If I read China’s latest liquidity crisis right…

The manner in which the banking liquidity crisis currently underway in China is being reported and discussed worldwide by the media, analysts and very respected academics, as an attempt “to teach banks a lesson” baffles me. There is no central bank in the world that would stifle liquidity to an entire banking system or tweak the market in order to “teach banks a lesson” or to “kill off a shadow banking system,” as is being accepted widely today.

Central bank liquidity management runs within a very prescribed and tested operational framework. Knowing the Chinese regulators as I do, I think the problem itself was more prosaic, but the prognosis is of a more profound change taking place in China’s economy today, and for someone in the system to take responsibility for some very hard decisions to be made.

While the regulators would be relieved to read how the whole world interpreted their move as efforts to slow loans growth, they are battling a much more fundamental crisis. The usual tools for ensuring sufficient liquidity in the banking system that the central bank has become accustomed to applying have become unusable. The central bank is in a very stressed period of having to negotiate authorizations from its political masters to modify its operational framework for a new era.

The period of liquidity stress that we saw in the past month was a miscalculation. The source of the miscalculation is not important. It could have been driven by either a genuine judgment error or an attempt to align its policy rates to respond to the recent US announcement to reduce its bond buying programme. The way central bankers go today, on a normal day a Governor Zhou would be closer to his US and European counterparts than he would be to his own political masters, and vice versa.

But the time has come for Governor Zhou to spend more time with the Chinese Politburo, because the change in operational framework he will need to take will have a profound factors such as inflation, liberalizing interest rate margins and therefore competition within the banking industry, a potentially deficit public spending or externalizing the renminbi to make up for the loss in foreign exchange as a source of assets to continue providing liquidity in the marketplace.

For so long as the new authorizations are not in place, the tools available to the central bank have been failing one after the other. “Sterilization” of foreign exchange has been the primary tool for pumping liquidity into the banking industry by converting foreign exchange into renminbi. The effective use of this tool ended sometime last year. I do believe that the US announcement of its own measures to potentially slow down its bond buying programme, which the global markets absorbed fully up front instead of waiting till it actually happened, had an effect on China’s capital inflow in June. But the liquidity crisis was foaming already in May when the Chinese banks were issuing 37 day certificate of deposits at high rates to lure funds.

In any economy, the central bank has several ways in which to provide liquidity into the banking system. On the asset side, it conducts Open Market Operations (by buying or releasing repos), Covered Bond Buying Programmes, extending Marginal Lending Facilities to its counterparties and most important of all, sterilizes foreign currency assets. Central banks also physically print and issue currency notes, and run deposit facilities which are captured on the liabilities side of their balance sheet and used more to reduce liquidity, but I believe these were not the problems faced this time.

Outside of the central banks own balance sheet, it can require banks to increase or reduce reserve requirement ratios, as some central banks in high inflationary economies are wonton to do. This is a very blunt instrument and affects different types of banks differently. Another tool outside of the central bank but requires coordination is for government itself to run deficit budgets to expand the money base.

All of these are perfectly normal tools applied to any changes taking place in any economy. But China is undergoing a profound change. It is becoming a net importer. It does not have a strong inflow of net foreign exchange. Wages are increasing. Manufacturing has been moving out to either be closer to their new markets or to even cheaper markets. The policy decisions taken by the Politburo will have a long term implications on all these factors. I do believe that the process has only just started.

China’s own Ministry of Commerce data shows that its days as a net exporter nation is fast dwindling. The gap between import and export figures is disappearing fast. In absolute terms, the source of foreign exchange today is more investment and capital account than trade. But even that has slowed down, driven by falling return on investment, overcapacity in production and infrastructure.

A small blip showed up in the export figures earlier this year, that I followed very curiously, hoping it was a sign of the US economy recovering. But on closer examination, the blip was due to the practice of falsification of export documents by hard-pressed companies looking for ways to bring off-shore renminbi borrowings back into the country as local currency, because the local banks were already slowing their formal lending quite aggressively.

If my prognosis is correct, then in the next few months, we will see the central bank showing changes in its liquidity operations framework to make up for the permanent loss of some of its traditional liquidity tool. The problem is that under the circumstances, it has very few tools left and as such will be increasingly dependent on fiscal and other public policies. I think we will see more political leaders openly discussing the need for inflation and higher wages, increased public spending, externalizing the renminbi and so on.

The banking liquidity crisis, believe it or not, is a wholly different beast generating its own liquidity and capitalization problems. This is why there is this strange phenomenon of a drought when there is so much water, or a liquidity problem in a very liquid marketplace. Technically, all Chinese banks are very liquid to begin with, with strong deposit bases and high capitalization. They then lend these out, mostly to state-owned enterprises, who have decreasing use of the funds for capital investments, and return some of it into the banks as deposits, which are then lent out yet again, again to state-owned enterprises who will again underutilize them and the process builds on itself.

