China’s economy has seen plenty of headwinds recently weak exports numbers, slower growth in both services and manufacturing and a weak recovery of corporate earnings despite rapid credit growth. China’s equity markets have performed weakly too and have been extremely volatile. But much of the recent volatility has less to do with sagging growth and much more to do with a cash crunch and tight liquidity in China’s banking system. What is going on?

These developments are taking place amid major reform efforts in China's capital markets. There is now stronger demand for wealth management and savings and trust products in China. As a result, the actions of central government authorities should be seen not merely as a response to an uptick in credit growth but as steps toward reshaping its entire financial system, liberalizing its currency and creating international financial markets, centered around Shanghai.

China's cash crunch, which began in mid-June, came just before its three-day Dragonboat holiday. (Public holidays are typically times of high demand for cash.) At the same time, banks were scheduled for regulatory review and as such, typically require cash to close their quarter-end books. The Shanghai Interbank Offered Rate (SHIBOR) started to rise due to these high interbank borrowing demands. This has happened in the past toward quarter-end and, typically, the central bank has stepped in to help ease banking system liquidity and thus lower the SHIBOR rate. However, what surprised the market this time was that China’s central bank held back from pumping cash into the market. Instead, it allowed the SHIBOR to soar, at one point reaching as high as 13%. Expectations that the interbank interest rate hike might lead to widespread default among the system’s weaker banks and spark a banking crisis led to severe selling activity in the equity markets of China and Hong Kong.

Some analysts claimed that this was a crisis “self-created” by the central bank. True, the Chinese central bank can very easily defuse the crisis by injecting liquidity into the system. But the fact that the central bank did not intervene also sent a strong signal to the banks: They need to source their own liquidity and shed the assumption, particularly held by the country's smaller banks, that interbank interest rates will remain constantly low and liquidity typically abundant. China's banks should also not rely too heavily on low-cost interbank borrowing as their funding source to issue a variety of wealth management products. Banks need to own up to the consequences of a liquidity squeeze and not expect an automatic government bailout. In recent years, the amount and types of wealth management products issued by banks have grown quickly and become central to China’s risky shadow banking system. Wealth management products bear much higher interest rates and are not reflected in bank balance sheets.

So far this year, although China’s overall credit growth has been quite strong, it has not translated into higher economic growth. A big part of credit creation has taken the form of wealth management products, some of which have involved the country's somewhat unhealthy real estate market as well as local government-funded projects. This has posed significant risk to the financial system. Given the fast development and lack of transparency in China's shadow banking system, inappropriately managed wealth management products could significantly deteriorate a bank's asset quality and, ultimately, lead to further needs to recapitalize. China's banking sector liquidity crunch seems likely to have a significant impact on the behavior of financial institutions and could eventually slow the pace of growth in its shadow banking activity. At Matthews, we have tracked the evolution of China's banking sector cautiously. We believe that a widespread banking crisis seems unlikely for China, but we have nonetheless taken a cautious approach and typically are underweight in Chinese financials, especially banks, in our portfolios.

If the interbank interest rate remains high for an extended period, it could ultimately lead to higher financing costs for businesses, harming the growth of China’s already slowing economy. By leaving the SHIBOR rate high, the central bank is taking a risk. But this move also demonstrates its determination to reform its financial system and place it on a more sustainable long-term footing. One would assume that the central bank is aware of the risk in taking these steps and will ensure that it won’t go too far. At the time of this writing, the central bank has announced that it has provided some liquidity to support financial institutions “in prudent need.” As a result, the SHIBOR rate has lowered substantially. The relatively tight liquidity may still exist for some time, but it seems that its peak may be behind us.

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