Central bank tests new money supply tools for Year of the Monkey

By Lu Jianxin and Nathaniel Taplin SHANGHAI, Feb 5 : In the weeks leading up to the traditional Lunar New Year liquidity squeeze, China’s central bank has been busy testing its new “interest rate corridor”, a tool that could help reduce the need for deeper monetary policy easing.

The People’s Bank of China (PBOC) late last year introduced a new band to guide interest rates on loans and deposits, abolishing official restrictions on such rates that market participants had criticised for distorting capital flows.

Traders say the move to a market-based approach to money supply management ultimately helps policymakers in stabilising the currency and stemming capital outflows, which have been roiling the Chinese currency and markets.

“Money markets have become a battleground for the PBOC to try to keep the yuan stable partly by keeping interest rates within its intended ranges,” said a senior trader at a Chinese state-owned bank in Shanghai.

In its corridor management, the PBOC sets the upper and lower limits of the interbank rate band and uses short-term money market instruments to keep the rates within that range.

The central bank has been busy testing the corridor during the traditional liquidity shortfall ahead of Lunar New Year on Feb. 8, in which people withdraw large sums of money to travel and get through a week when banks are closed.

Over the past three weeks, the central bank has pumped more than 2 trillion yuan ($304 billion) in short-term funds into the markets via monetary tools in a bid to keep rates steady and within the corridor.

The PBOC has set the ceiling at 2.75 percent and the floor at 2.25 percent, traders said.

The new tools could have implications for longer-term central bank policy.

Currently, there’s widespread expectation that Beijing could cut banks’ reserve requirement ratios (RRR) to cushion the slowdown in the world’s second-largest economy, where firms still complain that real interest rates are far higher than returns on investment given the semi-deflationary environment.

However, if the PBOC’s repeated injections keep rates stable, the case for immediate RRR cuts could diminish.

Analysts say this would be welcome news for authorities wary that RRR cuts increase base money supply, which could in turn work its way offshore as capital flight, sending the currency lower.

INTEREST RATE LIBERALISATION

By using price targets, rather than supply constraints, to control money supply, a rates corridor reduces the fear factor that has historically overhung China’s money market.

“Once market rates rise close to the upper limit rate, banks will look to the PBOC to inject liquidity, and thus they will not panic and hoard cash,” said Zhang Yiping, an economist at China Merchants Securities in Shenzhen.

Importantly, the corridor’s lower limit helps cushion possible capital outflows, the kind of which China experienced in the lead up to the U.S. Federal Reserve’s interest rate hike in December.

The ability to use smaller operations allows the PBOC to manage rates with more precision than is afforded by broader official moves, such as interest rate and RRR cuts.

As such, the PBOC has sought to guide interest rates while injecting enough short-term liquidity into the banking system ahead of the Lunar New Year.

/Reuters

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