China's upside-down money market tests PBOC's role

[BEIJING] It's now cheaper for Chinese financial institutions to borrow from their peers than to seek funds from the central bank - a situation not seen in nearly three years.

Amid ample central bank liquidity, funding costs in the money market have fallen below the interest rate of seven-day reverse repurchase agreements offered by the People's Bank of China (PBOC) as eases policy in a bid to shore up the economy. The inversion is the first since September 2015, when the central bank injected large amount of liquidity to stamp out risks rising from a stock market riot.

While the extra funding could help ease credit stress in the real economy, it poses a challenge to the PBOC's efforts to transform the seven-day reverse repo rate into a policy rate - the floor of funding costs in the entire financial system - as it tries to build a price-based monetary policy framework.

"The PBOC is likely to keep the money market rates low, hoping that a low risk-free money market rate will lead to a decline in corporate bond yields" said Nie Wen, economist at Huabao Trust Co in Shanghai. "That will help pump money into the real economy and prevent systemic risk in the second half."

BLOOMBERG