralized to maturity. However, these features alone do not eliminate liquidity risk. Funds are unequally distributed through the system, with some banks highly reliant on interbank funding. Banks’ large required reserves cannot be used as a buffer, and only a limited share of banks’ liquid securities are held on their trading book. Together these characteristics mean that banks may have only a relatively limited share of truly liquid assets on the balance sheet at any time. To limit the resulting risk, a number of refinements to the PBC’s framework would ease the task of liquidity management for many banks, as well as ensure that the PBC is in a position to quickly provide liquidity through its standing facilities and operations. Such reforms would include the introduction of reserve averaging, automation of existing PBC standing facilities, and strengthening the ability to undertake high-frequency liquidity operations.

These reforms will also help mitigate the risk of liquidity crises going forward as new financial products spread and China’s financial system becomes increasingly open and less bank dominated. In such an environment, market and funding liquidity risks are likely to be higher, allowing a localized liquidity shortage to transmit to other institutions through a traditional run or tighter wholesale funding conditions, the impact on financial prices due to the need to liquidate assets quickly, or failed money market transactions as both funding and market liquidity stresses rise in tandem. As mentioned in Box 5.1, such events can occur even with ample aggregate liquidity in the system. The refinements to the operating framework mentioned above should limit the contagion by allowing the PBC to target its liquidity support to institutions in ways that break contagion across institutions.

In general, the conclusions of this chapter are to move operations in the direction of greater reliance on indirect, rather than direct and administrative, instruments, and to make standing facilities operate in a more transparent and automatic way. Not only should these changes enhance system stability in the case of extreme events but they should also improve the efficiency of (and thereby information conveyed by) financial prices and the allocation of funds by reducing the distortions related to the use of administrative tools. This will become increasingly important as domestic (and eventually external) liberalization proceeds and quantitative-based liquidity management becomes less reliable.

Liquidity Management: Framework, Instruments, and Facilities

The focus on aggregate liquidity management has largely reflected the need to sterilize large foreign exchange inflows. To do this, the PBC sets an annual broad money target, although it has increasingly paid attention to the information provided by interest rates. While the exchange rate regime is a de jure “managed float,” and despite increased flexibility and gradual application, the bilateral rate with the U.S. dollar has remained tightly managed. The PBC has been able to pursue both domestic quantitative targets and an exchange rate target due to China’s relatively effective capital controls. Although the PBC’s current intermediate monetary policy targets are monetary aggregates, the money multiplier is already relatively unstable. This instability will continue to increase over time given the increasing extent of intermediation outside the banking system, suggesting limits on the effectiveness of managing aggregate liquidity through quantity targeting, and the possibility that liquidity operations may add to aggregate volatility.

To achieve its aggregate monetary and liquidity objectives, the PBC has a rich set of policy instruments that can be broken into three categories:

  • Market-based instruments. The PBC regularly undertakes open-market operations (OMOs) through both repo transactions and the issuance of PBC bills to manage liquidity. OMOs are typically conducted twice weekly, on Tuesday and Thursday,1 with the PBC determining the maturity varieties of OMOs based on banks’ liquidity management needs. For example, while the majority of OMOs have occurred at one- and three-month maturities, during the peak initial public offering (IPO) activity in 2006 and 2007 the PBC moved to shorter (seven-day) interventions.

  • Standing facilities. The PBC has several standing facilities that are able to provide emergency funding during times of stress and absorb liquidity on a regular basis. It has intraday and other lending facilities, and a rediscount facility. These facilities were augmented during the recent crisis through the creation of term auction and currency swap windows.

  • Administrative tools. The PBC uses a number of direct administrative tools, including mandatory reserve requirements, the setting of retail benchmark lending and deposit interest rates (Figures 5.1 and 5.2), and direct window guidance, where the PBC communicates the intentions of monetary policy and guides credit decisions in order to ensure sound economic developments and financial stability. Benchmark interest rates set the ceiling on retail deposit interest rates and the floor on retail lending rates, with the regulation affecting the entire term structure.2 Reserve requirements must be met daily, and since early 2011 they are dynamically differentiated over time depending on each bank’s credit and other behavior. Adjustments are announced in advance, with some adjustment period provided for banks. Both required and excess reserves are remunerated.

