As is customary virtually every time the Chinese central bank commences some form of tightening, overnight the PBOC injected "hundreds of billions of yuan into the financial system after some smaller lenders failed to repay borrowings in the interbank market", according to people familiar with the matter.

According to a brief note by Bloomberg, Tuesday’s injections followed missed interbank payments on Monday, anonymous sources said; the matter is not made public over concerns of bank deposit flight risk. The institutions that missed payments included rural commercial banks. One of Bloomberg's trader sources said a borrower failed to repay an overnight repo of less than 50 million yuan ($7.3 million). China’s smaller lenders have been squeezed by a rise in money market rates this week, with the benchmark seven-day repurchase rate jumping to the highest level since April 2015 on Tuesday. As we described last Wednesday, the PBOC for the second time in a month engaged in tightening by hiking the rate on reverse repos as well as various liquidity conduit operations such as the MLS.

While the tightening of liquidity reflects factors including quarter-end regulatory checks and a wall of maturing certificates of deposit, BBVA said the People’s Bank of China may also be sending a message to over-leveraged firms to rein in borrowing.

“The PBOC wants to warn the smaller lenders not to play the leverage game excessively,” said Xia Le, chief economist at BBVA in Hong Kong. “It’s a tug of war between the central bank and the financial institutions.”

And while some smaller banks were on the verge of failure, overnight virtually everyone felt the surge in the 7-day repo fixing to the highest since 2014, driven by China's liquidity squeeze amid policy tightening and continued high leverage  

As Goldman's MK Tan explains, China's 7-day repo fixing interest rate rose to 5.5% on Tuesday, the highest level since late 2014. This followed PBOC’s statement last Thursday signaling a deviation from the previous framework of regarding interbank rates as de facto “policy rates”. Reflecting the prospective quarter-end MPA (macro-prudential assessment) examination and continued tightening bias from the PBOC, interbank rates may remain fairly volatile in the coming days, although most analysts do not expect such elevated rates to be sustained, especially since the PBOC will promptly have to bail out any banks suffering a liquidity squeeze.

Some more details for those unfamiliar with China's stealth tightening process.

Interbank interest rates had been more clearly drifting higher in the past month, especially following the PBOC’s OMO rate increase last Thursday. In particular, the gap between R007 (general repo rate covering all counterparties including funds) and DR007 (covering only banks) has widened again in recent days, suggesting tight liquidity conditions faced by non-bank financial institutions (NBFIs) (Exhibit 1).

Exhibit 1: Interbank rates spiked as liquidity scramble by NBFIs intensified (as seen in the widened R007-DR007 spread)

Tuesday's fixing rate (set at 11:30 am based on morning transactions) spiked, although funding conditions in the afternoon seem to have moderated somewhat (fixing is non-weighted average interest rate; see the appendix below for more on the fixing process). The rate surge reflects a combination of:

• A tightening bias by the PBOC. The central bank has shifted policy stance since autumn last year, but the clearer interbank rate rise in recent days suggests that the hawkish bias has stepped up further.
• Diminished clarity of the role of interbank rates in the PBOC’s policy framework. Since mid-2015, interbank rates had been kept largely steady, partly reflecting the PBOC’s efforts to build up a policy rate framework centering on interbank rates. The PBOC has also introduced SLF (standing lending facility), which is understood as a tool to keep volatility in interbank funding conditions low. However, in a signal that deviates from these previous efforts, the PBOC last Thursday tried to dissociate interbank rates from “policy rates”, which the PBOC said should mean benchmark bank lending and deposits rates. The comment appeared to open up a bigger scope for the PBOC to allow interbank rates to move higher (with the possible intention to avoid conflict with its official “stable and neutral” policy stance or potential pushback from other policy authorities).
• The SLF mechanism appears to have not functioned effectively in recent days. There have been occasional breaches of the general 7-day repo rate above the SLF rate (3.35% per PBOC’s official communication, although it was reportedly raised to 3.45% last week). This suggests that SLF has not effectively fulfilled its supposed function of imposing a ceiling to interbank rates. One possible reason is that SLF is accessible only by banks, and much of the spikes of the general 7-day repo rate have been a result of liquidity scramble by NBFIs (which have no SLF access), while banks' interbank funding cost (as measured by DR007; Exhibit 1) has remained more moderate and still below the SLF rate (note that the 7-day repo fixing rate is partly based on funding cost of NBFIs as well). Nevertheless, the apparent lack of effectiveness of SLF in suppressing interbank rate volatility might have weakened the anchoring of the market’s rate expectations in the near term, and such uncertainty could have compounded the liquidity squeeze.
• Continued high interbank repo borrowing by funds. The wide gap of R007-DR007 reflects continued stress imposed by NBFIs, likely particularly funds, on the funding market. Indeed, as of end-Feb, interbank repo borrowing by funds remained high at over 30% of the interbank repo borrowing (Exhibit 2) despite the increased pressure on the commercial viability of repo trades (borrowing via interbank repo to finance long-dated bond holdings).
• Regulatory impact. The PBOC has tightened the prudential requirements (particularly on the growth of banks' balance sheet) under its MPA examination, which is to be conducted at quarter-end. This has likely further contributed to, and amplified the impact of, a tightening in the interbank market.

In total, the interbank rate volatility may remain quite high in the coming days, especially in light of the near-term consideration of MPA examination at quarter-end and the PBOC's apparent deviation from the previous monetary policy framework. Alternatively, today's plunge in the dollar may have had a secondary purpose of easing Chinese financial conditions, where the ongoing dollar rally has pushed the local financial sector to the brink of illiquid collapse.

Analysts - Goldman included - expect the PBOC policy stance to remain in tightening mode, but do not expect interbank interest rates to remain at today's elevated levels in the weeks ahead. Sustained elevated rates could cause significant volatility in financial markets--particularly the bond market--given still-significant repo leverage of funds. More importantly, the recent rise in interbank rates will contribute to a moderation in growth later this year, and bank lending rates might also face upward pressures amid higher market rates and thereby increase corporates' borrowing cost (Exhibit 3).

Exhibit 2: Funds' borrowing still accounts for a large share of the interbank repo market 

Exhibit 3: The ongoing rise in market rates may feed through to banks' lending rates (and corporates' funding cost) in the months ahead.

For now, however, the PBOC may have come up with a deus ex machina again: moments ago the first print of the recently soaring seven-day money rate tumbled 64 bps from a two-year high tp 2.45%, affording banks some time to get their financial matters in order. Of course, none will, which means the next time repo rates soar again, it will be up to the PBOC to bail out the local banking system, all over again.