The window is open for China's central bank to raise bank reserve requirement ratios or use other tools as early as this week to mop up excess liquidity, which has seen money rates plunge from multi-year peaks hit last month.
The main short-term money rate has fallen to just a third of its high in late January when the market was hit by an unprecedented funding squeeze due to combined impact of central bank tightenings and cash calls ahead of a week-long holiday.
"The market is awash with money and the central bank is unlikely to stay on the sidelines," said a trader at a Chinese state-owned bank in Beijing. "It is only a matter of which tools it uses, rather than to tighten or not to tighten."
The People's Bank of China could also further raise the reserve requirement ratios (RRR) for selected banks, traders said.
As such the benchmark Shanghai Composite , which has rallied nearly 4 percent over the past week to around 2,920 points on the back of flush liquidity, would likely be capped below the psychologically important 3,000-level.
The weighted average seven-day bond repurchase rate, currently around 2.9 percent, is likely to find a floor around 2.5 percent, making short-term funding costs about 50 basis higher than mid-October when the PBOC started its monetary tightening cycle.
The weighted average seven-day repo rate fell to 2.6007 percent at Wednesday's close, having hit a multi-year high of 8.2640 percent on Jan. 27. It rebounded on Thursday after the PBOC resumed draining money via repo business in its regular open market operations.
The PBOC auctioned 10 billion yuan ($1.5 billion) in three-month bills on Thursday, having increased the volume after holding them at 1 billion yuan or no sale since early December, in a sign it wants to partially resume liquidity draining via its regular open market operations.
On All Fronts
The PBOC has also signaled recently that it will more frequently use tools other than its traditional open market operations to help drain liquidity from the financial system.
The main shift, traders say, is that the PBOC appears to be relying more on RRR increases for all banks to drain liquidity, a trend they see continuing in the near term.
A more effective tool, however, will be imposing differentiated RRR for selected banks, which will limit individual banks' lending ability without harming those which abide by the government's anti-inflationary policy, traders said.
The PBOC has already imposed differentiated RRR on some small- and medium-sized domestic banks, according to a media report last week.
"The PBOC will certainly not tolerate fundings costs to pull back to the pre-tightening level because too much liquidity in the system will reignite consumer price rises," said a trader at an Asian bank in Shanghai.
The seven-day repo rate was moving just below 2 percent when the central bank surprised the market by an official interest rate hike on Oct. 19.
The PBOC has since raised official rates twice more on top four RRR hikes to tighten liquidity as China's inflation remained stubbornly high at 4.9 percent in January.
The PBOC is also considering means to help it more accurately judge how much liquidity is in the financial system, including introducing new economic indicators.
These include a gauge that measures the overall pace of fundraising which will widen than the current benchmark M2 money supply indicator, state media have said.
The "aggregate social fundraising" indicator will be an important step towards managing liquidity more effectively as it includes money flows via debt and equity issues.
The existing benchmark money supply indicator, the M2, only reflects liquidity movements in the banking system.
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