Figure 5.1China: Benchmark Deposit Rate Structure

(In percent)

Source: CEIC.

Figure 5.2China: Benchmark Lending Rate Structure

(In percent)

Source: CEIC.

The PBC’s standing facilities operate in a fundamentally different way from those in other countries. In particular, the use of the facilities is not automatically triggered at the discretion of eligible financial institutions. The PBC maintains considerable discretion over the use of the facilities. In other places, standing facilities (for solvent institutions) are designed to be large, immediate (on demand), and automatic and predictable. It is these three characteristics that allow them to effectively limit the impact and spread of a liquidity crisis. Moral hazard concerns are dealt with through the (high) penalty rates that the use of the facility incurs and through strengthened supervisory inquiry and appropriate (but ex ante transparent) haircuts on collateral. While the PBC already has an impressive array of facilities, the discretionary and capped nature of its facilities, together with limited information on acceptable collateral, means that the facilities cannot play their full financial stability role as smoothly and quickly as possible.3 There also seems to be a stigma associated with the use of these facilities, meaning that financial institutions are reluctant to consider using them. Moving the facilities toward being automatic, immediate, stigma-free, and large should substantially limit stability risks in the event of an extreme event. The limited nature of the standing facilities is evident from the fact that short-term market interest rates have exceeded standing facility charges at times of stress, a development discussed later in the chapter.

In China, required reserves are high and do not provide a buffer against shocks. Reserve requirements have to be met strictly each day rather than on average over some maintenance period (as is common elsewhere). The absence of reserve averaging increases liquidity risks, since reserves cannot provide a buffer. Averaging reserve requirements would, therefore, improve stability, reduce distortions, and improve the market position of smaller banks. In addition, these requirements are exceptionally high and are currently, on average, just under 20 percent of deposits. Since these reserves do not act as a buffer, banks have typically held even higher reserve levels for operational purposes and liquidity insurance; although, as described later in this chapter, tightening liquidity conditions in recent times have led banks to reduce this buffer.4

By enhancing the buffer role of reserves, as well as reducing the implicit tax they make on financial activity, the introduction of reserve averaging would seem to be a critical reform that could be easily implemented. The successful introduction of reserve averaging should, for instance, help stabilize liquidity conditions at the bank level, even if it were to require additional liquidity draining by the PBC in the short term, which could be achieved through additional OMOs.

The stability concerns resulting from the structure of reserve requirements are accentuated given the dynamic differentiated nature of these requirements—individual institutions may face a sudden change in their reserve requirement. Dynamic differentiation could increase financial instability given its potential differential impact on sets of smaller institutions, and therefore provide incentives to move intermediation outside the regulated financial system. Given this, it may be better to limit the extent of this feature, leaving macroprudential concerns to be addressed by other prudential policies (e.g., capital adequacy and credit quality, that is, through lending standards), since reserve requirements are not primarily a macroprudential tool.

Developments in Domestic Liquidity

China’s financial system has traditionally been flush with liquidity, although more active monetary management has reduced those levels. This largely reflects autonomous monetary injections. In fact, China’s significant structural liquidity surplus increased by almost five times between end-2005 and end-2009, but the rate of increase has slowed—only increasing another 30 percent by end-2011 (Figure 5.3). The growth largely resulted from the accumulation of foreign exchange reserves, and is principally the counterpart of China’s persistently large balance of payments surpluses. Ultimately this liquidity surplus has shown up in commercial banks, which as a group hold many more deposits than they require for lending or to meet the regulatory requirements of the PBC and the China Banking Regulatory Commission.5 More recently, the pace of the increase in the structural liquidity surplus has slowed to below that of foreign reserve accumulation, which most likely reflects deliberate changes in PBC liquidity operations. However, even with this liquidity surplus, there remains a potential for systemic liquidity events, given that the surplus is unevenly distributed across banks; there are informational asymmetries between banks; and there are imperfections in the PBC’s toolkit, as described later in the chapter.

