Premier Li Keqiang’s rise to power in March of 2013 has marked a pivotal turn in Chinese economic policy. While previous administrations had been characterized by its leaders’ willingness to endeavor to produce stellar growth rates, Premier Li has instead adopted aggressive tactics in order to push eventual economic reform and end reckless banking practices. The new government has recognized that past growth models are no long sustainable, and in some ways is attempting to purge the lending system before it deteriorates beyond its control. The People’s Bank of China (PBOC) has openly told bankers that deeper issues could not be mediated by monetary expansion and that abundant liquidity will not last forever. The fact is that more money is being printed, but most money lending is not being directed into industries but into real estate, local government’s financial platform and money markets, creating bubbles. The new government will likely aim to shift China’s reliance on exports and investments and focus on increasing consumption. Expectations remain optimistic, but growing pains in the wake of such dramatic changes are inevitable. Case in point: the credit crunch in China.
Foreign exchange outflow, tax payment and quarter end window dressing put significant pressure on liquidity of inter-banking market. Thirsty for short term funding over the past several weeks has been accompanied by a soaring inter-banking interest rates which reached double digit last week. This has created an unfavorable situation for banks that engaged in irresponsible investments, namely funding long-term investments with short-term assets acquired via the interbank lending market. As the interbank rate rose, a liquidity crisis ensued.
The deep underlying problem is some banks’ excessive reliance on interbank borrowing as an important funding source. The disparity between short-term funding and long-term lending is significant, and especially true for small-scale commercial banks, some of who experience a 25% dependency on the interbank market. Traditionally, the Chinese government has intervened by injecting cash into the markets when rates spike or providing the liquid assets necessary to alleviate a similar cash crunch. However, this time the PBOC withheld its support from the banks, forcing them to resolve their own problems. Many banks were obligated to withdraw money from riskier businesses, namely the informal loans market in order to address their liquidity deficits. Fueling this is the administration’s desire to encourage banks to return to funding loans via deposits rather than through capricious money markets. The PBOC’s unmistakable lack of action immediately following the crisis hinted at the government’s willingness to tolerate economic hardship in order to create the necessary political momentum to enact policy reforms this fall. Li and his team have placed China’s outstanding credit—double the country’s $8.6 trillion economy—in their crosshairs, and are clearly taking steps to address this issue and create a more sustainable growth path, and have demonstrated their grit in ensuring change. Their hardline has some experts questioning whether their approach will backfire, but at least in the case of the recent credit crisis they did relax their stance in the end and pledge support to those needy banks that practiced more responsible lending habits, demonstrating their tolerance for risk without letting the Chinese banking system crash. Large banks will likely suffer less than the small, as they maintain larger reserves and their risk of default is greatly reduced. Small banks, on the other hand, are likely to struggle significantly, and some are already taking measures to dispose of assets to ensure liquidity. Private companies may subsequently suffer as well as they will have fewer opportunities to secure loans through the smaller banks, and will rely more heavily on private equity or acquisition.