Late December usually brings worries of a liquidity crunch in China's money market as financial institutions' demand for cash peaks before the year's end. But this December, investors are worried the bigger scare could come early in the new year.

Rising cash demand for the Lunar New Year holiday and a flood of special bond issuance by local governments is likely to tighten cash conditions in January, and could prompt the central bank to free up funds banks must hold as reserves, analysts at Guotai Junan Securities said in a note this week.

The Lunar New Year, which falls on January 25 next year, is expected to boost short-term demand for cash by about 1.5 trillion yuan ($214.18 billion). Banks' demand for cash for special bonds is also expected to peak in late January, bringing the total liquidity gap to as much as 2.8 trillion yuan, the analysts said.

China has let local governments issue up to 1 trillion yuan of the 2020 local government special bonds quota early as it seeks to avert a sharper economic slowdown. In previous years, local governments have had to wait until quotas are approved at China's parliamentary session in March before issuing special bonds. "Although short-term liquidity pressure is not huge, pressure will mount in January," Hua Changchun, analyst at Guotai Junan Securities said in the note.

He said the People's Bank of China (PBOC) might need to lower banks' reserve requirement ratio (RRR) to make up the liquidity shortfall.

Xing Zhaopeng, China market economist at ANZ in Shanghai said he expects the PBOC to cut the RRR by 50 basis points to counter the effects of bond issuance and consumer cash demand.

China's short-term money market rates fell after the central bank made its biggest daily net cash injection in 11 months on Thursday, following another generous injection a day earlier. It injected a net 480 billon yuan through open market operations over the two days.

The PBOC also cut the interest rate on 14-day reverse repurchase agreements on Wednesday, in step with a similar cut in the 7-day repo rate last month. The volume-weighted average rate of the benchmark seven-day repo traded in the interbank market, a closely watched liquidity indicator, was 2.3696% on Thursday afternoon, about 18 basis points lower than the previous close.

Overnight borrowing costs were at a one-week low, and traders said that they saw no difficulty squaring their books.

Copyright Reuters, 2019

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