In recent developments, China's central bank, the People's Bank of China (PBOC), has taken significant steps to refine its monetary policy frameworkThe introduction of temporary repos, both conventional and reverse, marks a notable shift in the way liquidity is managed within the financial systemThis concerted effort is aimed at bolstering the PBOC's capability to regulate short-term liquidity more effectively, providing a trial for narrowing the interest rate corridor.

As part of these new operations, the PBOC announced on July 8, following the earlier implementation of government bond borrowing in July, plans for temporary reposThese temporary measures are designed to enhance the precision and effectiveness of open market operations while ensuring that the banking system maintains a reasonably sufficient level of liquidity.

The mechanism of repos includes two primary types: the conventional repo and the reverse repo, both of which serve to adjust liquidity through the central bank’s open market operations

In a conventional repo, the central bank sells securities to financial institutions with an agreement to repurchase them at a later dateConversely, in a reverse repo, the central bank buys securities from these institutions with a commitment to sell them back in the futureThus, the operations serve both to inject and withdraw liquidity from the financial system.

Historically, reverse repos have dominated the PBOC's liquidity management strategiesThe increasing use of reverse repos as a primary benchmark interest rate signifies market confidence and the efficacy of this toolHowever, traditional repos have been relatively absent from recent practices, rendering the recent temporary conventional repo somewhat unfamiliar to market participants.

Prior to 2015, conventional repos were a staple tool for the PBOC, used effectively alongside central bank bills to manage liquidity

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As the Chinese economy transitioned from excess liquidity to a scarcity model, the employment of conventional repos dwindledThe reinstatement of this tool not only underscores the PBOC's intention to regain control over liquidity management, particularly in times of unexpected demand, but also enhances its flexibility in adjusting liquidity levels.

One notable feature of the new temporary measures instituted by the PBOC is their scheduling: these operations occur between 4:00 PM and 4:20 PM on business daysThis timing was strategically chosen to address late market liquidity issues that can arise at the end of the trading dayOn October 31, 2023, for instance, liquidity pressures caused the overnight borrowing rate to surge to an alarming 50% due to concentrated refinancing activities.

Financial analysts from Huatai Securities indicate that some financial institutions tend to hold onto their funds until the closing bell, which leads to spikes in borrowing costs as market liquidity tightens

By intervening during the late trading window, the PBOC can stabilize lending rates, particularly at critical junctures such as the end of the month or quarter.

An important aspect of this initiative revolves around the interest rates stipulated for the temporary reposThe current 7-day reverse repo rate is set at 1.8%. According to official communication, the temporary conventional repo will operate at 1.6%, while the reverse repo will be at 2.3%. The establishment of this operational framework, with a designated corridor of 70 basis points, is an attempt to foster clearer parameters for market fluctuations.

This introduction of a defined width for interest rate fluctuations is particularly vital in ensuring that overnight market rates do not deviate excessively from the core values, aiding in maintaining a stable liquidity environment

Structural integrity in monetary policy communication is critical, and this effort by the PBOC to delineate clearer trading boundaries appears to be a key strategy in enhancing market confidence.

The PBOC also operates under a concept known as the "interest rate corridor." This framework involves a mechanism that stabilizes market interest rates through providing various lending and deposit facilities to commercial banksIn effect, if market rates dip below a specified threshold, banks may abstain from lending, while if they exceed an upper limit, the PBOC will inject unlimited funds to rein in exuberant ratesThis system facilitates a balance that is crucial for sustainable economic growth.

Currently, the PBOC’s implementation of the interest rate corridor is crucial for maintaining market equilibrium

With the standing lending facility (SLF) rate set at 2.8% and the excess reserve requirement rate at 0.35%, the corridor spans approximately 245 basis points, providing ample room for fluctuationHowever, disparities in the effective rates can mislead market signals and demand fine-tuning.

Understanding the nature of temporary repos alongside established mechanisms reveals important distinctionsUnlike regular operations, standard interest rate corridors and temporary repos are less rigid in their structure, introducing variability in terms of liquidity accessShould high demand arise in extreme conditions, the temporary repo’s restrictions could theoretically permit breaches of the established range.

From Huatai Securities' perspective, however, the reintroduction of temporary repos should not be interpreted as a radical overhaul of existing policy frameworks