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China Options Limited As Repo Rate Hits Record

We’ve said on a number of occasions lately that China is currently stuck between a rock and a hard place and may have no choice but to join the global QE party (perhaps by purchasing local government debt). On a REER basis, the yuan is the second most overvalued currency in the world and as Soc Gen recently noted, that’s hurting the Chinese economy at a time when it can ill afford further headwinds. Unfortunately, devaluation could risk exacerbating capital outflows at a time when data on FX deposits for corporates suggests nervousness abounds about the near-term outlook for the yuan. We summed up the situation as follows: devalue too much, and the capital outflows will accelerate, not devalue enough, and the mercantilist economy gets it. 

As Bloomberg reports, evidence that the PBoC is being pressured on both sides hasn’t abated, as interbank rates hit record highs: 

The seven-day repurchase rate was 4.41 percent on average so far in 2015, up from 4.16 percent a year earlier and the highest for the period since the fixing began in 2004. Australia & New Zealand Banking Group Ltd. and AXA Investment Managers Ltd. see a reserve-requirement ratio cut this month, while Barclays Plc. predicts one “in the coming weeks.”


Two benchmark interest-rate reductions and one lowering of banks’ reserve ratio in four months failed to bring borrowing costs down, as the world’s second-largest economy faces capital outflows that drain cash. Premier Li Keqiang told reporters Sunday that policy makers will act if growth, which the government targeted at about 7 percent this year, drifts toward the lower limit of its range and cuts into employment or wages.

With money getting tighter and with the risk of imported deflation rising, expect further easing sooner rather than later. 

“I’m in the camp expecting a reserve-requirement cut,” Rajeev De Mello, who manages about $10 billion as head of Asian fixed income at Schroder Investment Management Ltd. in Singapore, said in a March 12 interview. “Interbank rates are not showing any signs of coming down. That worries me a bit because that shows liquidity in China is still very tight”...


“Export growth will not be enough to offset domestic weakness,” said Aidan Yao, a Hong Kong-based senior economist at AXA Investment, which manages $660 billion of assets globally. “Without lowering interbank rates, banks will unlikely pass on the latest rate cut to borrowers. We think the next move for the PBOC is to cut the reserve ratio, possibly before the end of this month.”

That’s all well and good, but again, easing risks spooking FX markets and accelerating capital outflows and indeed, some still contend that the government may be willing to tolerate some economic pain if it means countering devaluation jitters. Here’s more from Bloomberg: 

China’s effort to keep yuan relatively strong suggests govt’s concerns about capital outflows outweigh the harmful side-effects a high currency can have on exports...


Yuan’s REER vs major trading partners is 3.06 standard deviations higher than the average since start of 1995, based on BIS data; that’s the largest deviation among the  world’s 10 biggest economies…


Yuan’s REER has risen on the back of the currency’s “soft  peg” to the dollar, Shi Lei, Beijing-based head of fixed-  income research at Ping An Securities, said in March 13 interview. “The PBOC thinks currency depreciation will create instability in the financial sector.”

In the end, there really isn’t a right answer here, which is why, as we noted almost two weeks ago, Chinese QE could be right around the corner: 

China is suddenly finding itself in an unprecedented position: it is losing the global currency war, and in a "zero-sum trade" world, in which global commerce and trade is slowly (at first) declining, and in which everyone is desperate to preserve or grow their piece of the pie through currency devaluation, China has almost no options… ongoing deterioration in Chinese economic conditions, coupled with a weaker, but not weak enough, currency, [means] the PBOC [will likely] first go to ZIRP, and then engage in outright QE.