The surprise withdrawal of liquidity by the People’s Bank of China (PBoC) in the last week of January and fortnight ahead of Chinese New Year triggered a spike in short-term interest rates and raised investor concerns that the central bank was contemplating interest rates hikes.  This episode was reminiscent of the Federal Reserve’s taper tantrum in 2013.  However consistent PBoC monetary policy communications over the past several weeks suggest these anxieties are unwarranted and the central bank is simply normalizing liquidity conditions.  Stable and higher interest rates should create a beneficial investment environment for CNY cash investors in 2021.

Sudden Liquidity Reduction:

On 27 January 2021, the PBoC injected CNY180bn of liquidity via its usual 7-day Open Market Operation (OMO).  However, with CNY280bn of central bank repo maturing, this was equivalent to a CNY100bn withdrawal.  This capped a 6-day period[1] of liquidity withdrawals totaling CNY 568bn (Fig 1).  Market-driven repo rates, which were already edging higher ahead of the Chinese New Year holiday, spiked upwards to multi-year highs; while investors contemplated the spectacle of a more hawkish PBoC and significantly tighter liquidity conditions.

The PBoC has withdrawn a significant amount of liquidity since the start of January.  This is a sharp contrast with previous years, when the central bank typically increased liquidity in anticipation of higher demand ahead of the Chinese New Year holidays.  A hawkish PBoC pivot would be in direct contrast to the Federal Reserve’s monetary policy stance and potentially stifle the recent rally in Chinese asset prices.

Fig 1: Recent PBoC open market operations have withdrawn liquidity, but these are relatively small compared with the longer-term trend.Source: Bloomberg & JPMorgan Asset Management: As at 29^th Jan 2021

Pivot to normality:

With benchmark deposit and lending rates unchanged since 2015, the PBoC has utilized a range of quasi-monetary policy tools to adjust interest rates, regulate market liquidity and manage investor expectations.  Together, these tools form the interest rate corridor.  The 7-day interbank repo determines the cost of money, whilst the standing lending facility (SLF) and excess reserve rate represent the upper and lower restraints (Fig 2).  In addition, the PBoC uses OMO via a variety of reverse repo[2] and Medium Term Lending (MLF) operations - to ensure adequate financial system liquidity.

Fig 2: The PBoC uses quasi monetary rates to define the interest rate corridor.  7-day interbank repo rate movements within this range depend on liquidity conditions.Source: Bloomberg & JPMorgan Asset Management: As at 29^th Jan 2021

In early 2020, as the Covid-19 outbreak impacted Chinese economic growth, the PBoC cut the MLF, SLF and repo rates.  However, these interest rate cuts were small relative to Western market peers.  The PBoC instead relied on massive liquidity injections to ease investor concerns and reduce market disruption.

By early summer 2020, with Covid-19 contained and the economy showing signs of recovery, the PBoC pivoted from ultra-dovish to a more neutral policy stance.  The probability of additional rate cuts diminished.  Market driven interest rate moved above the mid-point of the interest rate corridor. 

“Tight-balanced” liquidity:

In early December 2020, several corporate and state-owned enterprise bond defaults temporarily upset PBoC monetary policy plans.  The unexpected defaults triggered interest rate volatility and investor apprehension, necessitating rapid liquidity injections by the central bank to stabilize the market.  This, combined with the re-emergence of Covid-19 in some northern cities, pushed market-drive interest rates lower in anticipation of another PBoC policy reversal (Fig 3).

Fig 3: Market driven interest rates remained remarkably stable throughout 2020 before spiking higher in January 2021.  Changing expectations of PBoC monetary policy have been a key driver of Shibor yields.Source: Bloomberg & JPMorgan Asset Management: As at 29^th Jan 2021

The PBoC’s rapid response to these events is likely a sign of new-found flexibility rather than a strategic deviation from its long-term objections.  With the economy back on track, both the government and the central bank remain focused on preventing asset bubbles, reducing the size of the shadow banking market and minimizing the probability of a systemic crisis.  The government is unlikely to announce a formal growth target in 2021 – partly to prevent unhelpful competition among provinces.  In recent monetary policy statements, the PBoC emphasized “tight-balanced” liquidity, managing open market liquidity operations to ensure adequate liquidity, while avoiding excess loosening to minimize excessive risk taking.

Future direction of short-term interest rates in 2021:

With 7-day repo rates now back above the mid-point of the corridor, the PBoC’s OMO should become more neutral.  Latest economic indicators suggest growth has moderated slightly as the spike in Covid-19 cases has negatively impacted consumer confidence and the service sector.  Nevertheless, the government’s economic priorities have not changed. 

This suggest the PBoC will continue to proactively manage OMO while keeping interest rates unchanged for the foreseeable future.  To discern PBoC future intentions, Chinese cash investors should focus on the deviation of market driven repo rates around the mid-point of the central bank’s interest rate corridor, while avoiding the temptation to succumb to periods of temporary market volatility.  

[1] Between 23^rd and 28^th of January 2021.

[2] The PBoC has not conducted repo operations (to directly reduce liquidity) since November 2014 nor has it issued central bank bills since November 2013.