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.