More Than Meets the Eye in China Liquidity Crunch
The central bank of the People’s Republic of China, called the People’s Bank of China, took an unexpectedly tough stance in mid-June as Chinese banks suffered the worst liquidity squeeze in a decade. It eventually gave in to pressure from the banks, however, and injected cash into the system. Analysts have reached different views on the reason for the unprecedented cash crunch, including two very opposite views: One, that there’s no shortage of liquidity and that the crunch was engineered by the PBOC; the second, that there was indeed a liquidity shortage, and that the PBOC wanted to keep that from the public.
Money market liquidity started tightening up in early May as global capital flows into China dropped sharply after the State Administration of Foreign Exchange issued new measures against falsifying trade data. This staunched an illegal influx of money.
Then on June 5, China Everbright Bank failed to repay six billion yuan borrowed from Industrial Bank Co. The next day, the one-day repurchase rate, which measures interbank funding availability, surged to an all-time high since July 2011.
However, instead of increasing liquidity, the central bank issued two billion in three-month central bank bills twice from June 18 to June 20, which actually reduced liquidity. On June 20, the Shanghai Interbank Offered Rate (SHIBOR) overnight rate soared to a record high of 13.44 percent.
Chinese stocks also suffered their worst drop in four years on June 24, falling into bear market territory.
Remarks during this period by the relatively new Chinese premier, Li Keqiang, were widely interpreted to mean that he wanted to impose financial discipline and clamp down on runaway expansion of shadow banking. He had already said in May that “there is not much room for stimulus and government investment.” In an economic work symposium on June 8, he reiterated, for the third time in a month, that banks should “make active use of existing funds to support the real economy,” the Beijing News reported.
However, after rejecting banks’ pleas for cash over two weeks, the central bank took a sharp turn late on June 25 and promised to inject liquidity.
A ‘Pre-run’ of Economic Reform
Nicknamed “central mommy,” the central bank usually responds to other banks’ requests for money quickly. A bank dealer told Southern Weekend that in the past they usually called the central bank and asked for money in the morning, and “they will send the money over before 4 o’clock in the afternoon.”
Many Chinese journalists and bloggers commented that “central mommy” started acting out like a stepmother, because Li Keqiang is not following his predecessor’s custom of quickly offering big doses of cash. Beijing News said the faint dawn of Li’s economic reform has broken during the recent liquidity crunch.
Barclays Capital has coined a word for Li’s plan for China’s growth: Likonomics. A research note said it has three key pillars: no stimulus, deleveraging, and structural reform.
Remarks by Chinese officials give indications along the same lines. In a Global Think Summit in Beijing on June 29, Zhang Yansheng, a researcher with the National Development and Reform Commission, said “The recent cash crunch is actually a pre-run of our future reform.”
Charlene Chu, Fitch Ratings’ senior director in Beijing, said in mid-June that the ratio of credit to GDP in China has jumped by 75 percentage points to 200 percent of GDP. “This is beyond anything we have ever seen before in a large economy.”
She also warned that China’s shadow banking system is out of control and under mounting stress.
According to another report by Fitch Ratings, the recent tightening in liquidity was sparked by a drop in foreign-exchange inflows and seasonal tightness associated with the mid-June holiday; quarter-end prudential requirements; and fiscal deposit submissions. Many Western and Chinese analysts reached similar conclusions.
However, these factors shouldn’t trigger a serious liquidity crunch, according to Liu Yuhui, director of Financial Key Lab at the Institute of Finance and Banking, Chinese Academy of Social Sciences and chief economist at Hutai Securities.
He pointed out in a commentary that banks experience similar seasonal shortage or even lower foreign capital inflows in the past, yet they didn’t suffer very serious liquidity tightening.
China’s credit market has a “very serious” mismatch in liquidity as reflected by the current tight money conditions, Liu said. “Some institutions match short-term interbank funds with long-term assets for profit,” he added, according to a translation by Hedge Fund Manager. “Risks are exposed when cash flows from long-term assets can’t cover short-term debt obligations when the economy slows.”
“The sale of new debt to cover interest payments on old debt displays ‘ponzi’ characteristics,” he continued.
He also warned that a quick drop in asset prices triggered by a sell-off of assets would cause a “hard landing.”
According to Liu Yuhui , the biggest fragility of China economy lies in the fact that “the government has too much power over resource allocation and distribution, which results in serious moral hazard and massive debt.”
“The real reason behind the recent liquidity crunch is the entire credit system is focusing on arbitraging from the financial system,” he added.
According to an editorial by the Caixin Weekly Magazine on July 1, it is precisely because the real economy is unbalanced, uncoordinated, and unsustainable that this cash crunch was triggered. “A great number of enterprises have been losing money. A large amount of funds became idle, or flowed into the real estate market or local government financial vehicles. Relying on high debt to achieve economic growth is no longer feasible.”
State media Xinhua said China’s banking system has ample liquidity. To demonstrate this, another state media China Daily said China M2 (a measure of broad money supply) grew 15.8 percent year-on-year in May.
However, money supply doesn’t translate into liquidity, according to Wen Quoqing a chief analyst at Liangxun Securities and a blogger for the financial magazine Caijing. Of the 104.21 trillion yuan in broad money supply, about 70 trillion was used to finance mid or long-term fixed-asset projects . According to Wen’s estimates, the total currency in circulation is only around 30-something trillion yuan, so liquidity is far from ample.
Picking up the PBOC’s Tab
One of the most intriguing analyses came from economist Liu Junluo, who last December wrote a book titled “Surviving the Great Depression, Picking up the Tab for PBOC’s mistake,” which predicted that the PBOC will react indifferently to quickly rising interest rates and a rapidly declining economy, and that stock market will crash in 2013.
By the “PBOC’s mistake,” Liu was referring to China’s dumping of U.S. dollars for euro and Japanese yen since 2010, a move that turned out to be disastrous in 2013, because the Eurozone is still mired in serious financial trouble and the Japanese yen is depreciating, while the U.S. economy is in a recovery.
Liu recently blogged that the PBOC has engineered this liquidity crunch to hide its own out-of-control bad accounts. He predicted that the PBOC will also create a disastrous stock crash, so that money will leave the stock market and go into bank accounts.
He warned that China’s economy will tumble at a rate far harsher than any have predicted, and that already major players in China’s stock market are jumping ship.