Sudden PBOC Easing Tweak Puts the Specter of Debt Crisis into the Foreground

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The specter of the China debt crisis, which for some time dropped off market radar due to the shifting of the epicenter of Covid-19 outbreak outside the country, again reminded about itself after the central bank unexpectedly took stabilization measures. PBOC has unexpectedly increased banks’ reserves by 50 billion yuan this morning through repos and has also reduced the 7-day reverse repo rate from 2.4% to 2.2%. The rate reduction step of 20 basis points was significantly larger than the previously observed 5 bp and 10 bp during the last rate cut.

The decision has drawn attention of market participants as PBOC hasn’t been offering liquidity to banks since March 16, avoiding being “overly pre-emptive” to signal that the banking system is stable. What’s most interesting is that, on March 28 (the previous business day), the Central Bank conducted reverse repo (i.e. tightened credit conditions) by “removing” reserves from the banking system to the tune of 33 billion yuan. Such a “swing” is extremely unusual not only for PBOC, but also for any Central Bank, where policy should be consistent. Which is why PBOC’s maneuver resembled emergency intervention.

In a reverse repo transaction, a central bank and a commercial bank change role. The Central bank borrows from the commercial bank, pledging security as a collateral. Reduction of reverse repo rate also reduces the opportunity cost of interbank lending (thus making it more attractive for interbank lenders). In other words, ceteris paribus, a decrease in the reverse repo rate may contribute to an increase in money supply in the economy and stability in the banking system.

The second reason could be more plausible given the rising pressure on the Chinese banking system which is presumably facing an avalanche of NPLs. According to SCMP, the overdue overdraft increased in February by 50% compared to the same period last year, and defaults on consumer loans in some banks rose from 1 to 4 percent. China Merchants Bank said it has suspended the issuance of consumer loans due to a significant increase in bad debts. However, the debt burden of Chinese consumers is small among developed economies – only 54% of GDP. Other countries may be more vulnerable to the growth of household defaults, for example Australia, where the ratio of household debt to GDP is 120%:

Increasing likelihood of a financial crisis in China and the risks of the similar scenario in other countries may become one of the factors keeping market optimism in check, what should be taken into account assessing medium term prospects of the economic recovery.

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