This recycling of deposits is called “fractional deposits” and after a while grows on itself like a Ponzi scheme. One Bloomberg data that speaks to the point I am making here suggested that $1 in loans yielded 83 cents in GDP growth in 2007 but only 17 cents in 2012 as banking assets became less and less productive, even as it kept growing larger.

The strange thing as this Ponzi scheme builds on itself is that the large banks get larger and seemingly even more liquid, while the smaller banks in lending out, become more illiquid because they will have to set aside more capital to cover the increased lending and more provisions against bad debt. When the large banks get a certain size, the Ponzi scheme itself limits the banks from lending anymore because the capital requirement for such a large asset book can cause the banks to collapse on themselves. So they “invest” instead in the so-called “shadow banking” institutions such as trust funds just to deploy the excess liquidity. For all the criticism of the “shadow banking” system, it is in fact the very child of the bloated banking system. To hurt it now would be to hurt the banks themselves, and this is why despite all the rhetoric being leveled on this monster, there is no way in the world that any central bank would have used market instruments to kill it.

The small city commercial banks get around their liquidity problems by asking for their best borrowers to make deposits when needed albeit at marginally higher interest cost and by borrowing from their counter-parties and yes, from the shadow banking industry. Even during the days of 10% GDP growth, I was surprised to see how anemic the small banks in China were on funds, and would borrow from any counterparty bank that would lend to them. The counterparty banks themselves would max out on their single bank or single country limits, which then left the small Chinese banks still gasping for liquidity, even in a healthy market. That is how bizarre the banking industry was, even during the good times.

It is the medium sized banks, four of whom have been mentioned by name, that find it hardest to grow their deposits because they don’t have as many state-owned enterprises as either depositors as the large banks do, or as anchor borrowers as the smaller banks do, to fall back on to help them with their liquidity or capital as required. China Minsheng Bank, China Everbright Bank, Ping An Bank and China CITIC Bank – the four named banks – have two important characteristics in common. They are all medium sized by China’s standards and all have strong small business customers.

The problem with small business customers in China, contrary to other countries, is that they are not the strongest source of deposits when required. If anything, to the credit of these four banks, they serve a customer base that the larger and smaller banks have shun in favour of the unproductive state-owned enterprises for the longest time. Also to their credit is the fact that all these years, these have been amongst the most innovative banks in terms of banking products and services because they try to generate income from a very difficult customer base, while the larger and smaller banks have become fat on their cozy relationships with state-owned enterprises. If these medium sized banks are seen as crossing-the-line sometimes, it is only because they operate in an extremely difficult space.

The problem with open market operations for China’s central bank is that the effect is dramatically uneven for large, medium and small sized banks. In fact, one of the most immediate reactions of the PBOC in the week when interbank rates broke the 10% level was to suspend repo (repurchase agreements) operations, because they could not predict its outcome. The problem was not liquidity per se, but a case of all banks grabbing whatever liquidity they could get their hands on because of so much uncertainty. Large banks even profit from such high rates and small sized banks have a quid pro quo relationship with their corporate borrowers as a fall back. The ones that were left to suffer the most were the medium sized banks, who did not have either recourses.

Some say that this seizing up of the repo market is predictable because banks do compete for funds at the end of every quarter to make their books look good for the regulators. But it appears to me that the central bank’s indecision to intervene was an end-of-the-road sign for the tools they had at their disposal.

China’s central bank has lost several opportunities to put in place certain infrastructure when they had the time. Specifically in liberalizing the domestic interest rate market and in opening up capital account convertibility. Just these two initiatives would have given both the banks and the central banks more tools to be able to respond to the current crisis in a more market driven manner. But these were decisions for the politburo to make and the central bank to implement. The only reason they were not made in a timely manner, I believe, was because nobody in the leadership wanted to make the decisions and just kept postponing it as long as they could. Even now, when the time has come for a decision, opinions can be very divided.

But events are forcing the time for decision, not because they want to internationalise the renminbi or other lofty goals, but because the economy has effectively run out of foreign exchange generating income to sterilize back into the economy. So the momentous decisions we will see later this year is at least partial loosening of the capital account convertibility, forcing banks to hold more foreign exchange, lending aggressively overseas (which has already been happening) and just maybe, running a deficit budget. But most difficult of all is for someone in the Politburo, at the possible cost to his career, to take a position on increasing wages and inflation. Whether right or wrong, only then will China be really able to enter the next phase of its development.


  1. Matthew Taylor

    Brilliant ED… this really hits the nail on the head.

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