Why China is pumping huge sums into its financial system

China's richest man isn't worried about economic slowdown
China's richest man isn't worried about economic slowdown

China is pumping huge sums of money into its financial system to stave off a cash crunch.

The reason? An upcoming major holiday combined with massive capital outflows from the world's second-largest economy.

The festivities of Chinese New Year, which falls in early February this year, put pressure on the financial system as people splash cash on gifts, meals and travel.

The People's Bank of China, the central bank, typically pours extra funds into the system ahead of time.

"If it didn't, the increased demand for cash during the holiday would cause liquidity conditions to tighten significantly," Julian Evans-Pritchard, China economist at Capital Economics, wrote in a recent report.

But this year, the stakes are particularly high. Chinese financial markets have been in turmoil amid concerns over the country's slowing economy and weakening currency.

Related: China hemorrhaged $676 billion last year

Many investors are moving funds out of the country, seeking better returns elsewhere. The outflows last year are estimated to have reached a whopping $676 billion, according to one financial industry group.

The money gushing out of the country makes life trickier for the central bank.

"On top of seasonal cash demand, the challenge looms larger this year due to capital outflows," economists at HSBC said in a research note this week.

The central bank has responded with a series of aggressive measures to inject more cash into the system and has pledged to do more after meeting with commercial banks late last week.

On Tuesday, it said it was injecting 440 billion yuan ($67 billion) into the system.

That's the most it's offered on one day in nearly three years, according to Bloomberg, and follows hundreds of billions of yuan it pumped in last week.

Related: China posts slowest annual economic growth in 25 years

But Tuesday's move didn't help calm the country's volatile stock market. The Shanghai Composite plunged more than 6%.

Analysts say the flood of cash is a way for the central bank to ease monetary conditions without resorting to more traditional tools, like allowing commercial banks to lend more money or cutting benchmark interest rates.

The central bank used those tools repeatedly last year as economic growth waned and the stock market tanked.

But it may be reluctant to employ traditional measures too quickly this year, economists suggest, because of concerns they could intensify downward pressure on the yuan.

The Chinese currency fell sharply against the dollar at the start of this month, unsettling investors who feared it would continue to weaken.

Pumping extra cash into money markets has bought the central bank some time, analysts say, but it is still likely to have to go back to standard monetary policy tools later this year to deal with the raft of challenges the economy is facing.

-- Shen Lu and Jessie Jiang contributed to this report.

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