Yuan Struggle for Stability: China’s drive to maintain the yuan’s stability inadvertently led to turmoil in money markets last week. As sources familiar with the matter report, it created a behind-the-scenes struggle for Beijing as it manages its economy through a significant slowdown. At the end of October, the routine demand for cash within China’s banking system unexpectedly escalated into a frenzy, resulting in short-term funding rates skyrocketing to 50% in some instances. Authorities are now investigating the incident, which left traders in Shanghai and Beijing bewildered and apprehensive.
To restore calm, the People’s Bank of China (PBOC), along with its affiliate, the China Foreign Exchange Trade System (CFETS), and bond clearing houses, intervened by instructing lenders, extending trading hours, and conducting meetings with financial institutions. This market upheaval was triggered by several factors, including the regular end-of-month liquidity demand, hoarding of cash in anticipation of a substantial government bond sale, and the reluctance of major banks to lend due to their mandate to counteract yuan depreciation.
Xia Chun, the chief economist at wealth management firm Yintech Investment Holdings, described this situation as an unintentional consequence of the government’s heavy-handed involvement in financial markets. Banks were cautious about lending, forcing non-bank entities to seek funds from one another, resulting in surging borrowing rates, with some being willing to pay any price.
This article delves into the reasons behind the sudden spike in interest rates and the ensuing market chaos, shedding light on a vulnerability that may persist as long as capital outflows continue to stress the financial system. Participants requested anonymity due to the sensitivity of the topic.
CFETS is reportedly investigating “abnormal” trades that occurred on October 31, which involved certain accounts repeatedly borrowing and lending money at extremely high interest rates towards the end of the trading day.
Short-term financing markets, including overnight repurchase agreements (repos), play a pivotal role in the daily operations of banks, insurers, and other financial institutions. These markets have a significant impact on foreign exchange movements since they are a primary source of money supply.
Funds and non-bank entities rely on loans rolled over in the repo market to finance their investments and trades. The end of the month is also a time when banks and other financial participants must square their books and adhere to capital buffer regulations. Disruptions in these markets can pose a threat to financial stability.
The root of the problem can be traced back to October when China greenlit the issuance of one trillion yuan ($137.32 billion) in sovereign debt, following the issuance schedule for the fourth quarter but increasing the size of each tranche. Typically, the PBOC would mitigate the cash drain resulting from additional bond issuance by providing extra funding support, such as relaxing bank reserve requirements. However, injecting more cash into the system would risk putting downward pressure on the yuan, which had already depreciated by over 5% against the dollar during the year.
This inaction by the central bank was primarily motivated by its concerns over further yuan depreciation. Consequently, the scramble for short-term funds turned into a frenzy on trading floors, causing repo rates between banks to surge from 2% the previous day to as high as 8% on October 31.
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Desperate last-minute borrowers found themselves in a predicament as state banks, typically the lenders of last resort, were absent at 4 p.m. Market participants had to pay exorbitant rates, ranging from 30% to 50%, to secure the loans they needed. This situation hadn’t been witnessed since defaults at China Everbright Bank and Industrial Bank a decade ago.
As 5 p.m. approached, markets closed with positions unfunded and trades left incomplete. The atmosphere was tense, with traders uncertain about the outcome, keeping everyone on the trading desk in a combat-ready mode.
To avert a crisis, the People’s Bank of China intervened, requesting state banks to provide funds. Additionally, the China Central Depository & Clearing Co (CCDC) and Shanghai Clearing House reopened settlements at 6 p.m. This emergency response managed to clear the market and return it to stability by 8.30 p.m.
A follow-up meeting with banks and brokers the next day saw the PBOC characterizing the behavior of institutions as “disturbing the market” and urged them not to “be emotional.” The money market operator CFETS imposed a 5% ceiling on repo transactions and informed those involved in high-rate deals closed on October 31 that they would need to explain their actions to regulators. Fear subsided as overnight rates fell back below 3%. However, analysts see the ongoing tightness in the market as a result of the backdrop, namely, increased control over China’s currency.
China’s efforts to stabilize its currency come amid a disappointing economic rebound from the COVID-19 pandemic and global interest rate increases, which have prompted capital outflows and caused the yuan to depreciate. Despite losing over 5% against the dollar between the start of the year and mid-August, the yuan has exhibited relative stability since then. This stability can be attributed to various measures, such as state-bank buying and regulations discouraging short selling, which have been implemented to support the currency.
Tighter liquidity remains a potential strategy, as the pattern of money supply and liquidity provision, if unchanged, could render the entire system fragile. Although some see less risk, the prevailing tight conditions are likely to persist as long as the pressure on the currency endures. While the yuan has benefited from the broad weakness of the dollar in recent times, its exchange rate, at 7.28 to the dollar, remains in close proximity to its 16-year low of 7.351 recorded in September.
Our Reader’s Queries
How is yuan so stable?
For over two decades, the Chinese yuan has been pegged to a fixed exchange rate. This strategy has resulted in the yuan being undervalued compared to other currencies, making Chinese exports more affordable and appealing to foreign buyers. As a result, China has become a major player in global trade, with its exports being highly sought after by other nations.
Why is the yuan weakening?
The significant difference in interest rates between China and the US has worsened the outflow of capital from assets denominated in yuan. This has been particularly evident since the US Federal Reserve started increasing its benchmark rate in March of last year.
What is preventing China’s yuan from becoming the world’s reserve currency?
Similar to the CIPS system, the yuan of China has not yet gained widespread acceptance overseas. For it to pose a genuine challenge to the USD as a global reserve currency, we need to witness more cross-border transactions involving countries other than China.
Why China’s policymakers are relaxed about a falling yuan?
Previously, China maintained a fixed exchange rate with the US dollar to avoid a sudden drop that could lead to a currency crisis. However, the yuan’s depreciation against the dollar is now less likely to cause chaos. As a result, China will not be as vigilant in preventing it.