China's liquidity crunch | Compass July 2013 | Barclays

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After years of excessive credit growth, China’s economy is being repositioned for an era of less-generous liquidity support. The recent spike in interbank market rates is an indication of how serious policymakers are about tackling the country’s financial imbalances – not least in the shadow-financing system. Breaking the addiction to credit will be not be easy, but it will be worth it.

What is risk (II)? 2 of 6 Compass July 2013

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Here comes the squeeze

“The tough decision has to be made. Gone is the liquidity largesse of yesteryears. The market has to face up to the reality that the credit-fuelled euphoria is simply not sustainable. We now have to do what’s right. It’ll all be for the better, trust us.”

Words like these could have come from the US Federal Reserve as chairman Ben Bernanke prepared the market for the eventual QE3 exit. We think they are also the kind of words that could have come out of China, where the squeeze on liquidity has already begun, and one such exercise by the government has proved particularly interesting.

While global investors were squarely focused on the outcomes of the 19 June Federal Open Market Committee (FOMC) meeting in the US, China’s interbank repurchase (repo) market was – relatively quietly – illustrating what can happen when policymakers decide that enough is enough. In this market, banks agree to sell and then repurchase securities with other banks, after a specified time, at an agreed discount rate.

On 20 June, as Asian markets were digesting the hawkish FOMC statement, China’s 7-day repo rate jumped to 11.2% from just 6.4% a week earlier, in what was the highest daily fixing since 2003. High repo rates indicate that some banks are willing to pay more to get short-term liquidity from others, and so can be seen as an indicator of how much cash is in the interbank market. A spike on this scale can be seen as a sign that China’s level of liquidity not only fell, but fell sharply.(We should say immediately that we do not expect US rates, when they start to rise, to do so quite so sharply!).

Figure 1: China’s interbank rate has spiked recently

Not just post-holiday blues

Apart from the holiday effect – China had a 5-day weekend from 8-12 June – the liquidity squeeze appears to have been deliberate. Specifically, the People’s Bank of China (PBOC) allowed the liquidity crunch to happen as a warning to some domestic banks against taking on too much balance sheet risk via excessive lending.

Amid expectations that the PBOC would quickly relieve the sharp rise in the interbank repo rate by injecting liquidity into the system, the central bank kept the market waiting until much later in the week. By delaying its liquidity injection, the PBOC was warning banks that it will not support resurgent credit expansion in some parts of the economy. Indeed, the PBOC’s delay in relieving that the liquidity crunch seemed to have a punitive tinge to it.

In particular, the authorities appear to be targeting some of the banks that have overextended themselves. The smaller banks have had a tendency to borrow from the short-term interbank market in order to finance their exposure to wealth management and other high-yielding products. Overall, they are seen as being conduits in the shadow-financing system, which has grown significantly against the wishes of the central bank.

“It takes two hands to clap: for every supplier of high-risk loans, there is a pack of yield-hunters on the other end”

Lurking in the shadows

Total social financing (TSF) – which measures the overall liquidity in the system, including the non-bank sector – showed that shadow financing has been building up more intensively over the past year. On a 3-month rolling average basis, the current level of TSF (more than CNY 1.8tn) is considerably higher than it has been over the past few years.

The fact that credit outside of the formal financial system continued to grow sizably – despite little official monetary easing during the period – came as a particular concern for policymakers. Hence, it is perhaps not too surprising that the PBOC reacted the way it did throughout the period – refusing to inject liquidity into the system despite a liquidity crunch that saw interbank market rates soar to 30% intraday at one point.

By engineering a squeeze on the interbank funding, the PBOC’s ultimate goal is to slow the growth of shadow financing – by targeting an important funding lifeline of the smaller banks. The chain of logic goes as follows.

Figure 2: Total social financing has been on an uptrend

To begin with, despite repeated official urgings, the smaller banks remain involved in the relatively murky process of circumventing official banking regulations and helping to perpetuate credit growth outside of the banking channels. While these banks may not be directly extending the shadow financing themselves, there is a sense that they have been actively perpetuating it via various creative instruments.

