Months after coping with the highest inflation in more than a decade, China’s money market is gearing up for a fresh shock: deflation.
The risk of consumer price inflation turning negative early next year is likely to leave the market awash in idle funds and push banks into buying bills at yields below their market funding costs.
‘‘Market expectations for aggressive monetary easing will strengthen even further because of serious deflation in producer prices early next year,’’ said Xing Ziqiang, analyst at the investment bank China International Capital.
‘‘Deflation could have a bigger impact on the economy than inflation.’’ Early this year, talk of deflation in China would have seemed absurd. Consumer price inflation hit a 12-year high of 8.7 percent in February, propelled by rapid economic growth and surging global prices of oil and other commodities. But the global economic crisis has reversed the trend.
The deputy central bank governor, Yi Gang, said last week that the focus of both monetary and fiscal policy next year would be to avert the threat of deflation.
China is no stranger to deflation; consumer prices fell 0.8 percent in 2002, 1.4 percent in 1999 and 0.8 percent in 1998. But more is at stake for the money market this time. The rapid growth of the banking system, reforms like the introduction of interest rate derivatives and rising debt issuance have lifted trading volume in the interbank bond repurchase market more than fivefold since 2002.
Bill market trading over the past few days suggests that banks have actively started preparing for the possibility of deflation.
The indicative secondary market yield on the central bank’s one-year bills slid to a 29-month low of 2.3290 percent Monday, for a drop of 67 basis points since the start of this month, Reuters Reference Rates show.
That brought it well below the seven-day bond repurchase rate, a major funding rate for banks, of 2.70 percent. This shows that some banks have abandoned their traditional yardsticks for gauging the value of bills, as expectations for further falls in bill yields make them desperate to buy at current levels.
Traders don’t think China’s central bank will go nearly as far as the Bank of Japan did in fighting deflation early in this decade, when short-term Japanese interbank lending rates were effectively reduced to zero.
China didn’t resort to zero rates during its previous periods of deflation, and after the announcement this month of a nearly $600 billion economic stimulus package for the next two years, it is clearly counting on fiscal policy to support growth.
But traders see ample room for yields to fall further as China continues a monetary easing cycle that began in September.
The commercial banks’ benchmark one-year deposit rate is now at 3.60 percent. A cut to 1.98 percent, the low end of a forecast from the Bank of China for the end of 2009, would bring it down to its level in 2002, when China last experienced deflation.
Reuters