The funding squeeze on Chinese banks tightened last month when the Shanghai interbank offered rate (Shibor) soared to 13.4% on June 20. On the same day, the overnight repo rate was quoted as high as 30%, double this year’s average rate so far and the highest in more than a decade.
Although struggling banks were expecting that the People’s Bank of China would step in to ease funding pressures, the Chinese authorities refrained from pumping liquidity into the banking sector, even denying that there was any shortage of liquidity. But in an attempt to soothe fears over the credit crunch, the PBoC did at least release a statement in late June promising to safeguard banks suffering from cash shortfalls.
"If banks have temporary shortages in their planned funding, the central bank will give them liquidity support," it said. "If institutions have problems in managing their liquidity, the central bank will apply appropriate measures under the circumstances to maintain the overall stability of money markets."
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| China’s markets took a tumble in late June |
Nevertheless, some analysts have argued that the PBoC should refrain from lowering the required reserve ratio and pumping liquidity into the system: "It’s like an old Chinese saying – drinking poison to quench thirst – especially given that the system is not short of liquidity," argues Jian Chang, economist at Barclays in Hong Kong.
"There is enough liquidity in the system to support between 7% and 8% GDP growth this year, and larger banks will continue to lend, but banks that rely on the interbank market for funding will be hit hard," she says. "We will see smaller financial institutions go under, and the regulators are preparing for some restructuring."
The rise of wealth management products and shadow banking in China has become a quick and easy channel for banks to attract bank deposits, offering high returns in a relatively low interest rate environment while banks are able to offload certain loans from their balance sheets.
But highly unregulated wealth management products have created a mismatch between short-term funding and long-term needs in the banking sector, fuelling a credit bubble in China. If the PBoC refrains from injecting liquidity into the interbank market, banks will be forced to delever, and shadow-banking businesses will have to shrink.
Indeed, PBoC inaction is sending an important signal to the banking sector, explains Li Wei, China economist at Standard Chartered in Shanghai. "The People’s Bank of China and the new administration are actually forcing banks to clean up their balance sheets and take responsibility for their own liquidity risks," he says. "Basically, the PBoC wants to refrain from giving in to banks’ demands, but if the situation was to worsen, the central bank would support the sector by injecting liquidity."
Credit in China has grown by about 23% this year, up from 20% in 2012 on the back of a weakening real economy with a credit-to-GDP ratio of more than 200% this year. Goldman Sachs was the latest bank to amend its outlook for China’s GDP growth from 7.8% to 7.4% in 2013 and from 8.4% to 7.7% in 2014.
New leadership in China, under the guidance of premier Li Keqiang, is pushing forward with the idea that structural reform is the only way out of China’s growth conundrum and that slower growth will have to be tolerated.
"There has been a shift in the orientation of policy in China since the new leadership took over" says Diana Choyleva, director of Lombard Street Research in Hong Kong. "Reformers appear to have gained the upper hand for now, and the refusal of the PBoC to come to the banks’ rescue is an expression of that. China needs to clean up its banks, recapitalize them and allow them to function like market institutions. The overall debt level in the economy is not excessive as yet, but it will soon become so unless the authorities rein in credit now."
But there will be other consequences to PBoC inaction, says Chang: "Obviously this poses new sources of downside risks to the real economy, as financial defaults and the bankruptcy of smaller financial institutions will be disruptive to the real economy and collateral damage has already been visible."
According to Moody’s, mid-sized banks received 23% of funding and capital from the interbank market at the end of 2012, compared with only 9% for the larger state-owned banks. Middle-tier banks in China, including China Minsheng Bank and China Merchants Bank, have already suffered share-price falls following worries that funding might tighten and restrict credit growth.
For the PBoC, this could also be viewed as a controlled experiment to see whether or not the financial system can withstand the pressure of capital outflows. "If the economy and banks buckle under the pressure, Beijing will likely slow down the pace on opening up its capital account," says Chang.
The test would also prevent money from circulating within the banking system and release it back into the deposits and bond markets, supporting the real economy, she argues.
But Wei argues that this is not the case: "What’s happening right now is only a temporary story and will not change the central bank’s schedule for opening up the capital account. Beijing will continue as planned; this is not a stress test."