Approaching the quarter end, liquidity conditions tightened at the margin. In the interbank market, the 7D fixing (FR007) climbed 33bp to 2.70% so far this week. The market rate only edged up 3bp for O/N repos (R001) and remained flat for 7D repos (R007), but the supply of short-term funds was generally tight. More strikingly, in the exchange market, the O/N repo rate (GC001) spiked to 8.27% on Thursday vs. 2.89% last Friday and the 7D repo rate (GC007) also increased 26bp to 3.13% in four days. In response, the PBoC pumped liquidity of Rmb790bn through its reverse repo operations into the banking system this week, a scale much higher than in normal times.

Tightening impact of the MPA on liquidity still present. Although the MPA seems to pose limited impacts on credit expansion, it tends to repress interbank lending when banks cut their use of funds in areas where the reduction is the easiest in order to meet regulatory requirements. In particular, there is reluctance for banks to lend to non-bank financial institutions (NBFIs), and the liquidity tightening in the interbank market will spread to the exchange market when NBFIs turn to new sources for short-term funds. Because of the first MPA review, money market rates spiked in late March. A similar rise of liquidity tensions seems to have appeared again.

Other factors could have also contributed to the marginal liquidity tightening: 1) seasonal factors, such as month/quarter-end settlements; 2) high supply of government bonds―the issuance of central government bonds rose to a historical high of Rmb328.4bn in June, whereas the issuance of local government bonds increased to Rmb1.03trn from Rmb527.1bn in May; 3) potential increase of FX outflows amid heightened external uncertainties associated with Brexit and renewed RMB volatility.

Looking ahead, we think the MPA mechanism may need an overhaul. The purpose of the MPA is to enforce financial stability by comprehensive reviews of banks against a set of prudential criteria. The PBoC uses customized interest rates on bank reserves as its main incentive apparatus, and banks take the reviews very seriously. Since the evaluation is based on banks’ profiles at the end of a quarter, it tends to disturb their operations, including liquidity management, which may amplify seasonal shocks. The PBoC has refined its reserve requirement rules to help smooth liquidity conditions by calculating banks’ required reserves on the basis of the average of their daily outstanding deposits, rather than the deposit level at the date of assessment. This has set a precedent which the MPA review can follow. Why not perform the review on the basis of the quarterly average of relevant indicators?