Figure 5.3China: Structural Liquidity and Foreign Reserves

(In trillions of renminbi and U.S. dollars)

Sources: CEIC; and authors’ estimates.

1The People’s Bank of China (PBC) net foreign assets (excluding other net assets) + net credit to government – currency in circulation – PBC capital.

PBC management of aggregate or central bank liquidity through its instruments seems to have become more aggressive. The impact of policy actions to offset the effect of “autonomous” monetary injections (e.g., from foreign reserve accumulation) is often measured through the central bank policy of sterilization.6 Before 2010, PBC policy actions (as measured by sterilization) had only partly offset the rise in structural liquidity. However, since end-2009, sterilization has responded more than proportionally to changes in structural liquidity (Figure 5.4), resulting in a steeper response of sterilization and structural liquidity. The PBC has relied mostly on reserve requirements in this more aggressive policy, probably reflecting their relative cost and comparative advantage in absorbing liquidity both quickly and for a long time. Given the size of the banking system, a small change in the required reserve rate can quickly absorb (or release) considerable liquidity, as seen by the impact of the reduction in the requirement in December 2008. However, the use of OMOs has increased considerably, and since 2010 has been important in injecting liquidity, given the extent of liquidity withdrawn through reserve requirements. This is an important change in the behavior of the PBC (Figure 5.5). Reserve requirements have, all else being equal, moved the system toward a deficit, with OMOs providing the additional liquidity needed by financial institutions. This can be seen in the behavior of money market rates during this period.

Figure 5.4Structural Liquidity and the People’s Bank of China Sterilization Policy

(In trillions of renminbi)

Sources: CEIC; and authors’ estimates.

Figure 5.5Composition of Policy Sterilization

(In trillions of renminbi)

Sources: CEIC; and authors’ estimates.

The more aggressive monetary response may have made aggregate management easier. When, as in China, a banking system has a positive structural liquidity position, the central bank must manage aggregate liquidity through the liability side of its balance sheet. Typically this is more challenging and costly due to the distortions created by sterilization, since financial institutions are not required to deal with the central bank for funding, at least in the aggregate, making it more difficult for the central bank to influence liquidity conditions (Gray, 2006; Gray and Talbot, 2006). In the case of a liquidity surplus, the default liability expansion—excess reserves—may directly lead to monetary expansion, as banks generally do not, for their operational needs, have to participate in central bank liquidity draining operations. Consequently, the tightening of liquidity is likely to have improved the traction of the PBC’s policy for its macroeconomic objectives because banks are more likely to rely on the PBC for refinancing.

However, the rise in funding liquidity stresses is evident in the recent behavior of money market rates. The PBC’s standing facilities should, in principle, define an interest rate corridor, with the emergency lending or discount rate at the top and the excess reserve rate at the bottom. This corridor is wide, with a median width of over 200 basis points between 2002 and 2011, compared with the current typical corridor of 50 basis points in countries with interest rate monetary policy targets. Moreover, the access limits imposed on these facilities, and the discretion maintained by the PBC, means the corridor is “soft” in the sense that it is not always binding on money market interest rates. This is clearly illustrated when repo rates significantly breach the top of the corridor, as was seen in late 2007, and as has been more endemic since late 2010 (Figure 5.6). To the extent that spikes in money market rates are attributable to clear transitory factors that do not affect the stance of monetary policy—such as temporary tightness due to a large IPO—the PBC is not inclined to intervene aggressively to smooth short-lived volatility and keep the interest rate within the corridor. However, more systematic violations of the corridor through the ceiling suggest persistent tight liquidity conditions that could have stability implications.

Figure 5.6China: Interest Rate Structure

(In percent per annum)

Source: CEIC.

