China Center Quick Note: What have we learned? Longer-term implications of China’s recent liquidity crunch

This China Center members-only quick note looks at June's events in the interbank bond market that led to a spike in interest rates and outlines the implications for the banking system and the real economy moving forward. We also outline some lessons that the markets and regulators have likely learned.

Now that the dust has begun to settle, our key takeaway from June's interbank interest rate spike is the realization of just how difficult it will be to introduce discipline to the banking system in a gradual, controlled manner. We assert that the PBoC was to a large extent caught flat-footed – engineering the event to some degree, but miscalculating the strength of liquidity demand due to a confluence of factors. The event highlights the probability that liquidity pressures are likely to continue spiking at various seasonal pressure points. It also calls into question the extent of authorities’ true control over the banking system, particularly in times of stress. Indeed, last week the guards seemed captive to the inmates.

To the point:

• The interbank crisis of the week of June 17th was significant and acute
• It will have a lasting impact, particularly as many factors that caused it are unresolved
• Liquidity needs will remain elevated through much of July
• Future liquidity bottlenecks may worsen if interbank issuance grows apace
• The risks of policy error are real and acute
• Weaning the economy (and banks) off its leverage addiction may be a volatile affair

Members should closely monitor the overall monetary policy stance going forward. Unfortunately, the PBoC seems to have hedged somewhat with its most recent statement that it will provide liquidity to banks that “support the real economy”. If it wants to gain the credibility to tighten, it will have to tow a harder line.

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