These would include bank acceptance bills, which allow banks to act as guarantors for short-term debt instruments issued by companies. While these are considered off-balance sheet items for the banks – and therefore do not show up as normal bank loans – the banks are still liable if the issuers default.

In other cases, banks may have been acting as middlemen for selling trust loans, (a process whereby a trust company receives funds from wealthy individuals or companies) to invest in ventures that promise high yields. However, this remains a relatively unregulated part of the financial flows, and subject to significant risk.

Two hands to clap

While much can be said about how some of the banks are complicit in aiding the growth of shadow financing, the simple truth is that such instruments are popular because there is genuine demand for them. It takes two hands to clap and, for every supplier of high-risk loans, there is a pack of yield-hunters on the other side of the transaction.

Even though the ample supply of global liquidity in recent years has kept a lid on yields in most parts of the world, for China, domestic financial repression has made the situation worse.

Specifically, in what is a still a controlled financial system, the interest that households receive for depositing their money in the banks remains tied to benchmark rates. Banks cannot readily offer higher rates to attract depositors if they choose to. Avenues for investment outside of China also remain largely closed, restricting those with the financial means to invest overseas.

Given the limited ways for those with excess cash to invest, it is no surprise that, among other euphoric investment recipients such as the still-buoyant property market, the hunt for yield has also fed the growth of shadow financing.

Awaiting the reforms

Given the role that financial repression plays in the growth of shadow financing, it will take more than a liquidity squeeze by the PBOC to root out the issue.

To that end, it is positive to see that top officials remain committed to resolving some of the structural financial imbalances. For one, financial liberalization appears to be a key plank of the reform agenda set out in May.

Specifically, there are some expectations that the PBOC may raise the ceiling for banks’ deposit rate to 1.2 times the benchmark, compared to 1.1 times currently. While the deposit rate will still be pegged, the new measure would give banks wider berth in competing for deposits.

Apart from that, there have been more active talks about further capital account liberalization. In particular, a program called QDII2 may be launched to allow qualified individuals to invest in overseas securities. As discussed, allowing investors to seek opportunities abroad will help to curb enthusiasm for high-yielding, but largely unregulated, trust products that form a significant portion of shadow financing in China. All these measures will take time, to be sure. However, judging from the robustness of the PBOC’s warning to the market – via the interbank system – the government appears to be building up a strong impetus for reform.

Of dilemma and trauma

Tackling financial imbalances in the system is not without risk. For instance, when it comes to liquidity, the PBOC wants to see enough of a squeeze to serve as a strong signal of its hawkish intentions. At the same time it cannot afford to ignore the fact that too much of a squeeze could perpetuate the economic slowdown.

Going by the latest data (Q1 2013), Chinese GDP growth has fallen below 8% for four consecutive quarters (for the first time in 20 years). Q2 GDP growth – due to be published in mid July – is also likely to be lacklustre by Chinese standards. Indeed, our researchers have revised down their growth forecast for 2013, from 7.8% to 7.4%.

Despite the fact that headline inflation remains subdued, at around 2%, the central bank has refrained from lowering rates. In fact, the last time the PBOC adjusted its benchmark rates was in mid-2012, during which period it cut the lending and deposit rates by a conservative 0.56 and 0.50 percentage points, respectively.

At the broad level, such restraint suggests that policymakers are relatively comfortable that, while growth will be slower than before, the economy is not about to decelerate uncontrollably. However, it also reflects their trauma about the impact of hyperstimulus, highlighted by the shadow-financing problem.

The next step for China’s growth will not come easy. Gone are the days when the world’s second-largest economy can clock double-digit growth in a seemingly effortless manner. The country must now face the realities of the trade-off between short-term growth and long-term sustainability.

China’s new policymakers appear to be taking the view that going ‘cold turkey’ is worth it if it means curing the economy of its addiction to credit, and rebalancing spending away from frothy fixed investment (including real estate) towards more subdued but solid consumption. We concur. It may be a bumpy ride, but China remains one of our favourite long-term emerging market investments.

Figure 3: Both growth and inflation have come down

Figure 4: Benchmark rates have been on hold recently