This heightened stress, together with the uneven distribution of funds in the banking system, raises the importance of well-functioning money markets and nimble PBC liquidity management for stability. This uneven distribution leaves many institutions dependent on the money markets and on holding higher excess reserves (Figures 5.7 and 5.8). Specifically, China’s “big five” commercial banks, and many of the midsized joint stock banks, have surplus funds, while smaller commercial banks, policy banks, credit cooperatives, and nonbanks are typical net borrowers in this market.7 Consequently, despite a system that has been flush with liquidity, particular sets of institutions can be vulnerable to liquidity shocks and are forced to maintain higher excess reserves.8 Indeed, the switch from OMOs to reserve requirements for liquidity draining (sterilization) operations, ceteris paribus, effectively tightened conditions at a bank level given the nonexistent buffer role reserves play in the absence of reserve averaging. As a result, some banks are left with relatively limited liquid assets (Table 5.1), especially after a period of rapid loan growth, increasing their volatility. The imbalance is also reflected in the patterns of interbank funding, in which the larger state-controlled banks are predominantly the borrowers in the unsecured market, while in the collateralized repo market they are the dominant lenders to the other financial institutions. The recent spikes in money market rates suggest that funding conditions have been tight for some institutions.

Figure 5.7China: Interbank Funding

(In percent of liabilities)

Sources: CEIC; and authors’ estimates.

Note: Prior to January 2010, “large commercial banks” were referred to as “state-controlled banks.” Since January 2010, the data on other commercial banks and city commercial banks reflect data for medium-sized and small banks, respectively.

Figure 5.8China: Estimated Excess Reserve Ratios

(In percent of deposits)

Source: IMF staff estimates based on aggregated balance sheet data.

Note: Prior to January 2010, “large commercial banks” were referred to as “state-controlled banks.” Since January 2010, the data on other commercial banks and city commercial banks reflect data for medium-sized and small banks, respectively.

TABLE 5.1China: Aggregated Bank Balance Sheet(In percent of assets net of interbank claims, as of December 31, 2011)
AssetsLiabilities
Cash0.5Retail deposits81.4
Deposits at the People’s Bank of China (including excess reserves)17.5Net interbank−8.9
Loans66.2Securities7.9
Securities7.5Other16.6
Other8.2Equity3.0
Source: The People’s Bank of China.

Since Chinese banks cannot average their required reserves, excess reserves have been required to play an essential buffer role. In recent times, these buffers have been relatively low. The daily nature of the requirement means that it is principally an aggregate liquidity management tool for the PBC rather than a liquid asset for banks. Across the banking system these excess reserve buffers have averaged around 2–3 percent of deposits, but the actual holdings vary substantially by type of bank, although they were at historically low levels in 2011 (Figure 5.9). Supporting their buffer stock role, excess reserves are also relatively insensitive to their opportunity cost. On the other hand, interest rates react to changes in excess reserves, seemingly consistent with the PBC using quantitative liquidity changes (brought about by repo and bill transactions) to influence short-term money market interest rates. Specifically, as illustrated by the impulse responses (Figures 5.10 and 5.11) from a simple two-variable vector autoregression (VAR)—including the excess reserves ratio over total deposits and the spread between the overnight rate (SHIBOR) and the rate of the remuneration of excess reserves—a positive shock (around the trend) to the excess reserve ratio leads to a temporary reduction in the spread (around the trend), but a shock to the spread does not have any impact on the excess ratio.9 So, with buffers lower than that traditionally required for the smooth functioning of the system, liquidity shocks could have larger stability implications.

Figure 5.9China: Bank Reserves

(In percent of deposits)

Sources: CEIC; and authors’ estimates.

1IMF staff estimates based on aggregated balance sheet data.

Figure 5.10China: Responses to an Increase in the Total Excess Reserves Ratio

Source: Authors’ estimates.

Note: Vector autoregression (1 lag); excess reserves ratio; spread overnight SHIBOR over rate of excess reserves; constant.

Figure 5.11China: Responses to an Increase in the Spread

Source: Authors’ estimates.

As such, the interbank money markets, and the efficiency of their operation, are central to intermediation. Recent international experience has shown that a liquidity crisis can occur even when aggregate liquidity is ample if the distribution of funds in the system is uneven and institutions are sufficiently interconnected. Although such events have not in the past spread across institutions in China to become a systemic event, this remains a risk for the future. In the case of China, a deterioration in the liquidity of the markets for repo collateral is less likely to be disruptive than was seen in the recent crisis in developed markets, given the high-quality (near-sovereign) securities mostly used as collateral. However, this could change as new forms of collateral become increasingly important (Chu, Wen, and He, 2010), and frictions in the system could exacerbate a localized crisis.

