Worst over, but banks still under pressure

Sharp liquidity tightening could usher in new prudent banking era

With the overnight interbank lending rate falling back to 6 percent, from previous highs of above 13 percent, analysts and economists are of the view that the worst of the banking sector's recent credit crunch appears to have passed.

But the pressure on banks to improve their act will continue to build, after the government came out in the open for the first time earlier this week to urge them to better manage their liquidity positions instead of counting on the central bank to save them, whenever they get themselves into a tight spot.

That message, economists agreed, has marked a key turning point in China's financial reform and ushered in a new banking era in which self-discipline, prudent management, accountability and fiduciary duty will count for more than government support and patronage.

Those banks that fail to adapt to the new market-oriented rules are likely to be left out to dry, analysts said.

But if and when they do adapt, their customers will stand to reap the benefits of less central control, they said.

"The central bank and the China Securities Regulatory Commission are not 'wet-nurses'. Government rescues do no good to the financial market," the People's Daily said on Tuesday, after China's equity market suffered its worst performance in almost four years, with a 5.3 percent plunge on Monday.

News reports on Tuesday said small commercial banks were suffering from a capital squeeze that forced some to stop lending.

Economists said that the sharp and sudden liquidity tightening will hit the shadow banking sector that is based largely on low interbank interest rates.

But it will also crush small financial institutions and increase credit costs, which will hurt the real economy.

Prepared for decontrol

The People's Bank of China issued a statement after its second-quarter monetary policy committee meeting on Sunday afternoon, which reiterated its commitment to interest rate reform.

On the same day, Zhang Chenhui, director of the finance research institute at the State Council Development Research Center, was reported as saying that China may lift the lower limit for lending rates before the end of 2013.

Analysts said the central government is urging the banks to improve their ability to manage liquidity, and prepare for reform of the financial markets that will see the introduction of more market mechanisms in the future.

"Chinese banks have become increasingly dependent on a loose monetary environment and low interbank market rates," said Yang Guoying, a researcher with the Beijing-based China Finance Thinktank.

"As the central bank said earlier, M2 supply is sufficient in China - but the problem is the poor liquidity management of the banks.

"China should enhance interest rate liberalization, to improve the efficiency of circulation of money, and banks should prepare for that."

The credit crunch is being blamed mainly on an unreasonable capital structure of the banks - they are pursuing higher returns by putting a lot of capital into arbitration and speculation, rather than the real economy.

Guo Tianyong, director of the Research Center on the Chinese Banking Industry at the Central University of Finance and Economics in Beijing, said on his microblog that the government is making a clear stance, that the current priority is to adjust the economic structure, even at the expense of growth, and the banks should cooperate.

How long will it last?

Zhang Jun, director of the China Center for Economic Studies, under Fudan University in Shanghai, added: "It seems Premier Li Keqiang has a strategy - to bring the fundamentals of the Chinese economy back to those of before 2008, and to continue to upgrade China's economic structure."

It would take a painful dismantling of the investment expansion of the past five years, he said, to reduce the excessive production capacity and correct the distorted investment structure.

He added that the central government will have to accept a continuous slowdown in economic growth, maintain a tightening macro economic policy, and encourage local governments and local companies into finding new ways to grow.

The central bank said in its Sunday statement that it will adopt "fine-tuning policies when necessary".

But most industry insiders and analysts are still not optimistic about liquidity in the short term.

"It seems the central government is determined to hit shadow banking activities this time, and bring the risks hidden in their off-balance sheets under control," said Zhu Zhou, an employee at one of the "big four" banks.

Mainstream banks are relatively less affected and some have even benefited from the highly volatile SHIBOR recently.

It is the medium-sized and small banks, whose operations are more aggressively leveraged and dependent on the interbank market, that find themselves under the biggest pressure, he added.

Nomura Securities said in a report on Monday that China may enter a prolonged period of policy tightening, and that the new leadership was likely to follow former Premier Zhu Rongji's approach of the 1990s, when he tried to avoid a hard landing through structural reforms to achieve more sustained, balanced growth.

But there are those with more optimistic views.

Ting Lu, China economist at Merrill Lynch in Hong Kong, said this latest credit squeeze "will have to end soon", with the country's current growth rate closer to the floor than the new leadership has indicated it is willing to tolerate.

"Although we recognize that some financial deregulation and innovation in the past couple of years has created new risks, including the much-talked-about "shadow banking" sector, we don't think the sector and its debt levels will lead to a nationwide financial crisis or economic hard landing anytime soon," he wrote in a note.