Daily Note

June 7, 2013 Chinas s liquidity stress more than a holiday phenomenon?

Chinas interbank nk rates have shot up ahead of the the Dragon Boat Festival. But there is i more to this than just a spike in cash demand for the holiday. Banks anks are facing increasing liquidity pressures. The authorities have scope to alleviate alleviate bank liquidity stress for now, no but they are close to exhausting their ability to use the banks b as an ATM to finance their expansion plans. One could argue that analysing the possibility of bank liquidity stress in Chinas China semicommand economy is s a waste of time. The government has direct control of the mainly statestate owned banks, which hold high levels of required reserves, so it could always intervene to relieve a potential seize up in the interbank market. But while this may be the end outcome, the emergence of such stress tells us a lot about about the state of the economy and the banks and the likely ely outcomes for asset markets. Chinas s interbank rates have shot up in the last few days to the highest level since the start of 2012. It is customary that demand for cash rises ahead of public holidays in China and next week sees the three-day three day Dragon Boat Festival. But this is unlikely to be the sole explanation behind the tightening of interbank liquidity. SHIBOR 7-day rate
12 10 8 6 4 2 0 6/7/2007

Capital flows (change in reserves less CA+FDI)

400 300 200 100 0 -100 -200 -300 -400 2006 Q1 2007 Q4 2009 Q3 2011 Q2 2013 Q1

6/7/2009

6/7/2011

6/7/2013

4-quarter quarter sum

Quarterly flows

Chinese banks are operating in an environment where liquidity liquidity pressures are about to start mounting. Chinas s current account account surplus has fallen to just 2.6% of GDP in 2012, down from a high of 10% in 2007. 7. This means that capital flows have become a more important driver of domestic c liquidity conditions in Chinas China s managed exchange rate system. And the likelihood of

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capital outflows is much higher than capital inflows despite Beijings efforts to encourage the latter. The reason is that whatever policy route the authorities take domestic money is likely to go for the exit. China is currently losing growth momentum fast after only a brief recovery from its cyclical hard landing at the end of 2011 and first half of 2012. Growth concerns drove domestic capital out of the yuan last year at the highest rate on record. Most of the outflows were into foreign currency at domestic banks, but Chinas capital controls are notoriously porous and the smart money is getting more sophisticated. If the authorities decide to go for growth and engineer another stimulus, inflation is likely to rear its ugly head very quickly. The global financial crisis marked the end of the road for Chinas export-led growth model. Unless there are structural reforms, just throwing money at the economy will produce inflation and bubbles rather than sustainable growth as happened after Beijings gigantic post-2008 stimulus. But this could well induce not just capital but also current account outflows. Chinese households have two thirds of their financial wealth in interest-bearing deposits. Accelerating inflation hurts their real wealth. Moreover, last time around Beijing went for administrative control in its efforts to curb the overheating rather than raising interest rates and thus didnt provide households with an offset. Accelerating inflation is also likely to drive domestic capital out. Moreover, a domestic stimulus in the face of still weak external demand is likely to further diminish the current account surplus if not turn it into deficit. The other option is for the authorities to ease capital controls. Indeed, since the end of last year they have made concerted efforts to entice capital in by raising the foreign investor and offshore yuan quotas. In fact May saw the largest increase in the scheme that raises offshore yuan to invest in the mainland bond and equity markets since December 2012. The move was not just aimed at boosting the sagging domestic equity market, but also importantly to support bank liquidity. Chinas banks may have been insolvent for a long time, but as long as they were liquid the excess investment show could go on. The problem is that to place the economy on a sustainable growth path, China will have to open up outflows as well as inflows. Beijing made a more concrete commitment to allow Chinese people to invest abroad a few weeks ago. It will provide a concrete timetable by the end of this year. But if China opens up the capital account fully, outflows in search of higher return amid weaker and more volatile Chinese growth are likely to outweigh inflows. Rising domestic liquidity pressures suggest that Beijing is likely to have to cut the banks required reserves ratio this year. At the same time, they could well raise domestic deposit rates as well which will be a necessary rebalancing measure until the market is allowed to set interest rates fully. Banks will bear the brunt of the structural adjustment China faces over the next few years. They will embark on a quest to raise capital abroad, but investors should be wary of the risks this will involve. Diana Choyleva

Daily Note - June 7, 2013