Pressure on China to withdraw excess funds from the banking system is likely to intensify in March, fed by hot money inflows and a flood of maturing central bank bills, which could spur more aggressive policy steps.
For weeks, expectations of a near-term hike in interest rates have been ebbing as the market approves of China's campaign to rein in bank credit, which has included two reserve ratio hikes and restrictions on lending.
Traders think the People's Bank of China (PBOC) will keep policy stable for the time being to avoid facing strong disapproval during the annual two-week session of the National People's Congress, the largely ceremonial parliament, which starts on March 5.
But the PBOC may have to resort to new measures in the next month or so, such as further reserve ratio increases, guiding up bill yields in its auctions, or adding three-year bills to its weekly bill sales, if it wants to combat an expected marked rise in liquidity that could fuel consumer inflation and asset price bubbles.
"The pressure to withdraw liquidity will accelerate sharply in March, so it can't continue to be so modest in its use of liquidity management tools," said Liu Jinyu, analyst at China Merchants Bank in Shenzhen.
Expectations of new policy steps may limit how much further longer-term yields can fall in the bond market in coming weeks and add renewed upward pressure on bill yields.
A flood of liquidity into the banking system in February and March will complicate the PBOC's efforts to establish a floor under market interest rates.
The central bank boosted bill yields and repo rates in its open market operations in the first three weeks of January as part of its drive to rein in liquidity.
But it injected a generous net 222 billion yuan ($32.6-billion) in its open market operations in February to ease a funding squeeze ahead of last week's Lunar New Year holiday.
And even after its second 50-basis-point reserve ratio hike this year came into effect on Thursday, the financial system was still left with plenty of cash.
Flush liquidity has helped to push longer-term government bond yields down as much as 25 basis points from a 2009 peak in November.
"The decline in long-term yields may spread to the short end but the PBOC will want to keep that from happening, after it already pushed them up," said a trader at a major domestic bank in Shanghai.
But even more liquidity looks set to slosh into the banking system over the next month.
A massive 776 billion yuan of bills and repos will mature in March. The bill volume of 686 billion yuan is expected to be one of the highest in 2010 based on projections of maturing debt.
And while officials said a surge in China's capital surplus to $109.1-billion last year from $18.9-billion in 2008 was mainly from repatriated overseas investments, traders believe more speculative money may flood into China in coming months to bet on future yuan appreciation and a strong economic recovery.
At the same time, the weekly volume of PBOC sales of one-year bills has shrunk so far this year to just 23 per cent of total bill sales in open market operations from 81 per cent in the fourth quarter.
That's because the secondary market yield on the one-year bill is 9 bps above the primary auction yield of 1.9264 per cent, so market players would incur a loss if they sell the bills after buying them at auction.
Shenyin & Wanguo Securities forecasts that the central bank will raise bank reserve ratios by another 1.0 percentage point or more this year, including a 50 basis point increase in March. A 1 percentage point rise would take reserves to the previous record high level of 17.5 per cent hit in 2008.
Shi Lei, analyst at Bank of China in Beijing, believes there is currently too narrow a spread between the one-year bill yield and the weighted average seven-day repo rate, the key measure of liquidity, which is now at 1.7 per cent.
He expects the PBOC to guide the one-year bill yield at auction up to at least 2.1 per cent from its current 1.9264 per cent to attract buyers.
China Merchants' Liu agrees, although she adds that the PBOC may also consider the harsher step of draining funds by resuming the issuance of three-year bills, which was suspended in July 2008, to lock up funds for a longer period.
The PBOC already appears to be gearing up to drain more aggressively. On Thursday, it drained funds via short-term repos for the first time since the end of January. It has also drained funds from the financial system this week, reversing four consecutive weeks of cash injections.