Beijing is under pressure to steer its economy and markets through a significant slowdown, which is why efforts to prevent the yuan from depreciating played a part in the turmoil that rocked the financial markets last week, according to Reuters based on information from people with knowledge of the matter.

Authorities are currently looking into a routine month-end cash demand in China’s banking system that turned into a panic on October 31 that drove short-term funding rates up to 50% in some situations.

By late afternoon on that day, according to six market participants, a combination of circumstances spread dread and bewilderment throughout trading rooms in Beijing and Shanghai.

In order to calm the markets, the People’s Bank of China (PBOC), the China Foreign Exchange Trade System (CFETS) it is connected to, and bond clearing houses eventually intervened, directing lenders, extending trading hours, and scheduling meetings with institutions.

The typical month-end need for liquidity, cash hoarding ahead of a significant government bond sale, and a market where the largest banks were already reluctant to lend due to a mandate to offset pressure on the yuan were the contributing causes.

“It was an accident,” said Xia Chun, chief economist at wealth manager Yintech Investment Holdings, calling it an unforeseen consequence of the government’s heavy hand in financial markets.

“Banks were grudging in lending, leaving non-banks asking each other for money in afternoon trade,” he said. “Borrowing rates surged as a result, with some willing to take any price.”

For the first time, the causes of the interest rate surge and the subsequent upheaval in the market are explained in depth here. According to participants, the exposed vulnerability will persist as long as capital outflows maintain pressure on the system.

The majority of them asked to remain anonymous since they were not permitted to speak about a private matter in public.

According to the PBOC, CFETS was looking into “abnormal” trades that occurred on October 31. These trades involved some accounts that were frequently borrowing and lending money at “extremely high interest rates” close to the conclusion of trading hours.

The day-to-day operations of banks, insurers, and other financial institutions depend heavily on the short-term funding markets, which include repos and overnight repurchase agreements.

They have an impact on fluctuations in foreign exchange since markets serve as the primary channel for the supply of money. 

In order to finance their trades and investments in the repo market, funds and non-banks take out loans and roll them over. Banks and other players in the finance sector are also required to balance their books and adhere to capital buffer regulations at the end of each month.

Therefore, disruptions may pose a risk to the stability of finances.

The first signs of trouble were planted in October when China approved the sale of one trillion yuan ($137.32 billion) in sovereign debt. According to people familiar with the arrangements, the goal is to roll out the sales by sticking to the fourth-quarter issuance schedule but increasing the size of each tranche.

According to a fund manager in Shanghai, the People’s Bank of China (PBOC) would usually provide additional funding support, such as easing bank reserve requirements, to counterbalance the cash outflow from the additional bond issuance.

However, injecting more money into the system runs the danger of weakening months’ worth of attempts to stabilise the currency and placing further downward pressure on the yuan, which has dropped more than 5% versus the dollar this year.

“The inaction by the central bank is mainly due to its concern over yuan depreciation,” said the fund manager, who declined to be identified as he was not authorised to talk to media.

The rush for short-term funds on trading floors that Tuesday turned into a stampede.

Even repo rates, which are the primary indicator of short-term lending costs and are typically steady, shot up to 8% on October 31 from an overnight rate of 2% the day before.

Three market players said that by 4 p.m., the state banks that often lend to desperate last-minute clients were nowhere to be found.

Due to the lack of availability, a few desperate borrowers had to pay rates between 30% and 50%—rates not seen since China Everbright Bank and Industrial Bank Co Ltd defaulted ten years ago—in order to obtain the loans they required.

Markets closed at 5 p.m. with unfunded positions and incomplete trades.

“No one left the trading desk, as you don’t know how things will go … the whole trading room was in combat mood,” said one fund manager in Beijing.

“If you need to square your positions in such an environment, and want to avoid default, you need to borrow at high rates,” the fund manager said. “For each individual, it’s rational behaviour.”

In an emergency response, the China Central Depository & Clearing Co (CCDC) and Shanghai Clearing House both reopened settlements at 6 p.m., but the PBOC filled the void by requesting state banks to provide funds. After the issue was resolved by 8:30 p.m., the market cleared and closed once more.

The following day, at a follow-up meeting with banks and brokers, sources claimed the PBOC informed the institutions that their actions were “disturbing the market” and advised them not to “be emotional.”

According to sources who received the warning, the money market operator CFETS instructed traders to maintain a 5% ceiling on repo transactions and stated that anyone involved in high-rate deals that concluded on October 31 would have to provide an explanation to authorities.

As the overnight rates dropped down below 3%, the fear faded. Indeed, the majority believe that the threat has passed.

However, many have focused on the background—intense control over China’s currency—as the fundamental cause of the conflict.

China’s COVID-19 pandemic-related economic recovery has been less than stellar. In tandem with global rate increases, it has stoked capital flight and devalued the yuan.

Despite the dollar depreciating by 5% from mid-August to the beginning of the year, the exchange rate has been remarkably stable since then due to various measures taken to stabilise it, such as state-bank purchases and the implementation of new regulations that prohibit short sales.

Another approach is tighter liquidity.

“If the pattern of money supply and liquidity provision remains unchanged, the whole system remains fragile. Another liquidity shock is always possible,” said the Beijing-based fund manager.

Some anticipate less danger, but tightness will persist as long as the currency is under pressure. Although the yuan has recently benefited from widespread dollar weakening, at 7.28 to the dollar, it is still close to September’s 16-year low of 7.351.

(Adapted from Reuters.com)

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