China's prudent monetary policy to reduce leverage

More on the current liquidity squeeze. There's been a lot of talk about SHIBOR, China's version of LIBOR and how its been spiking lately, indicating that liquidity is very tight in China's banking system. The central bank hinted on Monday that it won't inject liquidity into the system to address the current problem, keeping their stance firm on reducing leveraged operations. So why isn't the central bank stepping in? What's behind the liquidity squeeze and will it evolve to a liquidity crisis?

China's interbank rates began spiking before the Dragon Boat festival earlier this month. While rates appear to have peaked, they remain at elevated levels. Comments from the Central Bank stating that they will "prudently manage liquidity risks that have resulted from rapid credit expansion" caused the Chinese stock market to plummet.

The statement is telling banks to tone down risky activities in the shadowing banking market and reduce their reliance on the central bank to bail them out when they face a cash squeeze.

The Central bank also stated that overall bank liquidity conditions are a reasonable level. The M2 supply for the first 5 months of this year reached 16 percent, 3% higher than the government annual target. So why the abundant money supply in the system cannot meet the demand for cash? Cao says there is a mismatch in the system, the cash is not go into where its needed.

Cao says the growth of shadow banking loan products accounts for more than 20 percent of total loan growth. The size of shadow banking is around 20 trillion US dollars. China's financial regulators are very aware of the issue and are now willing to accept slower growth and short-term hits to ensure the longer term health of the economy.