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Yesterday the Asian markets got an unexpected volatility spike on news from China. What’s the big deal about a few changes in the 7-day repo rate anyway?

What the heck is a 7-day repo rate?
Repurchase rates, also known as “repo” rates, is the rate at which a central bank lends money to the country’s commercial banks in case of a shortage in funds.

In China, it is the 7-day repo rate that is used as the benchmark for the funding ability in the banking system. The higher the rates, the more expensive it is for commercial banks to borrow, which leads to less money in the system.

What caused the spike yesterday?
The People’s Bank of China (PBoC) typically injects money into the system through bi-weekly reverse-repurchase operations.

But with the central bank pausing its operations since October 17 and with corporate tax payments due this month, the commercial banks are beginning to worry over the lack of liquidity. The 7-day repo rate jumped by as much as 100 basis points to 4.5%, its highest since July 29, before it settled at 4.05%.

How did the markets react?
Investors were reminded of the cash crunch in June when the 7-day repo rate went up to 10% while the overnight repo rate rocketed to 30%.

The spike first took its toll on Asian bourses like Nikkei, which snapped its winning streak with a 1.95% decline. This in turn sharply boosted the yen (and even the dollar) against its higher-yielding counterparts. In short, risk aversion ensued and it did not let up for the rest of the day.

Before you click the panic button though, you should know that market geeks don’t believe that the sky is falling just yet. In fact, the PBoC’s refusal to inject money may just be a way for the central bank to control the rise of consumer and home prices as well as credit growth.

Prices will most likely stabilize before November when China’s Communist Party is set to hold a key economic policy meeting. Analysts suspect that the party would like to see stable rates as they establish a roadmap for the next couple of years.

Until then, this means wait-and-see mode for us and closely monitoring the rates’ impact on risk sentiment.