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While all eyes are on the Federal Reserve today as the market awaits clues into when the central bank will begin slowing its liquidity provisions, China's central bank continues its own snugging operation, keeping the money market rates at lofty levels. (Note: Snugging means not exactly enough to qualify as tightening.)

Rather than inject liquidity into the money markets, as the banks were clamoring for, the PBOC drained CNY2 bln yesterday, which continued the cash crunch and ensured that today's 10-year bond auction would see lukewarm demand. Sure enough, today's CNY30 bln 10-year bond offering saw its lowest bid-cover ratio in a year.

The 7-day repo rate, which is an indicator of interbank liquidity, rose 144 bp today to 8.26%, which is the highest rate since in two years. It has averaged about 3.3% this year through last month and has averaged about 6.2% this month. Other measures of liquidity, such as the inversion of the swaps curve, also reflects this shortage of liquidity.

There are several factors at work, some of which are market based. For example, there are reports that a large amount of wealth management products sold by the banks are coming due at the end of June. There is also has been a decline of capital inflows into China. Yuan holdings by Chinese banks from sales of foreign exchange to almost CNY67 bln in May (reported June 14), which is the smallest increase since last November.

Yet if it was just this, the PBOC could have counteracted it. In addition, if the PBOC had simply under-estimated the holiday impact and other liquidity needs, the PBOC could have injected liquidity into the system. There was some speculation that the PBOC was going to cut reserve requirement today, which it has not. Many participants appear to have misjudged the PBOC's policy intentions.

The PBOC is taking advantage of the tighter liquidity conditions, ensuring that they stay tight as Tuesday's draining operation indicates to drive home an important point. That point is that there has been an overly rapid expansion of credit from the banks that it will not accommodate. It wants banks to scale bank on the credit expansion plans and manage their own liquidity better.

Total social financing, which is understood as a broad measure of China's credit expansion, rose 52% in the Jan-May period from a year ago. Much of these funds appear to be remaining in the financial sector rather than the real economy. Money supply itself has exceeded the government's 13% target every month so far this year and was up 15.8% above year ago levels in May.

Chinese regulators are forcing trust banks and wealth management firms to shift assets to publicly traded securities. This began at the end of Q1 and is in essence taking funds from the so-called shadow banking system that was drawn upon by property developers and local government financial vehicles. The impact is beginning to be felt. Trust loans, for example, in May (reported June 9) slowed to 8.4% from a 16% pace at the end of last year. Rating agencies such as Fitch previously, and Moody's today has issued warnings about the risks posed by the shadow banking system related to local governments' financing arms.

Total credit in China, include off-balance sheet loans stood at 198% of GDP at the end of last year. This is up from 125% in 2008. According to Fitch figures this rise is a bit faster than what Japan experienced at the tail end of its bubble (45% growth 1985-1990) and South Korea (+47% 1995-1998).

Chinese officials are trying to reduce the excess in the banking system, which appears to be of growing concern to the new government, despite the liquidity squeeze that has led to failed auctions in recent days by the government and government owned banks.

Cash crunches in China are not that uncommon, but they are often short-lived. What make what is happening now noteworthy is that officials are tightening the proverbial screws tighter and longer than participants are accustomed. The tightness cannot be simply attributed to last week's holiday.

The tightening of liquidity was one of the factors that pushed Chinese shares to six month lows today. Banks and property developers were hit harder than the overall market. There was also talk that the government, which has refused to grant permission for new initial public offerings, may soon relent. There is also some nervousness ahead of HSBC and Markit initial PMI readings due out tomorrow.

Some near-term reprieve from the central bank is expected soon to prevent a deeper panic. Reports suggest that PBOC has asked local banks to submit orders for 14-day reverse repo agreements earlier today. This is one of the tools that the PBOC uses to inject liquidity into the system, but has not been used for more than four months. This would appear to offer the banking system some help to get through the quarter and month end. However, it also asked banks to submit orders for a 28-day repos, which would ensure that liquidity remains tight for longer.

The yuan itself was fixed lower for the second consecutive session. From mid-February through last May, the dollar fell about 2.1% against the yuan. Over the last couple of weeks it has stabilized in mostly a CNY6.1230-CNY6.1400 range. The 12-month NDF implies about a 2.4% depreciation of the yuan, which is the most in 4 1/2 years, which seems a bit exaggerated.

Source: China Snugs, Signals Banks Should Get Used To It