Shadows grow over China's banking stability

Spiking interbank lending is another indicator of the depth of China's banking troubles and will complicate the new leadership's attempts to rebalance the economy.

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The People's Bank of China released a statement June 24, though it was dated June 17, addressing the liquidity shortage that caused interbank lending rates to spike during most of June. The central bank claimed that the banking system's general liquidity level remained "reasonable" but that changes in financial markets and the need to tidy up books at the end of the first half of the year led to higher requirements, causing the liquidity squeeze.

The statement went on to warn commercial banks to better prepare to meet tax payments and reserve requirements. It also warned them to manage credit expansion at a time when the government intends to maintain "prudent" monetary policy and "steady and moderate" monetary and credit growth. Last, it warned against letting deposits fall too low.

The central bank has been heavily scrutinised amid the recent disturbances in interbank markets because the banks, as well as many investors and commentators, have called attention to its hesitancy to inject liquidity into the system to reduce the shortages. When the central bank finally took action last week by acting as lender of last resort past normal working hours and by providing special loans to particularly troubled lenders, interbank rates subsided from last week's record highs. The June 24 statement will reinforce the view that policy will remain tight and interbank rates elevated, but that banks will calm down somewhat in July as the scramble to meet half-year deadlines ends and as a number of central bank bills mature, sending cash back into the system. The People's Bank also says it will play a "stabilising" role.

But even if interbank rates fall during and after July, the showdown between the central bank and the rest of the banking system points to bigger risks and challenges.

Rumours surfaced in the Chinese media last week that the central bank provided emergency assistance worth "less than" 400 billion yuan (about $65 billion) to two of the Big Four state-owned commercial banks: Bank of China and Industrial and Commercial Bank of China. If accurate, these rumors show that the cash shortage is by no means limited to medium-sized lenders like Everbright Bank, whose Shanghai branch defaulted on a six billion yuan loan on June 6. The Big Four form the backbone of China's financial system. A bailout for two of them illustrates the central bank's willingness and ability to intervene to prevent widespread contagion. However, it also suggests that the entire system is severely strained.

Moreover, focusing on matters within the central bank's control, such as liquidity injection, directs attention away from smaller signs across the country over the past year that businesses in various sectors, along with the shadow loans tied to investment projects, have been failing:

– October 2012: Jiayue Co, a leading real estate company in Zhanjiang, Guangdong province, and dozens of connected firms went bankrupt, leaving about 6.1 billion yuan in debts unpaid.

– October 2012: Chenyang Rural Credit Cooperative in Sheyang County, Jiangsu province, suffered a rush on deposits after a credit guarantee company was shut down for illegal lending. The Sheyang County government forced the company to sell 25 million yuan in assets to pay depositors.

– December 2012: Citic Trust Co, an division of China Citic Group, delayed payment on one of its trust products after a steelmaker, Three Gorges Quantong, missed a 74.6 million yuan payment. Eventually the city government in Yichang, Hubei province, paid one billion yuan to support Quantong, which is now said to owe seven billion yuan to several banks because of a failed wealth management product.

– January 2013: Huaxia Bank in Shanghai failed to make an interest payment on a 140 million yuan wealth management product, according to a high-profile report by Caixin. The chief borrower collapsed after embezzling the funds lent, but the company that guaranteed the product, Zhongfa Investment Guarantee, paid back investors.

– Various other defaults on loans or wealth management products have occurred. Jilin Trust defaulted on a 150 million yuan trust product, as did unnamed companies in Ordos, Inner Mongolia, where excessive housing construction has led to overcapacity. China Communication Bank also saw the failure of a wealth management product.

– Reports in Chinese media suggest that privileged state-owned enterprises have increasingly begun defaulting on payments owed to small- and medium-sized companies, which have little recourse.

From these incidents – and several other rumoured events, including the most recent troubles among large banks – it appears that the rapid and vast expansion of shadow lending is unraveling, at least to some extent, under the pressure of China's economic slowdown and rebalancing reforms. The highest risk areas are joint-stock banks and other banks most exposed to wealth management products (13 trillion yuan total) and trust products (more than five trillion yuan total), plus the credit guarantee companies and banks that remain liable when such products fail and the hierarchy of local governments that are forced to bail out failed companies and banks. Ultimately, these risks even threaten the central government, since large banks can be affected and local governments themselves, which are often struggling with debt levels well above 100 per cent of revenues, may prove incapable of handling local crises.

The central government has extensive resources and plenty of room to lower reserve requirements or take other actions to ease policy. It could moderate its recent attempts to crack down on high-risk financial products and illegal capital inflows, though it will not want to backtrack unless circumstances force it to do so. Nevertheless, the emergence of problems among core institutions raises substantial fears that the sheer magnitude of China's credit boom since 2009 has produced systemic risks that could spiral out of control for even the best prepared and best equipped governments. Even in a less precarious scenario, the new pressure on banks to reduce risky lending, shore up their reserves and plan for the longer term will translate into less credit for the non-financial economy. Already Chinese reports suggest that small- and medium-sized banks have begun to scale back some preferential low interest rates for buyers of real estate, portending a broader impact. 

The State Council, which controls the central bank and is responsible for the government's general drive to tighten controls on the economy for the purposes of reform, will be challenged by the risk that a combination of its actions and weakening international growth could spoil too many investment projects, causing more defaults on unconventional loans tied to underlying assets of unclear value. Thus, even if interbank rates fall back to more normal levels in July or August, the gradual enervation of China's financial system could well continue, greatly complicating the new administration's bold reform efforts by necessitating more financial intervention.

Republished with permission of STRATFOR.

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