Exclusive: China’s conflicting priorities are behind the rare financial market distress

Exclusive: China's conflicting priorities are behind the rare financial market distress

SHANGHAI/SINGAPORE (Reuters) – China’s attempts to prevent the yuan from falling contributed to the chaos in financial markets last week, sources familiar with the matter say, pointing to pressures taking place behind the scenes as Beijing tries to steer its economy and markets along a major path. Slower.

Routine end-of-month demand for cash in China’s banking system spiraled into a stampede on October 31, sending short-term financing rates soaring to 50% in some cases, an incident that authorities are now investigating.

Six market participants say a combination of factors sent fear and confusion across trading rooms in Shanghai and Beijing late that afternoon.

Eventually, the People’s Bank of China (PBOC), its China Foreign Exchange Trading System (CFETS), and bond clearinghouses intervened to guide lenders, extend trading hours and hold meetings with institutions to calm markets.

Contributing factors were the usual demand for liquidity at the end of the month, cash hoarding in the run-up to a large government bond sale, and a market in which major banks were already reluctant to lend due to a mandate to counter pressure on the yuan.

“It was an accident,” said Xia Chun, chief economist at wealth management firm Yintech Investment Holdings, describing it as an unexpected consequence of the government’s heavy hand in financial markets.

“Banks were reluctant to lend, leaving non-bank institutions asking each other for money in the afternoon,” he said. “As a result, borrowing rates have risen, with some willing to accept any price.”

The reasons for the rise in interest rates and the ensuing market chaos are detailed here for the first time. Participants say exposed vulnerabilities will remain as long as capital outflows keep the system under pressure.

Most of them requested anonymity because they were not authorized to discuss a sensitive topic publicly.

The People’s Bank of China told Reuters that CFETS were investigating “abnormal” trades on October 31, which included some accounts repeatedly borrowing and lending at “extremely high interest rates” near the end of trading hours.

“combat mood”

Short-term financing markets, such as overnight repurchase agreements, or repurchase agreements, are essential to the day-to-day business of banks, insurance companies, and other financial institutions.

It affects foreign exchange movements because markets are the main way of supplying funds.

Funds and non-bank institutions borrow and roll over loans that finance their investments and trades in the repo market. The end of the month is also the time when banks and other financial sector participants must settle their books and comply with rules regarding capital buffers.

Thus, turmoil could threaten financial stability.

The seeds of trouble were sown in October when China approved 1 trillion yuan ($137.32 billion) in sovereign debt sales, which will be rolled out — according to sources familiar with the plans — by sticking to a fourth-quarter issuance schedule but increasing the size of the debt. Every slide.

In such cases, the People’s Bank of China offsets the cash drain from additional bond issuance with additional financing support – for example, by easing bank reserve requirements, said a fund manager in Shanghai.

But putting additional money into the system would risk increasing downward pressure on the yuan — which has lost more than 5% against the dollar this year — and undermining months of efforts to stabilize the currency.

“The central bank’s inaction is mainly due to its concern about the depreciation of the yuan,” said the fund manager, who requested anonymity because he was not authorized to speak to the media.

On the trading floors that Tuesday, the scramble for short-term money became a stampede.

Even interbank repo rates, which are usually stable and the main measure of short-term funding costs, rose from an overnight rate of 2% the day before to 8% on October 31.

Desperate borrowers

At 4 p.m. (0800 GMT), state banks that usually lend to desperate borrowers at the last minute were gone, according to three market participants.

The absence left two desperate borrowers paying between 30% and 50% – rates not seen since the defaults at China Everbright Bank (601818.SS) and Industrial Bank Co Ltd (601166.SS) a decade ago – to secure loans that They need it.

At 5pm, markets closed with positions unfunded and trades incomplete.

“No one left the trading desk, because you don’t know how things are going to go,” said one fund manager in Beijing. “The whole trading room was in a fighting mood.”

“If you need to unwind your positions in such an environment, and want to avoid default, you need to borrow at high interest rates,” the fund manager said. “For each individual, it is rational behavior.”

The People’s Bank of China (PBOC) intervened in the hack, asking state banks to provide funds while the China Central Depository and Clearing Corporation (CCDC) and the Shanghai Clearing House reopened settlements at 6pm in an emergency response. By 8:30 p.m., the crisis had been averted and the market had been cleared and closed again.

Don’t be emotional

In a follow-up meeting with banks and brokers the next day, the sources said the People’s Bank of China told institutions that their behavior “disturbed the market” and that they should not “be emotional.”

Money market operator CFETS asked traders to maintain a 5% cap on repo transactions and said anyone involved in high-interest-rate trades that closed on October 31 would need to explain their position to regulators, according to sources who received the notice.

Fear subsided as overnight interest rates fell below 3%. To be sure, most people see the danger as over.

But analysts have turned to the backdrop – intensifying control over the Chinese currency – as a primary source of tension.

China’s economic recovery from the COVID-19 pandemic has been disappointing. Combined with rising interest rates around the world, this has led to increased capital outflows and the yuan has suffered.

However, after falling by 5% against the dollar over the year to mid-August, the exchange rate has remained remarkably stable since efforts to prop it up, starting with buying by state banks and the imposition of new rules discouraging short selling.

Another way is to tighten liquidity.

“If the pattern of money supply and liquidity provision remains unchanged, the entire system remains fragile. Another liquidity shock is always possible,” the Beijing-based fund manager said.

Others see the risks as lower, but expect the tightness to continue as long as there is pressure on the currency. The dollar’s widespread weakness has helped the yuan recently, but its price at 7.28 yuan to the dollar is not far from a 16-year low of 7.351 yuan hit in September.

($1 = 7.2822 Chinese yuan)

(Reporting from Shanghai newsroom) and writing by Tom Westbrook; Edited by Vidya Ranganathan and Raju Gopalakrishnan

Our Standards: The Thomson Reuters Trust Principles.

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