* Demand for 1-day and 7-day repurchase agreements slows
* Follows central bank intervention in money markets
* PBOC concerned banks too reliant on short-term borrowing
* Raises memories of 2013 when short-term rates spiked
By Nathaniel Taplin
SHANGHAI, Sept 19 China's central bank can take
some measure of success from its attempts to force small banks
to reduce their reliance on risky short-term borrowing, but
uncomfortable memories of a 2013 cash crunch that spooked global
markets is keeping traders on edge.
Three years ago, the PBOC engineered a cash squeeze that saw
some short-term rates spike as high as 30 percent. Financial
markets interpreted the manoeuvre as a PBOC warning to banks to
curb risky lending practices, but the jump in rates also sparked
fears of a banking crisis.
Worried that banks are again too reliant on short-term
loans, the central bank has changed tack by forcing banks away
from overnight and seven-day repurchase agreements (repos) and
into 14-day and 28-day instruments, while at the same time
injecting cash into the financial system to avoid a cash crunch.
But the delicate balancing act still pushed the benchmark
overnight lending rate up to 2.15 percent on
Wednesday, its highest level in more than a year. Other money
market benchmarks, including the volume weighted average
seven-day bond repo agreement rate, have also
risen sharply. China's markets were closed on Thursday and
Friday for a public holiday.
"It's been incredibly tense these past few days," said a
money-market trader at a mid-sized Chinese commercial bank in
The risk for small and mid-tier banks, which unlike big
banks can't rely on a large deposit base for funding, is that
interbank funding exposes them to any market disruptions - such
as a sustained rise in interest rates, Moody's Investors Service
If the small banks are faced with a liquidity crisis, the
problem would reverberate across a banking system already
concerned with the highest level of non-performing loans since
the global financial crisis and a deterioration in asset
But half way through September, the volume of trade is
running at a slower pace than in August, suggesting the PBOC's
measures have to a degree curbed banks' appetite for short-term
repos - a form of lending with an agreed repayment deadline and
China Foreign Exchange Trading System figures show that 21.3
trillion yuan of one-day repos had been traded as of Sept 14, or
about 40 percent of the record high volume in August. The volume
of seven-day repos was less than 40 percent of the August
The use of repos is critical for many bank operations, but
the central bank is concerned that many banks are using them to
help fund trading strategies that contain too many layers of
borrowing, or leverage.
Typically, a bank money manager can boost returns by using
deposits invested in the bank's wealth management products to
buy bonds. They would then use those bonds as collateral to
raise short-term funds from the repo market, which in turn are
used to buy more bonds. In theory, this cycle can continue but
the tactic is fraught with risk.
As long as bond prices keep rising, the banks can profit
before the repos fall due and provide the returns that attract
investors to deposit funds in the wealth management products.
Since the middle of this year, China's bond market has been
rallying, so the practice has largely paid off but the central
bank's money-market intervention is a sign that it is worried a
bond market bubble could be forming, traders said.
It has clamped down as the broader economy appears to be
levelling off following worries earlier this year that economic
expansion was slipping too quickly.
"As (economic) growth has stabilised, it appears that
Chinese authorities have turned the focus to 'risk control,'"
Zhou Hao, senior emerging markets economist at Commerzbank wrote
in a research note.
"However, from the Chinese authorities' perspective, it will
be also dangerous to conduct a rapid deleveraging in the bond
market if the central bank raises the funding costs sharply.
This is where we can expect some volatility in the coming
Rates this time around remain far below where they were in
2013, but the scale of outstanding debts in China's nebulous
wealth management sector, a portion of which relies on money
market leverage to boost returns, is also larger now, and bank
profits and margins are weaker.
HOW TO PRICK A BUBBLE
Critically, analysts say, the portion of repo leverage that
has made its way into the bond market is not clear.
During a similar leverage scare in late 2015, wealth
management sources told Reuters they were offering bond market
products featuring leverage as high as 400 percent.
This time around the worries are centred on the much larger
interbank market rather than the smaller exchange traded bond
market, another reason the run-up has drawn policymaker concern.
With capital outflows rising again and the real extent of
bond market leverage unclear, analysts say market participants
should be prepared for a bumpy ride.
"Investors should remember that the Chinese authorities
attempts to reduce leverage in the stock market in 2015 ended
disastrously," Commerzbank's Zhou said in the note.
"Let's hope some lessons have been learned and that the
authorities tread softly."
(Reporting by Nathaniel Taplin in SHANGHAI; Editing by Neil