In addition, ongoing structural changes have contributed to tighter liquidity conditions. Indeed, the ongoing process of disintermediation from the banking sector, as well as the development of the offshore renminbi market, has tightened conditions (Chu, Wen, and He, 2011). The rise in wealth management products has been associated with increased depositor mobility (given that these products offer higher returns than the ceiling on deposit rates), and the payouts associated with these products often also raise liquidity stress, as they are products generally not matched with the payment profile of the underlying product, which can cause banks to use their own funds or tap the money markets. More generally, the disintermediation leads to a general drain in liquidity and often returns to the banks “in the form of loan repayments rather than new deposits” (Chu, Wen, and He, 2011, p. 4). The development of the offshore market can also lead to destabilizing cross-border flows, and while much of the renminbi funds raised offshore (in Hong Kong SAR) remain there, corporates can use onshore renminbi to repay offshore obligations, resulting in funds leaving the system.

Risks arising from sudden changes in market and funding liquidity make it important that the PBC be able to respond quickly and relatively automatically. Therefore, developing the ability to undertake daily liquidity management would improve liquidity risk surveillance and crisis management. Although during normal times the ability to undertake such frequent liquidity operations may bring little marginal benefit, and indeed may not even be necessary under a reserve averaging regime, during times of stress the financial stability benefits could be significant. This will require additional effort in forecasting liquidity accurately at very high (daily) frequencies to ensure that high-frequency operations reduce rather than exacerbate market volatility. In particular, if a crisis involves heightened counterparty risk, then central bank operations become an important contributing element to the ongoing smooth functioning of the financial system (Cassola and Huetl, 2010). This is even more important when, as in China, required reserves cannot play a buffer role for financial institutions.

Money Markets, Fixed-Income Markets, and the Interest Rate Regime in China

The PBC is at the center of fixed-income pricing in China. Not only do its OMOs influence money market interest rates as described above, it also sets benchmark lending and deposit rate structures, which influence the interest rates in the money and bond markets. This section lays out the behavior of China’s interest rates and suggests some areas for operational reform that may improve the efficiency of these price signals. We find some anomalies in the operation of the money markets, and bond markets display some inefficiency at shorter maturities, likely reflecting regulation, segmentation, and illiquidity. Despite these inefficiencies, prices seem to reflect economic expectations and transmit shocks across yield curves.

Efficiency of fixed-income prices in the money and bond markets is critical for their functioning and, hence, market liquidity. Indeed, there are several reasons to suspect that these prices are far from efficient. Despite no formal segmentation, the secured and unsecured fixed-income and money markets appear segmented.10 China’s bond markets have traditionally been segmented between those for retail investors and those for institutional investors. Although the impact of this segmentation has been reduced, with some large banks now able to operate in both markets on a pilot basis, the distortions are likely to exacerbate market illiquidity in normal times, and especially during times of stress. Removing the final divisions in the bond market, strengthening existing standing facilities (including by making them automatic), and liberalizing financial prices would likely address these remaining anomalies and improve the functioning of these markets.

Money Market Interest Rates

China’s money markets include a collateralized (repo) market and an uncollateralized (call-loan) market. Collateralized lending activity clearly dominates, averaging 10 times the size of the unsecured market. Large banks dominate the lending in the repo market, with smaller banks and other financial institutions generally short of liquidity (Figure 5.12). In the unsecured money market the roles are reversed, with smaller banks predominantly lending to the larger banks (Figure 5.13). Financial—policy and commercial bank—bonds are the most popular instrument for repo purposes, but PBC paper and, increasingly, the newer middle-term notes are also used (Figure 5.14).11 Although most of the collateral is very high (near sovereign) quality, Chu, Wen, and He (2010) report the increasing use of discounted short-term bills as collateral, as well as corporate medium-term notes, deteriorating the quality of the collateral pool.12 Such a change in the nature of collateral increases the likelihood of systemic risks if it becomes sufficiently widespread, and haircuts on these bills may be smaller than suggested by their risk characteristics (Chu, Wen, and He, 2010).

