China’s Central Bank Bails Out Unidentified Bank

June 20, 2013 Updated: June 20, 2013

While the West is fretting about a few days of declining stock markets, China is rapidly approaching a full-fledged crisis in its banking system. According to industry sources, the People’s Bank of China (PBOC) had to bail-out an unnamed bank June 20.

Hao Hong, the chief China strategist at the Bank of Communications Co., cited unidentified sources while claiming the People’s Bank supplied 50 billion yuan ($8.6 billion) to an unnamed bank June 20 via a “targeted  liquidity operation,” or, in other word, a bail-out.

The People’s Bank subsequently denied this, According to Bloomberg. But Hong’s sources are probably correct as the interbank market for loans in China has virtually ground to a standstill. Banks, which usually finance a majority of their debt short term, do not lend to each other anymore because of mutual distrust.

The situation is similar to what happened in the United States before and after the Lehman crisis. Banks know about the bad loans they have on their books and are aware that other banks are in a similar or worse situation.

Once an overnight loan cannot be extended or “rolled,” the bank is technically in default. This is what likely happened to the unidentified bank, which resulted in the PBOC bail-out.

In addition, it was only two weeks ago that China Everbright Bank Co. could not repay 6 billion yuan ($1 billion) to Industrial Bank Co., according to Market News. Some rumors even put that figure closer to 100 billion yuan ($17.2 billion), a number that Industrial Bank dismissed as “untrue and exaggerated.”

“Some smaller banks may be unable to cover cash openings as big banks are unwilling to lend cash,” Chen Jianheng, a bond analyst in Beijing at CICC  (the nation’s biggest investment bank), told Bloomberg June 7.  “If the central bank doesn’t inject more capital into the financial system, the cash shortage will probably last for the rest of June.”

His prediction proved to be correct, as China’s central bank is not adding liquidity on a wholesale basis. Now the interbank funding market, which depends almost entirely on the central bank, is in complete disarray.

The rate which banks charge each other for overnight loans, Overnight SHIBOR (Shanghai Interbank Offered Rate), exploded to 13.4 percent annualized June 20, up almost 6 percent from the day before. Another indicator, overnight repurchase agreements, went up to 25 percent. The Shanghai composite lost 2.8 percent June 20 and is now down 8 percent for the year. 

Previously, China’s central bank has always injected massive amounts of liquidity when needed, but seems to have altered its stance.

Bank of America’s Ting Lu wrote in a note to clients: “There are many factors behind the interbank liquidity squeeze that might be cited, but we believe that the ultimate reason is the central bank’s tough stance as the PBOC can practically provide unlimited liquidity to ease every squeeze if it wishes to.”

The motivation could be to stem a tide of unproductive lending, which has characterized the country since at least 2008. Banks could borrow cheap either from deposits or in the interbank market and lend to money to mostly unproductive infrastructure investments. This business was supported by the government and the PBOC, but recently, it seems that policy has changed.

The head of the PBOC said in a state-owned newspaper: “We cannot use fast money supply growth as in the past, or even faster, to promote economic growth, and must control the pace of money supply growth.”

Legendary investor Stanley Druckenmiller commented on this problem in a recent interview with Goldman Sachs.

“In essence, the frantic stimulus China put together at the end of 2008 sowed the seeds of slower growth in the future by crowding out more productive investments. And now, the system’s building enough leverage and misallocation of resources to warrant risks of a financial crisis, but the timing of that is still uncertain in my mind. What we’ve seen in China since 2009 is similar to what happened in the US in 2005, in terms of credit growth outpacing economic growth.”