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The People's Bank of China is desperate to stimulate a slowing economy, but flagging enthusiasm for Chinese assets is blunting its traditional monetary policy tools and forcing the central bank to adopt different tactics.
Sustained capital outflows have reduced the effectiveness of the PBOC's open market operations to such an extent that the central bank all but abandoned them in early December, market participants say, following its surprise cut in guidance lending rates the previous month.
Open market operations – injecting and withdrawing funds from the interbank market on a weekly basis – are a transparent way of managing the money supply and guiding interest rates.
Tinkering with short-term liquidity has proved ineffective, however, in offsetting the deeper capital outflows that China is facing.
"It's very difficult to drive down lending rates in a very short time, that's the root issue," said Zhou Hao, an economist at ANZ in Shanghai who specializes in the money market.
"Short-term injections can only calm market fears; not provide long-term liquidity to drive down interest rates."
Instead, the PBOC has turned to new tools such as short- and medium-term lending facilities (SLFs, MLFs), credit lines it extended directly to banks behind closed doors. These provide liquidity, but their opacity blunts their effectiveness in guiding funding costs for heavily indebted Chinese firms lower.
Finally, a reversal of the long trend of accumulating foreign exchange reserves, combined with the increasing reluctance of companies to hold on to a yuan that slid steadily against the dollar in 2014, have choked off a major supply of liquidity.
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"The traditional channel of injecting liquidity via FX reserve accumulation has been absent," wrote J.P.Morgan economist Zhu Haibin in a research note on Thursday, adding that foreign exchange reserves fell every month in the second half of 2014.
Chinese firms sold yuan to the tune of $19 billion in December, the most in seven years, according to Reuters calculations of official banking data.
Banks' corporate clients offloaded yuan in favor of dollars to protect themselves from exchange rate losses linked to a rising U.S. currency.
Such risks have intensified as more Chinese firms, locked out of China's squeezed capital markets, have turned to borrowing in dollars offshore.
The problem is capital outflows.
Rising yields on dollar assets and a weakening yuan have diminished investor interest in holding yuan-denominated assets, while reforms have made it easier for capital to leave the country in search of better returns.
"Cross-border capital flows aren't creating much base money for the Chinese banking system," said a senior trader at a major Chinese state-owned bank in Shanghai.
Inbound portfolio flows have also shown signs of drying up of late.
In addition to the poor take-up of the Hong Kong-Shanghai stock connect program, which allows foreigners to buy Chinese stocks directly, data from Markit shows that China-exposed ETFs saw massive outflows in the fourth quarter, even as mainland indexes rose north of 50 percent.
Reuters Lipper IM data showed a similar trend among ETFs specifying China as their investment target, with the average fund seeing outflows of 275 million Chinese yuan renminbi ($44.3 million) in December, with total outflows more than 34 billion yuan that month.
The previous two months were worse, with outflows exceeding 75 billion yuan. One of the few funds to see positive inflows in December was an inverse ETF that shorts the Shanghai SSE180 Index.
Chance of tactics
All of this poses a challenge for Beijing.
If it wants to push money gradually into the system without flooding it, it might need to suspend or reverse moves to open up the capital account further in 2015.
Conversely, if it wants to leave the front door open, it will need to inject so much money into the system that all of it simply cannot go out the back.
That would mean cutting bank reserve requirement ratios (RRR), which economists fear could re-inflate the asset bubbles regulators spent the last two years trying to deflate.
The huge stock market rally that the interest rate cut set off in November heightened those concerns, given much of the rally was driven by the exuberant use of leverage.
"Recent communication from the PBOC suggests that the central bank is not against RRR cuts, but it is concerned about the structural issues in monetary transmission," wrote Zhu of J.P.Morgan, referring to the concerns that capital injected would be wasted on real estate speculation and overinvestment rather than put to productive use.
Cutting the RRR - the level of cash banks must hold as reserves - could inject as much as 2.4 trillion yuan into the system when accounting for the multiplying effect of loans, according to a Reuters analysis.
Whether or not it takes that step, the PBOC has already shown signs of changing its methodology. On Thursday, it resumed open market operations with a small 50 billion yuan 7-day injection, and at a low rate for the issue at 3.85 percent, signalling a move down from the benchmark money rate's current pricing of over 4 percent.
It also made public the results of one of its MLFs in advance of its quarterly reports – increasing transparency – although it refrained from naming the bank that got the funds.
But ANZ's Zhou believes that such monetary policies may prove more effective at preventing further deterioration than driving growth.
"I think it's very difficult to manage," he said. "The status quo is my baseline scenario."