Question

Topic: Open Market Supply

SHANGHAI -- Money markets are often described as the financial system's plumbing. When they work, which is most of the time, hardly anyone notices, but when they get blocked up, it creates quite a stink.

That is why China's money market -- in which banks and other financial institutions borrowed some $6.4 trillion from each other last month alone to fund their daily needs -- is becoming one of the world's most important markets to watch.

China's central bank has raised interest rates twice since early February. That immediately pushed funding costs to the highest in two years, hitting smaller banks that have come to rely on the market particularly hard. Last week, some small rural banks failed to make good on short-term loans from other lenders.

And while anxiety in the market has eased somewhat this week, short-term borrowing rates are still high. Brokerages and asset managers are having to pay interest of as much as 6% on short-term borrowings, more than double the central bank's benchmark rate.

Tightness in money markets is a worry because if banks stop lending to each other, they soon stop lending to the broader economy, too. A sharp rise in interbank borrowing costs thanks to a liquidity crunch in major Western markets in 2007 heralded the global financial crisis. China's money market has become just as central to the country's financial system as those of its U.S. and European counterparts after rapid expansion this century.

That has handed a new lever to the Chinese central bank, which is using money-market interest rates as its main tool to control the amount of money in the country, a big change from the days when it ran the economy by directly controlling banks' total lending.

But as the money market becomes more influential, so has the risk of widespread damage to the world's second-largest economy when it jams up.

"Because there's been a trend for small banks and nonbank institutions to play a larger role in the money market in recent years, the risk of a liquidity crisis is growing," said Julian Evans-Pritchard, a Singapore-based economist at Capital Economics.

China's banks for years relied on deposits from ordinary customers. As the economy expanded and banks lent more aggressively, they borrowed more from each other in money markets to get extra funding. Typical borrowers are smaller banks, which have lower deposit bases, while large banks flush with funds, such as Industrial & Commercial Bank of China Ltd., act as lenders.

The volume of interbank lending, usually uncollateralized, hit a record with the equivalent of $34 trillion in loans last year, nearly 100 times the amount of lending in 2002 when data provider Wind Info's full-year records began.

Banks also use large amounts of repurchase agreements, or repos, in which one bank borrows in the short term from another, typically using a Chinese government bond as collateral. Turnover in the repo marketsurged to the equivalent of $216 trillion last year, about 24 times its volume a decade ago.

China's central bank plays a big role, using daily open-market operations to adjust the supply and cost of funds in the financial system. When there is a cash shortage, it offers loans to banks, usually ranging from seven to 28 days. Its seven-day repo rate has become its main policy tool, the equivalent of the fed-funds rate.

What is worrying China's central bank is that lenders are plowing the funds they raise in these markets into speculative investments, fueling asset bubbles.

One big problem is the rise of what are euphemistically called wealth-management products. The products bundle together all sorts of assets or debt, even other wealth-management products, and aren't transparent. These are sold to bank customers offering much higher returns than ordinary deposits, by making big, leveraged bets on everything from government bonds to garlic. Critics consider them a big risk to banks and individual savers, with the outstanding amount issued having ballooned to the equivalent of $3.8 trillion, or 35% of gross domestic product.

Because the products are often short term, there is a risk investors won't be repaid if the value of the investments drops sharply. At that point, the issuers of wealth-management products often look to tap the money market to get the funds they need to pay back investors, a problem if rates have risen.

Beijing has set reducing the country's debt buildup and high leverage in financial markets as a top policy priority. The central bank has raised its seven-day repo rate twice recently, its first increases since October 2015.

As interbank borrowing rates soar, they are feeding through to hurt China's already slowing economy, as banks pass on the higher costs.

A quarterly record of 104 companies have dropped or delayed the equivalent of $14.1 billion of bond-issuance plans since the start of this year, according to Wind Info.

The central bank's control over China's markets is also being tested. After the latest rises, its seven-day repo rate remains a low 2.45%. But big state-owned banks that borrow directly from the central bank are charging much higher rates when they lend to smaller institutions.

"That means the transmission mechanism is not well developed, which can dilute the effectiveness of policy changes," said Tim Condon, economist at ING. China's money market is distorted by the big five state banks that dominate the supply of funds, he said.

1. From the article above, briefly explain the author's purpose for writing the article.

2. Summarize the article, focusing on the discussion of the topic the article addresses. Define the economic concept being addressed. Incorporate relevant economic theory that is present so that discussion of the article content is clear.

Word Count MUST be 300 words

Answer 1

1. From the article above we find that the author is explaining about the development of money market in China following in the footsteps of European countries and other advanced economies where the supply and demand for funds is directly impacted by the Central bank using the tools such as its benchmark interest rate.

The author warns about the fund crunch in the world's second largest economy and why the rise in interest rate has not worked as efficiently. That means the transmission rate doesn't work as effectively as it should. The funds are being invested in bubble assets where it doesn't help the economy in general.

2.

The economic concept being used is the money supply tool of the central bank.

As the interest rate rises to cool down overheating economy, the funds move to the financial institutions. Investment and saving rises due to expectation of higher return.

Despite the growing debt problem, China is trying to further stimulate lending of the corporate sector, especially small and medium-sized companies. On Monday, May 9, Bank of China announced another cuts in reserve requirement ratios. As a result, banks will have an additional 280 billion yuan (41 billion dollars) to be used as loans to companies with financial problems. That reduction would be divided over three stages, on May 15, June 17 and July 15. On Tuesday, May 21, they released statement saying that they had cut the ratio by 1% on May 15, and the next 1% cut is expected to be on June 17.

On the other hand, Chinese officials along with President Xi Jinping are trying to reduce shadow-banking system (financial intermediaries who provide services similar to traditional commercial banks, but are not subject to traditional banking regulations). In effect, we come to a situation where commercial banks are reluctant to continue lending to companies with a poor financial conditions also, more restrictive regulations on shadow-banking make it impossible for these enterprises to borrow outside the banking system.

All these aforementioned factors translate into the economy state, and this one currently does not look bright.