Figure 5.12China: Flow of Funds in the Interbank Market—Repos

(In billions of renminbi)

Source: The People’s Bank of China, Quarterly Monetary Policy Report, various issues.

Figure 5.13China: Flow of Funds in the Interbank Market: Call Loans

(In billions of renminbi)

Source: The People’s Bank of China, Quarterly Monetary Policy Report, various issues.

Figure 5.14China: Interbank Repo Turnover

(In billions of renminbi)

Source: CEIC.

Note: PBC = the People’s Bank of China.

While the money markets are highly active, and key to intermediation in China, two pricing anomalies can be identified:

  • Secured interest rates are typically above unsecured rates. The weighted average of the repo rate persistently exceeds the unsecured rate, particularly since January 2006 (Figure 5.15). Given the quality of the securities pledged for repos (and the haircuts applied), this suggests problems in the pricing of short-term credit. Market participants generally attribute this to a reflection of counterparty risk, as only large banks are typically able to borrow in the unsecured market. However, the security provided for the repo transaction, and the higher liquidity in the repo market, should imply even lower interest rates. As such, an average premium of over 50 basis points—between the overnight repo and uncollateralized call-loan rates—seems high.13 Reportedly, tiering is common in interbank pricing, and although conditional on a particular bank borrowing in both secured and unsecured markets, the rate of interest charged in the unsecured market is higher. This gap should then likely reflect factors other than pure counterparty risk. In particular, given the dominance of a few very large banks, it seems likely that relative market power plays an important role, particularly around times when money market conditions are especially tight due to IPOs or seasonal factors.14

  • The short-term money market yield curve is always positively sloped, irrespective of whether the interest rate cycle is on an upward, flat, or downward phase. This suggests that interest rates do not accurately reflect the expected path of short-term interest rates. This feature is illustrated in Figure 5.16 with five very short-term repo rates (1-day, 7-day, 14-day, 21-day, and 28-day maturities). Given their very short-term maturity, the term premia should normally be very small and constant. However, spreads are relatively wide (between 25 and 60 basis points) and are positive irrespective of the stage of the interest rate cycle: end-2008 and end-2009 share the same patterns, while in the former period policy rates were being cut and in the latter policy rates were kept constant. This not only suggests some mispricing but could lead to problems on the rare occasions the curve inverts, since market participants are unfamiliar with such behavior.

Figure 5.15China: Interbank Overnight Funding Rates

(In percent)

Source: CEIC.

Figure 5.16China: Interbank Collateralized Repo Rates

(In percent)

Source: CEIC.

Bond Turnover and Pricing

This section looks at the behavior and efficiency of bond market prices. Bond yields should (bidirectionally) reflect shocks that affect other yields as well as convey expectations about future macroeconomic developments. However, given the segmentation and other distortions in the Chinese financial market, this may not turn out to be the case.

Since segmentation, market turnover has been higher in the interbank (institutional) bond market, with inconsistencies in the pricing of securities across the retail and institutional Treasury markets. Despite this, and somewhat surprisingly, median bid-ask spreads tend to be lower for Treasury bonds across most maturities, although the market for one-year bonds seems equally liquid (Figure 5.17). The segmentation of the Treasury bond market—between retail and institutional (interbank) markets—has allowed different pricing for these bonds. This is apparent from the fact that the yield curves of the bonds trading on the separate markets tend to cross. The maturity of crossing has varied over time around a median of 12 months (Figures 5.18 and 5.19). As such, segmentation has clearly led to distorted price signals.

Figure 5.17China: Bond Market Bid-Ask Spreads, April 2010 to June 2011

(In basis points)

Source: CEIC

Figure 5.18China: Treasury Bond Yield Curves

(In percent)

Source: Authors’ estimates.

