After the liquidity crunch

The standoff between the People's Bank of China and China's banks, and the resulting "liquidity crunch", has far-reaching implications for credit and liquidity, financial stability, monetary policy and the economic outlook. The potential for broad impact was underscored when the stock market witnessed a "black Monday" on June 24 partly because a June 23 statement of the PBOC suggested a continued hard-line stance, before some relief was provided by a more accommodating June 25 statement.

The liquidity crunch on the inter-bank market largely resulted from a misunderstanding between the markets and the PBOC about the central bank's policy and implementation.

The misunderstanding arose because concerns among some policymakers about too rapid credit growth and financial risks, suggested a need for tighter policy at the same time as lower economic growth called for easier policy. Given the tighter conditions and remaining uncertainty, the inter-bank market is likely to remain tight and nervous in the coming weeks, with repayment risk being sizeable. Even though the inter-bank market should normalize gradually after that, the banks will probably become more prudent with lending and liquidity going forward, and "non-bank" lending activity and mid-sized banks reliant on wholesale funding are likely to be especially affected.

We may well see some defaults on inter-bank loans and/or other repayment obligations in the coming months, although it remains highly unlikely that pressures stemming from financial risks would become systemic enough to threaten China's financial stability or the overall economy.

On the growth front, the firmer policy stance in the face of weak data has increased downside risks to our economic growth forecast. In spite of weak recent activity data, the government and the PBOC have signaled that for now they do not want to ease the macro stance, in effect putting considerations of medium-term financial stability ahead of supporting short-term economic growth.

Their resolve may be tested in the coming months if activity data continue to disappoint. We keep our forecast of 7.5 percent GDP growth in 2013 for now, acknowledging the downside risks but also noting some possibly positive news about the US economy.

Since June 13, inter-bank market interest rates rose to uncommonly high levels as liquidity conditions on the inter-bank market tightened. While they have recently come down they are still higher than normal. Several specific factors contributed to the tightness, including a change in timing of corporate tax payments, strong liquidity demand around the national holiday (Dragon Boat Festival) and the impact of measures taken in May to clamp down on financial capital inflows. The turbulence in international capital markets after indications of possible QE3 (third round of quantitative easing) tapering in the US added uncertainty, even though fundamentally China is not really vulnerable to this shifting flow.

Despite these factors affecting liquidity, China's banks apparently extended credit quite aggressively at the beginning of June. They might have assumed that the PBOC would accommodate this by injecting more liquidity in the inter-bank market, given the sluggish economic growth and calls for an easing of the macroeconomic stance. However, it turned out that the PBOC did not want to be accommodative. It seems that the PBOC wants to stick to its existing quantitative targets, and have the banks stick to their credit quotas and contain expansion of the "non-bank" financial sector. As a result, the PBOC has initially abstained from providing more liquidity.