Lending between banks in China almost ground to a halt last month, as money market rates rose to record highs of 25% and the People’s Bank of China (PBOC) refused to turn on the taps to add liquidity to the system. Some feared a credit crunch comparable to the aftermath of the Lehman Brothers crisis in 2008. However, with the stock market sliding, the PBOC performed a volte-face and began to inject funds to ease the crisis. Looking at what this means for the future of China’s banking system, Liao Min writes:

For us here in China, the cash squeeze was not considered a sudden shock or a “black swan” event,  it was merely a one-time event within the money market, aimed at urging the local commercial banks to adjust to a changing market, and to upgrade their liquidity management mechanisms.

The trigger for the market turmoil was the PBOC’s hard line, as it refused to give commercial bankers the unending amounts of liquidity they were seeking. But its more fundamental cause lies in commercial banks’ incapability of managing liquidity in an evolving financial market, where the business models and the rules of the game have changed.

Previously, the central bank would inject money into the market in most cases of stress, providing relief to the interbank funding market. And in the case of China, it has been more than ten years since the last major cash squeeze, so commercial banks seemed to consider the phenomenon a thing of the past. With such belief in mind, the banks’ inter-bank assets, particularly for small and medium banks, had ballooned, exposing them to large maturity mismatches. And over the past year, the growing wholesale inter-bank market has been regarded by most small and medium banks as a new, ever-lasting source of liquidity.

I believe the move by the PBOC was the correct one. Given the commercial banks’ shortcomings in liquidity management, the country’s rapid credit growth and the decline of the newly issued Yuan to purchase the foreign exchange that has entered into China, the move was warranted to avoid possible future risks to the system. The retreat of capital inflows is partly due to signs of an exit from quantitative easing (QE) in the US. This move, together with its impact on capital flows and on China’s money supply, should come as no surprise to Chinese banks, but unfortunately bankers failed to detect or did not pay sufficient attention to the implications for their liquidity risk management.

The temporary disruption of the inter-bank market may cause some pain, but it is unlikely to become a systemic crisis in China’s financial system. Pressure on the market has eased as the rate has declined over recent days. The stock market slump both at home and abroad was an exaggerated and temporary reaction.

A deleveraging process is sure to accelerate in both China’s commercial banks and shadow banking system. This is a positive development in the long run. To correct financial imbalances in China, the central bank has an effective toolkit including the inter-bank lending rate, reserve requirement ratio and the ability to set interest rates. The China Banking Regulatory Commission (CBRC) has also been strengthening the firewalls between the regular commercial banking activities and the shadow banking market. Both the PBOC and the CBRC have enhanced their monitoring and regulation on shadow banking activities, including trust products, wealth and asset-management products.

By integrating both micro and macro prudential regulation, the PBOC and the CBRC are attempting to strike a balance between financial stability and economic growth, and between deleveraging and supporting economic growth. The current policy could prove effective for China to go from a “credit and investment” model of growth, to a more sustainable one backed by domestic demand.

However, certain risks remain. Through the channels of shadow banking, money may go to industries where overcapacity exists, or those of high pollution, or those consuming excessive resources. Small and medium enterprises may have less access to credit. External demands are hard to recover amid the uncertainty of sustainable global recovery. Commercial banks’ mindset and skill set may fail to keep up with the changing structure of financing.

Growing too fast can hurt more than it helps. Because of the process of urbanization and industrial upgrading, China, with its growth in excess of 7%, is very likely to be among the least impacted emerging economies when the withdrawal of global monetary easing begins. And China will most definitely remain the most attractive destination for long-term international investment, so long as a stable environment, clear expectations and higher economic and financial transparency are offered to the rest of the world. This one-time disruptive event in China’s money market has brought about more psychological impact than effects on capital flows and the real economy. Although China would pose a real threat to global finance if its economy continued to slip into significant recession, this is in my view highly unlikely. I’m sure that in the next 10 years, China will remain one of the relatively fastest growing economies in the world.

Author: Liao Min is a Director-General, Shanghai Office of China Banking Regulatory Commission and member of Global Agenda Council on the Global Financial System

Image: a black swan is seen in flight REUTERS/Daniel Munoz