Liquidity: a thorny issue

MONEY MATTERS: A clerk from a rural credit cooperative in Linyi, Shandong Province, counts banknotes. [Photo/bjreview.com.cn]

China's banking system suffered another credit crunch at the end of 2013. On December 19, trading in the high-value payment system was extended by an extra half an hour, followed by rumors of breaches of contract among banks. Although relevant departments clarified the rumors, interbank lending rates, which measure the cost at which Chinese banks lend to one another, shot up, with overnight, seven-day and 21-day lending rates all soaring to over 10 percent, and the 14-day rate even rocketing to 12 percent. This has raised fears of a credit crunch.

To alleviate stress and fears in the monetary market, the People's Bank of China (PBOC), the country's central bank, launched a short-term liquidity operation (SLO) on December 18, 2013. The next day, the central bank announced through its official Weibo, the Chinese equivalent of Twitter, that it had carried out an SLO and pledged to inject liquidity to qualified financial institutions via the SLO. On December 20, the central bank said on its Weibo account that it has injected over 300 billion yuan ($49.56 billion) to the financial markets within three days. On December 24, the central bank injected another 29 billion yuan ($4.79 billion) by selling seven-day reverse repurchase (repo) contracts, a process in which central banks purchase securities from banks with an agreement to resell them in the future.

With strong intervention from the central bank, this round of the credit crunch was immediately eased, with the interbank money rate falling back to below 7 percent on December 26.

This was the second outburst of a credit crunch in China's banking system in 2013. The overnight interbank lending rate hit a record high of 25 percent on June 20 when the first one hit. Fears filtered through the monetary market to the whole financial sector, causing stock markets to rout and surging yields on money management products and bonds.

The liquidity shortage in June was worse than the more recent crunch, but the central bank turned its back on the distress in June while injecting liquidity immediately after the recent credit crunch, signaling more attention had been paid to liquidity shortage by the central bank.

Yi Xianrong, a researcher with the Institute of Finance and Banking of the Chinese Academy of Social Sciences (CASS). said the credit crunch may become a common phenomenon in China in the future. Frequent occurrence of cash crunches, however, has exposed severe problems in China's financial markets that can only be solved by major institutional reforms.

Reasons

Many find it hard to understand why credit crunches would frequently occur in China's banking system, which seems to hold abundant cash. Central bank data showed that year-on-year growth of M2, a broad measure of money supply that covers cash in circulation and all deposits, surpassed the target of 13 percent during the first 11 months of 2013. During the same period, credit growth and total social financing both exceeded the whole-year volume for 2012.

A report issued by Founder Securities on December 23 said internal reasons are the major factors contributing to the December credit crunch. On the one hand, fiscal deposits are far below the expectations, and on the other, the central bank has tightened the monetary market by cancelling its usual "open market operations." In addition, rampant expansion of interbank businesses have worsened the liquidity shortage, said the report.

The report said short-term liquidity conditions may be further stressed by the required reserves due at the end of the year. If the central bank continues its SLO or other open market operations, the surge of interbank lending rates may be eased. In the mid-term, liquidity conditions in China's capital markets may be worsened by more cash demand before the Chinese New Year, which falls on January 31 this year, and the US Federal Reserve's (Fed) decision to taper its quantitative easing (QE) program, according to the report.

Yi said the credit crunch between banks is a result of the following factors. "First, banks face the pressure of handing in the required reserve. Second, the central bank unexpectedly canceled repo for five consecutive times. Third, the US Fed has been cutting QE faster than people have expected. Finally, a considerable amount of deposits left banks for Internet finance, dealing a heavy blow to Chinese banks," he said. "As a result, all financial institutions line up to get loans and the credit crunch is destined to happen."

The crunch is also related to severe imbalances in China's lending structure. China pumped billions of dollars of funds into its economy to prop up growth in the wake of the global financial crisis. A large amount of money went to the property sector, government-backed financing platforms and sectors with excess capacity. Meanwhile, only 5 percent of the real economy is funded by bank loans. Therefore, it's not a lack of money but a severely distorted lending structure.

Risks in money management products also exacerbated the crunch. At the end of each quarter, many of these products are due for redemption. Chinese-funded banks also have to meet the loan-to-deposit ratio of 75 percent. At the end of each quarter, they are subject to supervision from regulatory bodies. Therefore, credit crunch often happens at the end of a quarter or the year.

Frequent occurrence

A report from China International Capital Corp. Ltd. said the problem of frequent liquidity shortages haven't been fully solved, despite the easing of the recent shortage. Credit crunches may become a common phenomenon for three reasons—bank asset growth exceeding debt growth, no cash flows generated by the particular bank that needs cash, and poor preparation for separation of interest rate and finance from the department of assets and liabilities in banks.

A financial blue book issued by the Institute of Finance and Banking of the CASS on December 25 said the monetary market will continue to be tight in 2014, just as it was in 2013. If reforms on local government debt, the property market and state-owned enterprises are carried out, the money supply situation can be improved.

Yi said timely intervention from the central bank immediately eased capital stress in banking system in December, but the real solution lies in banks. "It's extremely important for commercial banks to adjust their balance sheets flexibly and to better manage the liquidity issue."

The Central Government made it plain that China will continue to follow a prudent monetary policy in 2014 and added that money supply should serve the development of the real economy. However, alongside the rapid development of Internet finance and the shadow banking system, more capital will bypass banks and directly get to those who need money. Therefore, liquidity shortages will be a common phenomenon.

Yi said a cash injection can't solve the problem. "Frequent occurrences of credit crunches mean there's something wrong with China's lending system. If the central bank only pushes money into the markets and doesn't launch reforms accordingly, the Chinese-style credit crunch is bound to happen again in 2014.