Analysts Debate Meaning of Central Bank's Newest Regulatory Tool

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Shortly after the central bank announced an addition to its regulatory tool kit, the Short-term Liquidity Operation (SLO), analysts started wondering if this meant small-scale quantitative easing.

There is debate over that issue, but most analysts agreed that the new tool will have a significant impact on current principal regulatory instruments: banks' reserve-requirement ratio (RRR) and deposit and lending interest rates.

In its announcement on January 18, the central bank said the new operation would mostly use repurchase agreements or reverse repurchase agreements that mature in seven days or less to supplement existing open market operation tools, which comprise central bills, repos and reverse repos.

The goal is to smooth out sharp liquidity fluctuations and stabilize short-term interest rates, the bank said.

Twelve banks, including the Big Four state-owned banks, have been named as participants in the SLO scheme.

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The move is very likely to create a situation where the central bank lends generously at low cost to commercial banks, which in turn can pump the market with liquidity, Xu Hanfei, Guangfa Securities' chief analyst, wrote in a commentary.

He was not alone in predicting a loosening credit environment. Across the financial and business community, mini QE, a reference to the predicted impact of SLOs, has become a buzzword.

A Five-Day Workweek

Analysts pointed to the fact that the central bank had been using reverse repos to flush the inter-bank market with liquidity in the past several months. It was possible it would continue doing so with the new tool, they said.

However, a source close to the central bank said they were drawing a conclusion too soon. A key difference between QE and SLO, he argued, is that the former is engineered to increase credit supply while the latter can either tighten or relax liquidity.

Indeed, SLO is a two-way valve. The central bank can choose either to conduct repos to mop up liquidity in the market or have it the other way round with reverse repos, the source said.

A state-owned bank's capital trader also said comparing SLOs to QE overstretched the point, saying that the new tool was only designed to strengthen the central bank's ability to prevent sharp liquidity fluctuations and stabilize short-term interest rates.

Like central bills, SLOs are scheduled on Mondays, Wednesdays and Fridays. The central bank can determine whether to take the action and its size and maturity.

The timing of SLOs complements that for repos and reverse repos, which are on Tuesdays and Thursdays.

That is important because now the bank can regulate money supply with short-term tools on all weekdays, the source close to the central bank said.

Tools of the Trade

Calls have been raised for such new tools because traditional regulatory instruments have failed to catch up with the changing environment.

The central bank's researcher, Wu Ge, for example, said in an October paper that a more balanced international payment account had fundamentally altered the condition for funds outstanding for foreign exchange, the amount of yuan put into the domestic market equivalent to foreign exchange taken in by banks during the same time.

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Once a major contributor to money supply, the funds increased by less than 500 billion yuan in 2012, sharply down from the previous year's nearly 2.8 trillion yuan, he wrote.

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Apparently, relying on the funds to regulate money supply would not work as efficiently anymore, Wu wrote.

The same can be said for RRR, a powerful money supply tool that works by changing the amount of cash banks are required to set aside in their accounts with the central bank.

Ping An Securities analyst Shi Lei said the pressures for a lower bank RRR had passed this year and the central bank would primarily use open market operations to increase money supply.

Shi predicted that the amount of outstanding reverse repos would grow in a year to the range of between 500 billion and 1 trillion yuan, a significant increase on the 200-500 billion yuan range during the second half of 2012.

The forecast figures may be subject to debate, but many agreed that money supply from open market operations would increase and thus reduce the possibility of cutting banks' RRR.

Liquidity conditions would have to be worse than if there were no SLOs for the central bank to lower the RRR, Goldman Sachs' economist Cui Li said.

"The possibility of the central bank cutting the reserve requirement is not completely all gone, but has indeed become smaller," said a bank's bond trader from Shanghai.

Yao Wei, economist from SocGen, a French bank, echoed the view in general, adding that small banks under pressure could be treated differently.

Only after exhausting all short-term tools would the central bank consider changing the RRR, the source close to the central bank said, because "cutting the ratio is a large-scale operation that sends a strong signal to the market and cannot be easily reversed."

Looking to the Future

The short-term nature of SLO and the great flexibility the central bank has when using the tool has a large impact on interest rates as well.

China International Capital Corp., an investment bank, predicted in a report that the yield of seven-day repos in the upcoming few months would fall as investors fret less about liquidity risk.

Moving forward, the central bank may seek to create a capital pricing mechanism, which allows it to affect interest rates for the long term by regulating those for the immediate future, the state-owned bank's capital trader said.

"From now on, people will be pay more attention to the yield of central bills, and the interest rates of repos will be more important," he said.

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In future, Shi said, the inter-bank interest rates would replace current guiding deposit-and-lending interest rates and become the new benchmark indicator of capital cost.

But a few requirements must be met before that can happen, including a high trading volume and close relevance to other types of yields, the source close to the central bank said.

At present, the participants in the SLO scheme are all big institutions that function as a net liquidity provider in the market.

"It would take some time to observe whether their conditions reflect the supply and demand for liquidity in the overall market," the source said.