Figure 5.19China: Interbank and Exchange Market Yield Curve Crossing

(In months)

Source: Authors’ estimates.

Offshore Market Development

The development of the offshore bond market poses some risks to liquidity management in China. The reform process has led to the creation of a rapidly expanding set of renminbi financial products and prices outside of mainland China. Given China’s binding capital controls, these prices tend to differ from those on the mainland, creating the incentive for capital flows to arbitrage these differences. This has particularly been the case since July 2010, when the PBC and Hong Kong Monetary Authority signed a Memorandum of Cooperation allowing nonbank financial institutions as well as non-trade-related nonfinancial corporations to open renminbi accounts in Hong Kong SAR. A key part of the functioning of this scheme is the convertibility constraint, by which banks acting as counterparties to non-trade-related renminbi conversion cannot automatically net their position with the clearing bank (Bank of China, Hong Kong). These convertibility restrictions are designed largely to preserve the mainland’s capital account restrictions.

Long-term development of the offshore renminbi market is likely to bring many benefits. Possibly an early tangible benefit will result from the introduction of new (and different) types of investors in the domestic bond market. Nonetheless, it is likely to complicate liquidity management and may raise some financial stability concerns.15 Having said that, the development of an offshore market does not require complete capital account liberalization, and there are ways to manage the emerging risks as the market develops. While the complete “going out” of the renminbi may be impossible without an open capital account, the substantial restriction that remained on the use of the U.S. dollar during the 1960s and 1970s did not seem to have impeded the international use of the dollar at the time.

The expansion of offshore renminbi activity may pose risks to the PBC’s ability to control domestic monetary conditions. Nonetheless, moving toward liquidity management targeting domestic interest rates is likely to ease the overall management task as the offshore market grows. Specifically, changes in offshore activity—as well as the endogenous money creation resulting from offshore lending—complicate controlling credit, domestic interest rates, and the exchange rate. However, provided capital controls remain effective, the PBC is likely to maintain control over monetary conditions. The reforms outlined above aimed at developing the offshore renminbi market clearly limit the extent of capital account opening but may possibly make evasion easier by making trade misinvoicing easier. If so, then additional measures to restore the strength of capital controls may be needed to maintain monetary control.

Beyond issues related to liquidity and monetary management, the development of a deep offshore market could eventually also have implications for the PBC’s financial stability role. The large expansion of renminbi lending by foreign banks made possible by offshore market development means that the PBC may be required to provide renminbi liquidity support to non-Chinese banks in the case of tight liquidity in the offshore renminbi market. Indeed, as offshore use of the renminbi expands, this could be even more relevant for the PBC than it was for the U.S. Federal Reserve during the 2007–09 financial crisis, as few foreign central banks are likely to have significant renminbi assets in their reserve portfolios. However, during the financial crisis the PBC gained some experience in providing renminbi swap arrangements with other central banks (although none have actually been used), demonstrating that it has already developed the necessary infrastructure.

Conclusions and Considerations for Further Liberalization

This chapter has surveyed liquidity management operations by the PBC and the operation of key fixed-income markets in China. The PBC has effectively managed domestic liquidity conditions in recent times, particularly given the remarkably large increase in structural liquidity since 2006. However, the chapter argues that future financial stability would benefit from reforming (and reducing the stigma associated with) the PBC’s standing facilities, developing an ability over time to undertake OMOs at a daily frequency, and introducing reserve averaging. Clarifying the PBC’s liquidity management objectives and moving toward indirect liquidity management instruments should also ease the PBC’s management task as the money multiplier becomes less stable, also aiding macroeconomic and financial stability. Finally, the efficiency of financial prices should improve as the financial sector is further liberalized and market liquidity grows.

Further financial and interest rate liberalization should bring a number of benefits, and the need is becoming increasingly urgent. Market-determined interest rates should become a more informative guide to domestic monetary conditions and provide more efficient price signals to guide investment allocation. Moreover, liberalization is also likely to result in access to bond issuance for an expanded set of corporates, particularly for short-and medium-term notes, and expand available saving and investment products for individuals. The disintermediation already under way, as well as the tightening of liquidity conditions, makes the need more urgent. Indeed, market liquidity should improve with the removal of a number of distortions.

