Market liquidity supply sees big change

A dramatic change is taking place in China's liquidity supply mode as capital flows out of the world's second-largest economy amid calls for the monetary authorities to look for new ways to inject money into the economy, said analysts.

For a long time, Chinese banks' yuan holdings for purchasing foreign exchange have been a major channel for the central bank to create money. Now the old pattern is about to change, which means the central bank needs to find new ways to issue currency if it wants to maintain stable money supply growth, said Cao Yuanzheng, chief economist at the Bank of China Ltd.

China posted a monthly capital outflow in August for the third time in 2012, as the growth of the world's second-largest economy fell to a three-year low and softened for the sixth consecutive quarter.

Yuan holdings among banks for purchasing foreign exchange, a key measure of capital flows, declined by 17.4 billion yuan ($2.75 billion) in August to 25.64 trillion yuan, marking the second straight monthly fall.

It widened from a decline of 3.8 billion yuan in July as the nation's economic growth slowed to its lowest rate in three years.

Foreign exchange has become a main source of the country's liquidity over the past two decades as the central bank sterilized its fluctuation to stabilize the yuan exchange rate.

Yuan holdings of foreign exchange purchases started to increase at the beginning of the year after three consecutive monthly declines in the fourth quarter of 2011. But the hikes ended in April, when a 60.6 billion yuan monthly fall was reported.

In the first eight months, the average monthly increase of yuan holdings was only 35.2 billion yuan, far from the average monthly gain of 231.6 billion throughout last year.

In August, despite the significant drop in international market hedging demand, banks' yuan holdings still declined. This proves that pressure for yuan devaluation will remain in the medium and long term, said Liu Yuhui, director of the financial lab of the Chinese Academy of Social Sciences.

This year, offshore non-deliverable yuan forwards have been higher than the onshore spot exchange rate, and the spread between the two is likely to become much greater, which indicates that expectations remain that the yuan will depreciate, said Cao.

But we tend to believe that the conditions do not exist for the yuan to depreciate further, as the Chinese economy is still in a stable and controllable range, and foreign reserves remain very large.

The depreciation tendency once again indicates that the yuan's exchange rate is close to equilibrium, he said.

We believe that capital flows related to yuan exchange rate expectations is the biggest factor affecting overall capital flows, said Wang Tao, head of China economic research at UBS Securities Co Ltd.

Capital outflows will be constant and substantial as China's current account surplus continues to decline, global demand remains weak, expectations grow that the yuan will depreciate, and Chinese residents prefer to hold foreign assets, she said.

The financial account deficit plus a lower current account surplus means that China may have entered a new era, that is, the stagnant growth of foreign exchange reserves.

Wang said the central bank, the People's Bank of China, has to change the combination of liquidity management tools, although the tone of monetary policy would not be affected.

For several years, with massive foreign inflows, managing domestic liquidity was fairly straightforward, ensuring that enough liquidity was mopped up. The central bank combined open market operations with higher reserve requirements to do this, said Louis Kuijs, chief China economist at the Royal Bank of Scotland.

With trend inflows now lower, monetary policy needs to be more agile.

Cutting the reserve requirement ratio for commercial banks had been a commonly used tool of the central bank to deal with capital outflows.

For example, from December to May, the central bank lowered the RRR three times as capital flew out and liquidity tightened, said a report from Guotai Junan Securities Co.

But since July, despite capital outflows, it seems that the central bank has been reluctant to cut the RRR. A major reason behind that is probably the hike in foreign currency-denominated deposits, it said.

In the first six months, such deposits held by banks have increased by $130.1 billion, up $99.4 billion compared with the same period last year, according to data from the State Administration of Foreign Exchange.

Adjusting the RRR usually lacks flexibility, and once the yuan appreciates, enterprises and individuals would prefer to convert those deposits to yuan, adding extra liquidity to the market, said the report.

The central bank has been increasing its use of short-term money market tools such as reverse repurchase transactions to ease liquidity tension, after it last cut the RRR in May by 50 basis points to 20 percent for major banks.

It injected massive liquidity through another round of reverse repurchase operation in the last week of September.

From Sept 24 to 27, it injected 365 billion yuan, a record high weekly injection through open market operations.

On Sept 25, the central bank pumped a record 290 billion yuan into the market by conducting reverse repos to ease a cash crunch as the quarter came to an end and the Mid-Autumn Festival and National Day holidays approached.

In a statement published after its third-quarter monetary policy meeting in September, the central bank said it would continue to implement a prudent monetary policy, while fine-tuning the stance with more targeted, flexible and forward-looking tools.

It added it will closely monitor the impact of recent rescue and stimulus policies in Europe and the United States, as global economic growth remains weak.

Zhao Xijun, deputy dean of the School of Finance at Renmin University of China, said the international financial market remains troubled at present and, judging from the current situation, there is no clear direction of capital flows.

It's still hard to say whether the capital outflows will continue in the next few months. But certainly the increase in yuan holdings for purchasing foreign exchange would fall compared with past years, mainly due to drops in the trade surplus, Zhao said.

Generally speaking, liquidity supply has already changed, although it wouldn't put too much pressure on the central bank right now.

Buying treasury bonds in the secondary market would become a major channel for the central bank to create money in the future, China Business News reported, citing an anonymous analyst close to central bank decision-makers.

But controlling liquidity through purchases and sales of treasury bonds requires a bigger and more mature secondary market, otherwise large-scale purchases made by the central bank would raise interest rates and spur the issuance cost of such bonds, said the analyst.

Currently central bank bills and treasury bonds are in separate markets. Only if China completely frees interest rates, could the two markets be linked and the central bank could operate like the US Federal Reserve, Zhao said.

Before the sterilization of foreign exchange fluctuations became a mainstream channel to issue currency, re-lending to commercial lenders was the main tool of China's central bank to create money, accounting for 80 percent of newly injected money in the 1990s.

It's unlikely that China will return to relying on re-lending, which lacks a direct connection with the real economy, said analysts.

Some said it was too early to say that the liquidity supply system will turn from a passive to proactive pattern as the yuan would probably go up and attract capital inflows due to policy loosening in major economies, such as the Fed's third-round of quantitative easing, the European Central Bank's bond-buying plan, and the formal launch of the 500 billion euro European Stability Mechanism on Oct 8.

The yuan climbed on Sept 28 to its highest level against the US dollar since it stopped being pegged to the greenback in July 2005.

Yu Yongding, a former adviser to the central bank, said in September that it's time for the central bank to reduce intervention in currency markets and let the yuan float freely, as economic growth will remain at a lower level compared with recent years and capital flows become two way.

China should take advantage of the opportunity that market sentiment might drive down the dollar to broaden the range of the yuan's exchange rate, said Liu from the academy.