China onshore interbank CNY repo rates (chart 1 and 2) have been creeping upward since CBRC chairman Guo Shuqing at the beginning of the month openly stressed the importance of financial risk control.
In our view, the sustained rise in repo rates in recent weeks is more or less attributed to government's efforts to clamp down on financial arbitrage.
Two types of financial arbitrage have been under scrutiny: first, increased interbank leverage with low overnight repo rates (around 1%) to invest in front-end bonds; second, corporates utilizing cheap funding from bill issuance (at a cost of around 2.5% for AA-rated borrowers for 3-month tenor) to invest in high-yielding structured deposit (at an annual return of around 5%). Among these two types of financial arbitrage, the second one is particularly worth looking into because many small banks have to rely on structured deposits issuance (chart 3) to absorb funding.
Recall, we did see a round of regulatory clamp-down on trust financing in the summer of 2017 after President Xi openly asked for stricter controls over financial risks. During that summer, the 7-day repo rate kept hanging around the upper end of the full year's trading range while government bonds were in a bear run. We expect such a bad market will re-appear in Q3 this year. Don't forget we will see huge supply of various kinds of government bonds in July and August (chart 4). If PBOC continues to refrain from injecting more liquidity into the banking system (chart 5), we will likely see another bloodbath in the bond market in Q3.
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