Reuters reported exclusively on Monday (November 6th) that relevant sources claimed that China's attempt to prevent the depreciation of the yuan led to chaos in the currency market last week. Sources also pointed out the behind the scenes pressure that Beijing is trying to guide the economy and market during a major economic slowdown.
On October 31st, the routine demand for cash by the Chinese banking system at the end of the month snowballed into a competition, pushing short-term financing rates up to 50% in some cases. The authorities are investigating this incident.
Six market participants stated that as of late afternoon of the same day, the combined effect of various factors had led to fear and chaos in the trading rooms of Shanghai and Beijing.
Finally, the People's Bank of China (PBOC), its affiliated China Foreign Exchange Trading Center (CFETS), and bond clearing house intervened, issuing instructions to lenders, extending trading hours, and holding meetings with relevant institutions to calm the market.
Contributing factors include the usual month end liquidity demand, cash hoarding before large-scale government bond sales, and the fact that major banks in the market have been ordered not to lend aggressively to withstand pressure on the renminbi.
This is an accident, "said Xia Chun, chief economist of wealth management company Yintech Investment Holdings, calling it an unforeseeable consequence of the government's heavy actions in the financial market.
Banks are very reluctant to lend, allowing non banks to borrow money from each other in afternoon transactions, "he said. As a result, borrowing rates have skyrocketed, and some people are willing to bear any price
The reasons for the surge in interest rates and the accompanying market turmoil are detailed here for the first time. Participants stated that as long as capital outflows put pressure on the system, the exposed vulnerabilities will continue to exist.
Most of them require anonymity because they are not authorized to openly discuss this sensitive topic.
The People's Bank of China told Reuters that the China Foreign Exchange Trading Center is investigating "abnormal" transactions on October 31st, involving some accounts repeatedly borrowing and lending at "extremely high interest rates" at the end of trading hours.
Combat sentiment
The short-term financing market, such as overnight repurchase agreements, is crucial for the daily operations of banks, insurance companies, and other financial institutions.
They affect the trend of foreign exchange because the market is the main source of money supply.
Funds and non bank borrowing and rollover loans provide funding for investments and transactions in the repurchase market. At the end of the month, it is also a time when banks and other financial sector participants must organize their books and comply with capital buffer rules.
Therefore, interruptions may pose a threat to financial stability.
According to insiders, in October last year, China approved a plan to sell 1 trillion yuan ($137.32 billion) of sovereign debt, which was launched by adhering to the fourth quarter issuance schedule but increasing the size of each batch. This has sown the seeds of hidden dangers for the current troubles.
A fund manager in Shanghai stated that in such cases, the People's Bank of China usually offsets the cash loss from additional bond issuance through additional financial support, such as relaxing bank reserve requirements.
However, investing additional cash into the system may increase the downward pressure on the Chinese yuan - which has fallen by more than 5% against the US dollar this year - and weaken efforts to stabilize the yuan for several months.
The central bank's inaction is mainly due to concerns about the depreciation of the renminbi, "the fund manager said, refusing to disclose his identity as he was not authorized to speak to the media.
On Tuesday's trading floor, the competition for short-term funds turned into a stampede of mixed grabbing by crowds.
The repurchase rate between banks, which is usually stable and a major indicator of short-term financing costs, has skyrocketed from 2% of the overnight interest rate on the previous day to 8% on October 31st.
Desperate borrower
According to three market participants, the state-owned banks that typically provide loans to desperate last minute borrowers disappeared at 4 pm.
Due to the absence of major state-owned banks, some desperate borrowers paid interest rates ranging from 30% to 50% - rates they had never seen since the defaults of China Everbright Bank and Industrial Bank Corporation ten years ago - to secure the loans they needed.
At 5 pm, the market closed with insufficient funds and incomplete trading.
No one left the trading desk because you don't know how things will develop... The entire trading room is in a fighting mood, "said a fund manager in Beijing.
If you need to close your position in such an environment and want to avoid default, you need to borrow at a high interest rate, "the fund manager said. For everyone, this is a rational behavior
The People's Bank of China intervened in this gap and asked the state-owned banks to provide funds, while the China Central Government Securities Depository and Clearing Corporation (CCDC) and the Shanghai Clearing House reopened settlement at 6:00 p.m. to make emergency response. By 8:30 pm, the crisis was avoided and the market cleared and closed again.
Don't be 'emotional'
Sources said that in a follow-up meeting with banks and brokers the next day, the People's Bank of China told institutions that their actions "disrupted the market" and that they should not be "emotional".
According to sources who received the notification, the China Foreign Exchange Trading Center (CFETS), a currency market operator, told traders to keep the upper limit for repurchase transactions at 5% and stated that anyone involved in high interest rate transactions completed on October 31st would need to explain their actions to regulatory authorities.
As overnight interest rates fall below 3%, fear subsides. It is certain that most people believe that the danger has passed.
However, analysts have identified strengthening control over China's currency as the root cause of the tension.
China's economic recovery from the COVID-19 epidemic is disappointing. Coupled with global interest rate hikes, this has contributed to capital outflows and the renminbi has also suffered losses.
However, in the year ending in mid August, after a 5% decline in the exchange rate between the Chinese yuan and the US dollar, the exchange rate has remained significantly stable, as efforts from state-owned bank purchases to implement new rules to prevent short selling have supported the stability of the Chinese yuan.
Tightening liquidity is another method.
If the patterns of money supply and liquidity supply remain unchanged, the entire system remains fragile. Another liquidity shock is always possible, "said the fund manager in Beijing.
Others believe that the risk is relatively low, but expect the tightening to continue as long as the currency faces pressure. The comprehensive weakening of the US dollar has recently helped the Chinese yuan, but the exchange rate of 7.28 yuan to the US dollar is not far from the 16 year low of 7.351 yuan in September.