Why Is The Chinese Government Engineering a Banking Crisis?

SHIBOR has now become a commonplace phrase among investors. The acronym for the Shanghai Interbank Offered Rate, the equivalent of Libor for Chinese banks or the rate at which banks will lend to each other, has risen sharply over the past week and poses a severe threat to the economy.

However, the People's Bank of China (PBOC), the central bank of China, has refused to intervene to quell rate rises and has seemingly sat idle while the interbank lending market seizes. So, why is the PBOC doing nothing and why are they seemingly allowing a banking crisis to unfold before their eyes?

Shadow Banking Growth

China's growth has slowed in the wake of the financial crisis as the company can no longer export its way to 12 percent GDP growth. In the face of this slowing global trade, the government launched a massive fiscal stimulus, funded by debt, which built infrastructure across the country, resulting in the so-called ghost cities that have become famous.

Robert Peston, Business Editor at BBC News, asked the question this morning, "What is the significance of the recent turmoil in China's money markets, the sharp reduction in the flow of credit between banks and the rising cost of loans between banks?" Simply, the answer is that the PBOC has started to drain liquidity from the system to prevent the shadow banking system, where much of this debt has been financed, from growing any farther.

He believes that the true cause of the jump in rates is the perception "that Chinese banks and so-called shadow banks have lent far too much, too recklessly over the past five years, and that a reckoning may loom." He warns that the amount of debt accumulated by property developers, local government, and speculators makes it dangerous for the PBOC to maintain its easy money policy at the risk of debts reaching dangerous levels. Also, he warns that continued policies aimed at infrastructure stimulus every time China's economy slows a bit risks a Japan-like collapse and that the economy needs to learn to deal with ups and downs to fully realize structural changes.

Inverted Lending Curve

The yield curve for interbank lending rates in China is now massively inverted. Bond investors know that an inverted yield curve signals an imminent recession in the next few months, however this inversion is of interbank lending rates.

The inversion of the yield curve most likely implies that larger banks are not having trouble accessing capital while smaller enterprises are facing a liquidity squeeze. "The liquidity crunch has occurred at the interbank market due to the duration mismatch and the lack of policy response," wrote Credit Suisse Chief China Economist Dong Tao overnight, "but so far neither has affected the real economy – large [state-owned enterprises] still remain cash rich while [small-to-medium enterprises] are struggling with liquidity."

As the chart below shows, the interbank lending curve is massively inverted, implying that a modern-day bank run may be in the works. Credit Suisse noted that there has not been a meaningful decline in deposits since rates spiked so the bank run is one similar to the 2008 crisis in the U.S. and other major financial markets, where banks simply pulled the lifeline from one another.

According to the SHIBOR's official website, the overnight lending rate climbed as high as 13.444 percent Thursday before retreating to 8.492 percent Friday. For most of 2013, the overnight fluctuated between 2 and 3 percent. The 1-week repo rate also spiked Thursday to 11.004 percent Thursday before retreating to 8.543 percent Friday.

PBOC Sells Bills

The liquidity crunch began earlier in June due to the Dragon Boat Holiday, which lasted from June 10-12. Savers withdrew money in advance because banks would be closed while companies withdrew money also in the period because taxes are due shortly in China. Further, a government crackdown on illegal capital inflows into China further hampered liquidity.

The expected policy response in the face of these liquidity declines would be to enact stimulative monetary policy by buying bonds. The move serves to inject cash into the banking system, keeping the financial system awash in liquidity. However, on June 18, the PBOC sold 3-month bills, withdrawing more liquidity from the market. On Thursday, they sold 2-month bills, drawing more liquidity out of the system.

Punishing Excessive Lending

The move has been seen by many economists as a punishment for banks who are using obscure methods to boost lending. The growth of the shadow banking system, where banks lend money in non-traditional ways such as repo agreements and other financial methods, has allowed the banks to exceed the pre-set credit growth targets of the PBOC.

Therefore, it may be that the PBOC is looking to punish the banks by increasing liquidity. If the banks cannot get access to short-term funding, they surely cannot extend any more longer-term loans either in traditional channels or through the shadow banking system.

Implications on the Economy

If rates retreat in the short-term, the rise in rates should have a muted effect on the economy. "The length matters a lot more than the height of the rate spikes in the interbank market," continued Tao. "The longer this lasts, the more likely that some banks may face serious liquidity trouble and that would further undermine the creditability between banks, creating a chain reaction."

"The net withdrawal of RMB4bn over two occasions is small and negligible, but the message from the central bank is very significant, in our view. The monetary authority has made it clear that it intends to penalize those aggressive lenders and to crack down on the potential for moral hazard."

"Some small/medium-sized banks have deployed an excessive amount of liquidity into high yield/high risk assets, including corporate bonds issued by local government financing vehicles that ratings agents warned about commercial viability and credit risk, counting on the central bank's rescue in the case that liquidity gets tightened. The PBoC decided not to inject additional liquidity for emergency need. The central bank seemed to shrug off the pressure from the banks asking for a lower reserve requirement ratio."