China indices have seen a rocky start to the year, with the China A50 futures dropping 4.9% this year and almost 9% over the last month. The fall began in early December, after investors were spooked by the rising inter-bank rates.
 
In a research report published on 23 December 2013, Macquarie Equities Research (MER) analysed the reason behind the soaring inter-bank rates and how things may pan out in 2014.

Deleveraging versus stability. On one hand, the PBoC clearly believes deleveraging should be one of the top price priorities, as it mentioned the D-word for the first time in the 3Q14 monetary policy report. Since the interbank market has become a major funding source for the shadow banking sector, the PBoC desires to keep inter-bank rates at a relatively high level to enforce deleveraging. But nor does the PBoC want SHIBOR to be too high, which would jeopardize economic growth. In practice, the balancing point is hard to strike, and the ideal point will change as well with the internal and external economic environment.
 
- Inter-bank versus real economy liquidity. The PBoC seems to believe the liquidity condition for the real economy should be ample. First, FX purchases, a source of liquidity supply like reverse repo in open market operation, came in at RMB2.5 trillion in 11M13, compared with RMB360 billion in 2012. Second, fiscal spending, another source of liquidity supply as well, should be higher in December 2013 as well. Therefore, the PBoC’s initial intention might just to offset the increase of liquidity supply through open market operation. However, its open market operation is closely watched by banks as a major gauge of policy stance. In other words, the suspension of reverse repo could be easily misinterpreted by banks as a signal for monetary policy tightening. To make things worse, the PBoC often doesn’t give clear guidance on its intentions, causing the market to panic from time to time.


 - Quantity versus price rules. For central banks, it’s impossible to follow quantity and price rules simultaneously in conducting monetary policy. That’s why most central banks in the developed markets neglect quantitative measures (say, money supply growth) by focusing on price measures (say, overnight rates) as the main tool for monetary policy. However, for the PBoC, its policy is largely a mix of quantity (loan quota, money supply growth, etc) and price (SHIBOR, 1-year benchmark rate, etc). In practice, once the PBoC wants to slow down money supply growth by stopping reverse repo, it will be hard for it to prevent rates from spiking. If the PBoC wants to stabilize inter-bank rates through liquidity injection, it could easily lose its control of credit growth.

 2014: Liquidity will top market concerns
MER doesn’t think a repeat of June is likely this time, as the PBoC has almost unlimited liquidity to inject if needed. And China’s central bank definitely wants to avoid excess volatility in the market. However, liquidity will likely be the top concerns for the market in 2014.
 
-  On banks’ liability side: Funding costs are on an uptrend due to the rapid growth of deposit substitutes such as wealth management products (WMP) and money market funds (MMF). By offering higher yields, WMPs are increasingly substituting for time deposits and MMFs are for demand deposits.
 
- On banks’ asset side: Banks are increasingly turning its asset holdings from low-return assets such as bond to high-return assets such as inter-bank assets, many of which are essentially bank loans. These loans are disguised as inter-bank assets to bypass the loan quota. Such movement could push up the required returns in all asset classes.
 
 
Trading the volatile Chinese market via China A50 warrants
Investors who are keen to trade the volatile Chinese markets can do so via Macquarie’s China A50 warrants.
 
The China A50 warrants track the movement of the SGX China A50 futures. The FTSE A50 Index in turn tracks the performance of the 50 largest A-share companies listed on the Shanghai and Shenzhen stock exchange. It includes mega-names like Ping An Insurance, China Merchants Bank and Shanghai Pudong Development Bank. The index gives investors a broad exposure to the China market.

Source: Macquarie Research - 16 Jan 2014