Chinese banks experienced an unexpected credit crunch in the past weeks. On June 20, the Shanghai Interbank Offered Rate (SHIBOR) and overnight repo rate reached, at certain points, 25% and 30% respectively. Following this unprecedented liquidity shortage, China’s stock market reacted with panic. On June 24, The Shanghai Composite SSE index fell by 5.3%, the sharpest plummet in four years. The shock is under control now, as the SHIBOR and repo rates are heading down after People’s Bank of China’s (PBoC) announcement to back financial institutions with liquidity on June 25. However, the increasing debt levels and recent panic exposed heightening financial risks in China. Whether the risks can be eschewed depends on future policies from PBoC and financial regulators.
The trigger of the credit crunch was a tightening of credit provision to the financial system by PBoC. In the past, the Chinese banking system would experience periodic liquidity squeezes because quarter-end regulatory reviews usually coincide with maturity of financial products. The central bank always used open market operations such as reverse-repurchasing to provide short-term liquidity to banks to get them past that period. But this time was different. PBoC turned off the flow of cheap cash and looked on. Not until the stock market tumbled did the central bank turn the taps back on. The market was caught off guard, and thus panic ensued.
The intention of PBoC’s inaction is not hard to speculate on: the Chinese government was demonstrating its determination to curb excessive lending via shadow banking. In fact, the credit condition has been relatively tight for a while (see Chart 1). The SHIBOR rate has been more volatile and, on average, higher since late 2010 than previously. But the credit squeeze in 2010 and 2011 was due to the need to fight rising inflation in that period (see Chart 2), not over-lending and shadow banking. With China’s inflation rate returning to its pre-crisis level in 2013, the central bank’s tolerance of tight credit can only be explained by its concern for China’s burgeoning shadow banking system.
Chart 1
Source: http://www.shibor.org/shibor/web/html/
Chart 2
Increasing off-balance-sheet activities made it harder for banks to meet ratio of reserve requirement at the end of accounting periods, when Wealth Management Products (WMPs) reach maturity on a large scale. Therefore, banks usually depended on interbank lending and, of course, the central bank’s leniency. Cutting liquidity provision at this crucial time can be viewed as a signal against off-balance-sheet activities. Actually, PBoC’s compromise on 25 June was conditional upon banks’ prudent lending behaviours, revealing government’s true intention.
However, the effectiveness of the PBoC’s signal is questionable. As previously discussed, the government must clarify the scope of insurance to kill moral hazard and generate long-term stability. But at the same time, kicking shadow banking out of the legal safe zone may cause panic and short-term crisis. The PBoC is now balancing the pros and cons: it slapped shadow banking in the face and later stemmed the panic by providing needed liquidity. But PBoC did show weakness in this tug of war with banks by announcing its role of lender of last resort. Nobody yet knows for sure if the message is credible enough for banks to stop over-lending. Since banks can meet cash requirements by selling more WMPs, PBoC’s stinginess may even lead to a bigger shadow banking sector.
‘A cash crunch is a terribly clumsy way to curb credit growth’, says the Economist. Rising rates will not only hurt the stock market, but significantly slow the country’s growth. After this recent drama, it is necessary to see whether the major banks will follow the government’s lead in the next few months. Further macro- and micro-prudential regulations on banks can also lower potential risks. If none of these happens, we will probably hear more stories like this.
