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Chinese enterprises are allowed to deposit foreign exchange earned from trade and approved investment channels with designated foreign exchange banks. With a couple brief exceptions, the steady appreciation of the renminbi over the past few years has made it advantageous for enterprises to convert their excess foreign exchange into renminbi.
Each of the foreign exchange banks has a foreign exchange allotment set for them by the State Administration of Foreign Exchange SAFE based on their size and business structure. After the designated foreign exchange banks convert foreign currency into renminbi for their customers they are required to sell the foreign currency in excess of their allotment in the interbank market.
Banks in need of foreign currency can buy the excess holdings of other banks through this interbank system. Most of the time, the supply from surplus banks exceeds the demand from banks in need of foreign currency. This is due to the mercantilist undervaluation of the renminbi which leads to persistent external surpluses and corresponding capital inflows.
To resolve the imbalance between supply and demand in the foreign exchange market, the PBoC must step in as the buyer of last resort and buy the excess currency. The chart below shows the relationship between the net foreign exchange position for the financial system and the growth in foreign reserves.
The growing divergence between the two is the result of currency appreciation. When the central bank purchases foreign exchange from banks it increases the amount of renminbi in the domestic financial system. To prevent inflation, the PBoC takes steps to limit the effect on the money supply, through central bank bills and the required reserve ratio.
To the extent that inflows are sterilized, they are taken out of circulation and not available for banks to lend out. This increase in deposits increases the denominator in the loan-to-deposit ratio, lowering the overall ratio and helping banks that are close to the regulatory limit of 75 percent. On first glance, the relatively conservative loan-to-deposit ratio of 75 percent makes it appear that banks have ample liquidity.
As a result, liquidity is often tight in the banking system. Relatively small changes in financial flows can have a large effect on the financial system. This shift, combined with reluctance by the PBoC to increase liquidity into the system, led to a dramatic spike in interbank lending rates as banks short on cash bid up the price of borrowing. The interbank market remains volatile now because the PBoC faces a policy conundrum. It has been aggressively signalling to banks that the pace of credit growth has been too rapid this year and has taken steps to tighten monetary policy.
In normal circumstances, the PBoC would intervene quickly to clear up a liquidity crunch like what is occurring now. A growing number of reports claim that PBoC has quietly been extending funds to weaker banks and instructing stronger banks to begin interbank lending again. All of this reinforces the peculiarity of the Chinese financial system where quantitative restrictions on credit are the dominant regulatory approach and sterilization is carried out on an immense scale.
To prevent excess lending, brought about by an artificially low interest rate, banking regulators have implemented a quantitative cap on lending in the form of the loan-to-deposit ratio.
However, due to the ongoing need to sterilize currency inflows, banks are required to hand over an enormous share of their deposits to the central bank. This leaves banks in a position of having relatively few liquid assets, irrespective of the loan-to-deposit ratio. The growth of deposits stemming from foreign currency inflows helps banks that are edging up towards their loan-to-deposit limit.
However, when these flows slow down, the entire market can suffer a funding crunch as shown by the recent interbank lending rate spikes. June 20, Leave this field blank. More from Nicholas Borst. New Risks Require New Reforms.