As discussed above, improperly sequenced liberalization is likely to increase risks in ways that dominate the benefits from reform. While a complete sequencing of financial sector reforms is discussed in Chapter 2 of this book, this chapter concludes with two sequencing considerations relevant to liquidity management.

  • Domestic liberalization. Domestic liberalization will likely increase both the level and volatility of interest rates and, as discussed, should be accompanied by tight monetary policy to limit the risks posed by a competition-driven expansion of lending. With interest rate volatility likely to rise, and the depth of hedging markets currently limited, a concurrent move to interest rate targeting should also smooth the transition during the liberalization process. At the same time, moving the exchange rate closer to its equilibrium level should add a further dimension to the tightening of monetary conditions, as well as slow the autonomous rise in structural liquidity. Ultimately, greater flexibility in both exchange and interest rates will deepen the hedging markets, allowing for greater market-based hedging opportunities.

  • External liberalization. Complete external liberalization ahead of domestic liberalization could lead to substantial and destabilizing capital flows, particularly if the exchange rate is considered to be near equilibrium at the time and domestic interest rates remain low. Moreover, a vibrant offshore market would likely make these pressures stronger and significantly complicate monetary management if attempted too early and, especially, if attempted before the PBC moves to the use of indirect policy instruments. Consequently, domestic financial and interest rate market reform should precede external liberalization, with the exchange rate close to equilibrium.

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Eligible participants are chosen by the PBC. Currently there are around 50 eligible participants, including both banks and nonbanks (securities firms, insurance companies, and fund managers). The list is adjusted over time depending on past operations and credit ratings.

The deposit rates are generally considered binding, while the lowest lending rate—90 percent of the administered benchmark rate—has traditionally been binding on a quarter to a third of new loans. The share of new loans at this floor, however, fell dramatically in 2011, reaching a minimum of around 5 percent in early 2012. The share ticked up later in 2012 and was around 11 percent in September 2012.

The PBC does not impose any haircut for Treasury bonds and central bank paper, but there seems to be less clarity over the margins applicable on other paper, such as commercial bills.

The absence of reserve averaging also increases the volatility of money market interest rates (Bartolini and Prati, 2003).

Commercial banks are not allowed to lend more than 75 percent of deposits.

Policy sterilization—the sum of changes in required reserves and OMOs—reflects the monetary actions undertaken by the central bank to offset autonomous changes in structural liquidity.

Porter and Xu (2009) provide a more detailed discussion of the parallel historical development of the interbank and exchange traded bond markets.

For foreign banks, the higher average reflects both higher buffer stocks and, in the case of some banks, a business model with limited reliance on retail deposit taking.

Besides the constant term, a time trend was added to the VAR because in the sample period both the excess reserves ratio and the interest rate spread have declining (linear) trends.

The segmentation of the bond market dates from 1997 and prevents banks from trading in the exchange market. Since 2004, bonds trading in one market have been able to be moved to the other platform, but since this requires moving bonds across depositories, it can take substantial time (up to a day). In early 2010, the authorities announced a pilot scheme to allow some commercial banks to operate in both interbank and exchange markets.

Middle-term notes are medium-term paper (up to five-year maturity) issued by (listed or unlisted) companies.

The China Government Depository Trust and Clearing Co. Ltd. (CDC) is the only institution entrusted by the Ministry of Finance to be the depository for government securities. In addition to the interbank and over-the-counter bond markets, government securities may also be traded in the stock exchanges. For this purpose, the China Securities and Clearing Corporation Ltd. holds an omnibus account at the CDC.

Although only overnight rates are shown in the figure, there is a substantial gap between repo and SHIBOR rates out to one year.

Feyzioglu (2009) also suggests market concentration as a possible explanation for the independence between profitability and efficiency observed across Chinese banks. The extensive use of pledged, rather than outright, repos may also play a role, as these are in principle relatively more expensive.

He and McCauley (2010) provide an excellent survey of the lessons for emerging economies that may wish to internationalize their currency.

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