China is pumping a lot of cash into its economy to calm investors

Key Points
  • China injected nearly $130 billion into its market in the last two weeks to quell a bond rout
  • The People's Bank of China is seeking to balance market sentiment with its need to crackdown on debt
  • Rapidly expanding liquidity could make it more challenging for Beijing to counteract capital flight — its relatively static foreign exchange reserves are growing less potent when compared to the amount of cash that could be leaving the country
A citizen shows new 100 yuan notes she withdrew at a counter of China Construction Bank in the Hangzhou province of China.
VCG | Getty Images

China has been pumping a lot of cash into its system to lift market sentiment, as the world's second-largest economy walks a thin line between curbing debt and keeping everything running smoothly.

Last week, the People's Bank of China injected cash totaling 810 billion Chinese yuan ($122.4 billion) in five straight days of daily liquidity management operations. Those actions, which represented the largest weekly net increase since January, were in part a Beijing response to its 10-year sovereign bond yields spiking to multiyear highs, experts said.

"Surging Chinese government bond yields hit the nerve of policymakers, so in order to further prevent a greater surge, they injected liquidity into the system to improve market sentiment," said Ken Cheung, a foreign exchange strategist at Mizuho Bank who focuses on Chinese currencies and monetary policies.

Nomura analysts said last week in a note that the bond rout was due to fears of regulatory tightening from Beijing. Bond yields, which move inversely to prices, briefly hit 4 percent in China for the first time in three years.

A rise in the benchmark government bond yield threatens to drive up overall borrowing costs — and potentially worsen the country's debt situation.

On Monday and Tuesday of this week, the PBOC injected a net 30 billion yuan ($4.5 billion), but it didn't expand that money supply on Wednesday. Analysts said that pause may have been due to market sentiment seemingly stabilizing, but it may be short-lived.

As Chinese 10-year yields are still near the psychologically important 4 percent level, Cheung told CNBC he expects more injections ahead if necessary, as Beijing needs to "maintain liquidity to please the market."

Will the PBOC follow the Fed higher?
Will the PBOC follow the Fed higher?

The PBOC's daily cash injections is done through the issuance of reverse repurchase agreements, or reverse repos. That's a process by which the central bank buys securities from commercial banks with an agreement to sell them back in the future at a higher price.

Conducted through open-market operations — daily, in the case of China — repos are a common money market instrument used for short-term funding between banks around the world.

The PBOC relies on those operations to manage liquidity, but Mizuho's Cheung said the central bank will keep expanding its toolbox in the future.

Despite the recent moves, the PBOC will keep a cautious stance, analysts note, as authorities continue to balance growth and debt deleveraging.

In fact, the PBOC highlighted in its third-quarter monetary policy report the need for financial stability and reiterated prudent management of the economy.

"We read this as a sign that financial deleveraging will be a multi-year theme and that deepening financial reforms are underway," Nomura analysts said in last week's note, adding that the market is pricing in maintenance of a prudent monetary policy stance.

Indeed, the PBOC drained a net 465 billion yuan from the money markets through open-market operations from the beginning of the year until November 10, Reuters calculations show.

Beijing officials have been outspoken recently about financial risks in the country, which is beset by high levels of debt, and investors are worried about a domino credit event unfolding. That being the case, it makes sense for the central bank to want to avoid overheating the economy with too much cash.

How Chinese liquidity can go very wrong

Even though many investors believe the financial risks in China are controlled due to its strong top-down control, the world's second-largest economy is still subject to external risks that can cause a crisis.

One factor that's making China more susceptible is the fact that its money supply has been growing at a very rapid pace while its foreign exchange reserves stay basically static.

Leveraging is expanding too rapidly in China, academic says
Leveraging is expanding too rapidly in China, academic says

"With the foreign exchange reserve being relatively fixed, foreign exchange reserve as a share of money supply has fallen from 40 percent just five years ago to 10 percent today," Victor Shih, a professor and China expert at UC San Diego, told CNBC.

The foreign currency reserve is a primary tool for managing currency values — an important issue for China — and the increasing base of liquidity should continue to dilute its power, Shih added.

Over time, as the ratio declines, it will get harder for the FX regulator to counteract capital flight: Beijing keeps money in its system (and the yuan strong) by buying up its currency in international markets with its horde of foreign cash. So if there's more RMB to buy, then the reserves won't go as far. Shih suggested such a situation could eventually "wipe out" the reserves entirely.

That would leave Asia's largest economy exposed to outside shocks.

"That is a great weakness of China, it's something external, especially if we have things like multiple rate hikes in the Federal Reserve," Shih said.