China faces liquidity squeeze amid efforts to defend the yuan against strengthening dollar

The People’s Bank of China has increased its efforts to defend the yuan against the strengthening dollar. The efforts have resulted in a surge in funding rates that have spiked to the highest levels in the last twelve months.

The Chinese Central Bank, the People’s Bank of China (PBOC), has increased its efforts to curb the rising dollar’s strength against the local currency, which is causing a cash squeeze in the Asian country. The liquidity squeeze has worsened over time, causing a short-term funding rate to surge to its highest level in the last twelve months.

China faces a funding squeeze as the government struggles to stabilize the yuan

China facing a liquidity crunch as it attempts to defend its currency against a stronger dollar. The cost of borrowing cash through a 7-day interbank repo rate soared to its highest level since October 2023! pic.twitter.com/LzVspGlSj8

— Barchart (@Barchart) January 17, 2025

According to data from Barchart, a financial markets trading and investing tool provider, China is facing a liquidity crunch. The data shows that the cost of borrowing cash through a popular institution funding tool called the seven-day interbank pledged repurchase contracts spiked to its highest level since October 2023. The spread between the central bank’s own reverse repo reference rate and the rate has widened significantly marking the widest point in the last four years.

The funding squeeze is a clear indication that the Chinese government is making frantic efforts to stimulate its economy and stabilize its local currency. Last September, the Chinese government unveiled a series of monetary policies aimed at boosting the economy. The monetary stimulus appears to be pushing back against the Chinese currency’s slide which has been fueled by declining yields.

The Chinese government pushed more measures this week in solidarity with the yuan including verbal promises to crack down on market disruption and making changes to its capital controls. Last week, the Chinese central bank unexpectedly halted its purchases of government bonds, in a bid to control the ongoing debt-buying frenzy.

Zhou Guannan, an analyst at Huachuang Securities commented on the situation saying that the People’s Bank of China is carefully managing the pace of liquidity provision now that currency stability has become a priority. The analyst expressed her uncertainties about how the PBOC will handle the liquidity crisis as the Lunar New Year holidays approach. She estimated that the gap is worth around 1.5 trillion yuan which is about $205 billion at current exchange rates.

The U.S. dollar strengthenes against the yuan amid projections of a booming U.S. economy

The strengthening dollar has brought the yuan to its knees as many anticipate strong economic data and expectations of inflation policies from the incoming Trump administration. Trump has continuously pledged to hit China with increased tariffs. According to CNBC, the tariff threats have fueled frontloading of trade shipments into the U.S., led by China.

Seasonal flows are catalyzing the liquidity squeeze. The demand for cash tends to increase ahead of the week-long holiday, which this year begins on Jan. 28. The Chinese people typically prefer having more cash withdrawing from banks to prepare for spending and traditional gift-giving. Maturities from a PBOC lending facility and tax payments also cause cash outflows from the banking system.

Market participants are closely monitoring how far the Central Bank of China will stomach a spike in borrowing costs. This may weigh on corporate debt issuers and banks at a time when cheap funding is required to sustain China’s delicate economic growth. 

According to a statement by PBOC Governor Pan Gongsheng at a forum this week China is expected to utilize its monetary adjustment tools such as interest rates and reserve requirement ratios to maintain ample liquidity in the market.

Wee Khoon Chong, a senior market strategist at BNY said the central bank is likely to step up liquidity through a 14-day reverse repo into the festive period. He explained that the central bank is likely to deliver more stimulus via cuts to interest rates or reserve requirement ratios sometime this year. The overnight repo rate has also inflated recently, hitting its highest point since August last year.

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