What do temporary repurchase agreements and reverse repurchase agreements mean for the central bank's monetary policy?

Introduction

On the morning of July 8, 2024, the central bank issued an announcement stating that it will conduct temporary reverse repurchase or temporary repurchase operations.

The operation will take place from 16:00 to 16:20 on working days, with an overnight term, targeting the 7-day OMO rate, adjusted by 20 basis points lower (for repurchase) and 50 basis points higher (for reverse repurchase).

It is evident that the purpose of this mechanism is:

1. In times of abundant liquidity, through repurchase agreements, to prevent R007 from deviating excessively below the 7-day OMO rate;

2. In times of tight liquidity, through reverse repurchase agreements, to prevent R007 from deviating excessively above the 7-day OMO rate;

This mechanism enhances the impact of the policy rate: the 7-day OMO rate, making it a more influential policy rate.

This mechanism signifies a further step in the central bank's monetary policy reform, transitioning further from quantity-based monetary policy to price-based monetary policy, aligning with international standards.

However, many investors' mindset still remains in the era of quantity-based monetary policy, constantly thinking about "reserve requirement cuts, interest rate cuts, excess MLF injections," which are somewhat outdated.

In this article, we will review how the central bank has evolved its policies, helping everyone better understand temporary reverse repurchase and temporary repurchase operations.

Relaxing Short-Term Quantity Constraints

The initial reform took place in the short term, where the central bank's monetary policy used to be a system of structural liquidity shortages.

The characteristics of this policy system were: 1. Tight constraints on excess reserves; 2. Significant importance of the central bank's base money supply.

Therefore, the focus of monetary policy research was on "base money injections," which fell into three categories: 1. Reserve requirement cuts; 2. Net MLF injections; 3. Net OMO injections.

Many investors' intuitions were shaped by this system, and various experiences stemmed from it.

![](https://wpimg-wscn.awtmt.com/f829f824-d17a-4338-823c-477ee45a13c2.png? The People's Bank of China later abolished this system in order to smooth the transmission mechanism of interest rates, and the foundation of monetary policy shifted from structural liquidity shortage to structural liquidity abundance.

As shown in the above figure, the central bank always provides basic currency in advance and in excess, and basic currency is no longer a tight constraint but a loose one.

Therefore, the correlation between reserve requirement cuts and interest rate cuts has weakened significantly. When there is already an abundance of basic currency, adding more does not make much sense.

New Constraint - Liability Quality Constraint

The purpose of the central bank's reform is transmission. The broken constraints are not strongly related to transmission, so the newly established constraints need to be closely related to transmission.

So, how to establish the new constraints? We can use tax reforms to induce intuition. One type is taxing goods, such as land tax, poll tax, etc., which are very old types of taxes, and another type is taxing behavior, such as value-added tax. The former has a very indirect impact on behavior, while the latter has a very direct impact on behavior.

Only by directly affecting behavior can transmission be influenced.

In the end, the central bank found a constraint, which is the liability quality of commercial banks, which can be simply defined as the weighted average maturity of short-term liabilities.

Once the new constraint indicator is established, the central bank can replace the old constraints. As shown in the figure above, the new system exhibits the following characteristics:

1. With economic development, the amount of deposits continues to expand;

2. The quantity of basic currency also expands with the expansion of deposit quantity, but it always remains a loose constraint;

3. Liability quality becomes a tight constraint;

This constraint switch tells us that as long as a new tight constraint is found, the old constraint will be easily relaxed.

It is for this reason that I repeatedly emphasize, do not abuse empiricism. Some empirical rules come from a system where a is a tight constraint, and they become invalid when entering a system where b is a tight constraint.

How Does the New System Work?

In the new system, commercial banks need to strive to improve their liability quality, and there is a very clever way to do this, which is to engage in asset-liability swaps with non-bank institutions.

