The recent spike in interbank lending rates began in late May after a combination of factors caused a liquidity shortage. The monthly average overnight rate stood at 2.9 percent for April but rose to 6.4 percent for May. In particular, companies sought to pay taxes at the end of May and banks rushed to meet regulators' reserve requirements, leaving them with less cash on hand. Meanwhile, the lead-up to the Dragon Boat Festival, a national holiday that closed markets from June 10-12, spurred consumers to withdraw deposits, further squeezing banks.
In addition to these seasonal factors, the central government's attempts to rein in the high rate of credit expansion also contributed. In February, the People's Bank of China started reducing liquidity injections, and as rates rose in early June it mostly refrained from softening this stance. Meanwhile, in early May, the State Administration of Foreign Exchange issued new measures against falsifying trade data in order to import funds illegally, a move that brought down reported export volumes and foreign exchange inflows.
A similar confluence of factors led to a spike in interbank rates during roughly the same period in 2011. But this time around the consequences have raised greater fears. On June 6, China Everbright Bank, the country's 11th-largest lender, defaulted on a 6 billion-yuan ($980 million) loan repayment to Industrial Bank Co. The default allegedly caused Industrial Bank Co. to default in turn, and various news reports have suggested that other banks also may have defaulted on loans, though this is unconfirmed. On June 7, the central bank allowed more cash to flow into the interbank market as previously scheduled, providing some relief for strained banks, though it did not take any additional actions. The cash crunch manifested elsewhere when the Ministry of Finance and state-owned Agricultural Development Bank failed to sell all the bonds offered in recent auctions, occurrences that, though not unprecedented, are rare and reflect the liquidity shortage. The Agricultural Development Bank has scaled back upcoming bond sales as a result.
These recent events point to the rising financial trouble in China, where debt levels have rapidly grown as a result of the investment-driven economic model and the post-financial crisis drop in export growth. Bank failures are rare in China, where state entities step in quietly to prevent panic and ensure stability. For examples one must look to the last banking crisis in the late 1990s, though the failure of a rural credit cooperative in Jiangsu in 2012 points to the recent rise in risk. Recently, for instance, China Securities Journal claimed that the total credit in China's system may add up to 221 percent of gross domestic product, far above officially reported figures.
The size and rapid growth of China's credit expansion is coupled with the murkiness of the details about the lending — the well-documented explosion in shadow banking and the huge growth in financial instruments such as wealth management products that deliver high returns but that regulators say are based on unclear or illiquid assets. Financial analysts have recently raised alarms about the dangers of this informal lending spree — Fitch Ratings, Societe Generale and others, including Stratfor sources, have all warned of these recent signs that the debt buildup may finally have reached a point at which growth rates cannot sustain it. The Chinese central government's attempts to clamp down on lending channels reveal it is aware of the risks.
It is too early to tell whether the latest cash crunch is the harbinger of an immediate descent into financial turmoil. First, at the moment there does not appear to be contagion from the Everbright default or other rumored defaults. Second, the fact that the recent liquidity shortages resulted from central government tightening policies suggests that easing those policies can alleviate the problem for a time. The central bank has large reserves with which to fight fires (about $3.44 trillion in foreign exchange reserves), though clearly it fears that the speed, size and opaqueness of recent years' credit expansion could lead to an unmanageable chain reaction. Third, Everbright itself is a chronically troubled bank — one that received a bailout as recently as 2007 and is mostly owned by an arm of the Ministry of Finance, Central Huijin, which is increasing its stake — and therefore its default does not seem to have created the kind of shock that the default of a supposedly healthy bank would have done. Nevertheless, its failure to repay is just the beginning — there are numerous other small- and medium-sized banks that are more highly leveraged than Everbright and more heavily exposed to innovative products with unknown risks.
The cash squeeze is expected to continue at least through June and July as a result of accounting practices at the end of the first half of the year and expectations that the central government will maintain tight policies on credit, not to mention other factors that could encourage capital outflows, such as the U.S. Federal Reserve reportedly considering halting its quantitative easing policies. Given the underlying factors of high leverage, slowing growth and tight government policy in a new administration that must prove its resolve in executing tough reforms, the conditions are ripe for further troubles among poorly managed banks.
At the moment, China's cash crunch resembles that of 2011 and seems mostly policy-driven. But the situation merits close attention. Stratfor has long called attention to the hidden debt eating away at the core of China's economic model, the debt surge after the global financial crisis and the constraints on Beijing's attempts to transition to something more sustainable. If more bank defaults occur and the central bank refuses to provide support, or if the central bank eases policy and bank troubles continue unabated, then authorities could soon find themselves overwhelmed. China's poor financial fundamentals point to increasing turmoil sooner or later.
Editor's note: An earlier version of this analysis misstated the name of the Agricultural Development Bank.
