Societe Generale SA (ADR) (OTCMKTS:SCGLY) (EPA:GLE) in a recent report noted that there can be no other ending to China’s massive credit misallocation than a painful  burst.

The question is when will it start  unwinding  and  at  what  pace.  Given  the control  that  Beijing  has  over  the  economy  and  financial system, the answer lies more with the political willingness and/or policy (mis-)calculation, at least at the beginning of the  process.  Beijing’s  tough  stance  on  the  ongoing episode of  interbank  liquidity  tensions  shows  that  the willingness  is  finally  here,  although  the  aim  is  still  to engineer  a  gradual  burst.  Whether  or  not  Chinese policymakers  will  be  able  to  pull  off  a  controlled  burst, more  negative  events  will  follow,  including  corporate failures,  nonperforming  loans  and  bond  defaults.

Slew of policy-tightening measures


Factors Behind China’s Liquidity Squeeze

There are several seasonal factors behind the squeeze in China, including corporate income tax payments, banks’ dividend payouts and reserve requirement. However, Societe Generale SA (ADR) (OTCMKTS:SCGLY) (EPA:GLE) thinks the persistence and the surprising degree of the tension has more to do with the slew of policy-tightening measures from Beijing on cross-border arbitrage flows, wealth management products and the bond market.

These measures are designed to limit the supply of easy liquidity  from  the  interbank  market  for  speculative  uses and  risky  shadow  banking  activities.  Market  participants were  clearly  unprepared  for  such  a  tough  stance  and have  been  slow  to  adapt.  By  offering  limited  relief,  the PBoC  is  forcing  lenders  to  swallow  the  bitter  pill. Therefore,  this  episode  of  tension  is  largely  an  intended experiment by policymakers.

Smaller banks more dependents on Interbank Funding


China Banking System Risk

In terms of banking system risk, smaller banks are certainly more vulnerable. Faced with fiercer competition and fueled by big ambition, they are more aggressive in cooperating with shadow institutions to expand their off-balance-sheet  borrowing and lending, a significant amount of which involves interbank activities.

True, these banks are always  on  the  receiving  end  of  interbank liquidity,  but  such  reliance  has  increased  significantly since  last  year.  Now  the  share  of  interbank  funding accounts for 12 percent of small and medium-sized banks’ total funding, up from 6-8 percent previously.  Also because of this, non bank credit  growth  should  suffer more than former lending.

Societe Generale SA (ADR) (OTCMKTS:SCGLY) (EPA:GLE) expects liquidity conditions to stay tight through the second half of 2013. They see credit growth falling from 25 percent year-over-year (YoY) to 16-18 percent YoY and expects non-bank credit growth to slow from 50 percent YoY, to about 30 percent.

Can China Avoid The Least Desirable Path

The  surprisingly  strong  stance  of  policymakers  supports Societe Generale SA (ADR) (OTCMKTS:SCGLY) (EPA:GLE)  long-held  view  that  the  new  leadership  is  poised  to tackle  the  economic  imbalance  head-on  and  the assumption that the central government will come to the rescue at the first sight of trouble will not hold.  Reducing credit and other resources to the inefficient part of  the  economy  is  a  necessary  condition  for  China  to unleash further growth potentials, so as to avoid the least desirable path similar to Japan’s lost decades.

Financial Crisis In China

However, doing the right  thing is  also  growth  negative in the near term.  Inefficient  corporates will fail, bond  defaults  will occur, and  non-performing  loans  will  rise.  Current interbank  liquidity  tensions  probably  just  mark  the beginning of a period of rising financial volatility.  The  risk  of  a  systemic  financial  crisis  in  China  is  still manageable in 2013, but will rise steadily going forward. Then the chance of achieving a controlled burst hinges on whether Beijing is able to liberalize the real  economic sectors  sufficiently  and  in  a  timely  manner,  by  reducing the state’s dominance and reforming the fiscal system.