As shown in the figure above, on one side, banks issue certificates of deposit to non-bank institutions to obtain longer-term liabilities; on the other side, they provide R007 to non-bank institutions to support them with funds. The essence of the entire exchange is that banks pay interest differentials, and non-bank institutions help banks improve their liability quality How does the central bank build transmission? The central bank builds transmission through adjusting this exchange behavior, with two specific methods:

1. Price-based: setting the lower limit for large banks to lend, for example, not lower than the 7-day OMO rate;

2. Prohibition-based: limiting the scale of lending by large banks, once the upper limit is reached, they are not allowed to lend anymore, and of course, an industry-specific upper limit can also be set.

Friends who deal with funds will have a deep understanding. Since the central bank carried out the MPA reform, two things have become particularly important:

1. Whether large banks lend money or not;

2. At what price do large banks lend money.

So, why are these two things more important than "reserve requirement ratio cuts and interest rate cuts"? Because strict constraints are the liability quality of banks.

At this stage, the central bank has already made significant reforms to the short end.

Further Strengthening Control

Governor Pan Gongsheng emphasized at the Lujiazui Forum:

In recent years, we have continued to promote the market-oriented reform of interest rates and have basically established mechanisms for interest rate formation, regulation, and transmission. From the central bank's policy interest rate to market benchmark interest rates, and then to various financial market interest rates, the overall transmission has been relatively smooth. In the future, it may be considered to clearly define a certain short-term operating interest rate of the central bank as the main policy interest rate. At present, the 7-day reverse repurchase operation rate has basically assumed this function. Other interest rates of monetary policy tools can weaken the color of policy interest rates and gradually clarify the transmission relationship from short to long.

Previously, the central bank could rely on invisible mechanisms to maintain the market interest rate's follow-up to the 7-day OMO rate:

1. The lending price of large banks;

2. The lending amount of large banks;

Now, it can also rely on explicit mechanisms to maintain this:

1. Temporary repo;

2. Temporary reverse repo;

Overall, the central bank's control over the short end has become stronger. In fact, the central bank + primary dealers have completely aligned with their American counterparts.

Reform at the Long End

In fact, reforms at the long end are also underway.

The essence of quantity-based monetary policy is discriminatory credit policy, where some industries are suppressed, such as the previously overcapacity and real estate industries; while some industries are supported, such as various manufacturing industries

Symmetrical, the essence of price-based monetary policy is non-discriminatory credit policy, treating all industries equally, with the highest price winning.

Previously, we were in an important transition period and had to adopt a quantity-based monetary policy.

Here, we must be clear that the markets we experienced before were abnormal.

As the entire economic paradigm gradually enters a new quality productivity paradigm, the necessity of discriminatory policies is also greatly reduced. Therefore, reforms at the long end have also been rapidly advancing.

There are two very important phenomena, one phenomenon is no longer focusing on some macro indicators, such as credit growth rate, social financing growth rate, M2 growth rate, M1 growth rate.

As shown in the above figure, the out-of-control M1 growth rate is more of a feedback: an old institutional system has been abandoned.

Another phenomenon is the central bank actively seeking a lever on long-term bond rates.

Everyone can think about why the central bank didn't borrow earlier but had to borrow this year?? Is it simply because the market was speculating too aggressively on bonds?? Another important reason is institutional reform.

If the long end continues to maintain a quantity-based monetary policy, the central bank has no need to seek direct control over long-term bonds. However, everything has changed now.

Conclusion

The reason why many people do not understand many of the central bank's actions is because these people's minds are still stuck in the ancient times of "always mentioning reserve requirement cuts and interest rate cuts".

However, the reality is, the central bank has iterated N versions, and making another change will align with international standards.

If you don't know how the system has changed, then don't talk nonsense about macroeconomics and keep babbling about the downward trend of long-term bond rates. That just shows that you have no idea about the reform of monetary policy So, how do you test how old-fashioned you are? Reflect on the importance of reserve requirement cuts in your mind, the bigger the more old-fashioned.

ps: Data from Wind, image from the internet

Author: Cang Hai Yi Tu Gou, Source: Cang Hai Yi Tu Gou Original Title: "On the temporary reverse repurchase and reverse repurchase of the central bank and the transformation of monetary policy"