Credit Crunch

Last June， a sudden credit crunch swept across China’s commercial banks， which had been unaccustomed to funds drying up. The liquidity squeeze in the banking sector was best evidenced by a sharp spike in interbank offered rates. On June 20， the Shanghai interbank overnight rate， a benchmark for interbank borrowing costs， climbed to a record high of 30 percent， while 7-day repurchase rate hit 28 percent. Over recent years， both rates almost always remained below 3 percent. The frantic day has become a worthy note in China’s banking history.

Reasons behind Crunch

Along with the bond market， the panic caused by the credit crunch also spread to the stock and gold markets. On June 24， the Shanghai Composite Index plummeted 5.3 percent to 1，963， its biggest single-day fall in four years. China’s gold futures market also closed after a precipitous drop.

Analysts attributed the crunch to a variety of factors. China’s regulation of the foreign exchange market resulted in a drop in foreign exchange inflow in recent months， while the quantity of bank loans rocketed in past months， causing a shortage in cash just as mid-year inspections approached at the end of June. Statistics show that in the first ten days of June， incremental bank loans climbed to 1 trillion yuan， and half of China’s 24 major commercial banks granted greater totals in loans than they issued in May. A mixture of such factors resulted in great liquidity pressure.

Another factor that led to the June 20 panic was that expectations for easing of monetary policy are constantly left unfulfilled. On June 19， an executive meeting of the State Council passed a decision to“revitalize current financial resources to support the real economy.” Almost simultaneously， the central bank urged commercial banks to “make full use of incremental funds and revitalize stock assets.” Both developments disappointed investors who expected the government to lend a hand， resulting in widespread panic across financial markets.

Commercial banks had grown accustomed to the central bank lending a hand in cases of liquidity squeezes. This time， however， the central bank didn’t swoop in to play savior， but rather further reduced liquidity by issuing 2 billion yuan in central bank bills on June 20. Later， on June 24， it urged commercial banks to control the risk associated with credit expansion and manage their liquidity.

Some analysts deem the central bank’s moves a signal that it wants commercial banks to pay for past mistakes. To cushion the impact of the global financial crisis in 2008， China unleashed a monetary stimulus package aiming to prevent the economy from being dragged down. The government-led credit boom has been a key contributor to China’s economic growth in recent years. However， an explosive credit boom brought increased risk， especially when a large portion of loans went into real estate and finance sectors instead of the real economy.

The central bank’s attitude toward the credit crunch reveals that China’s decision makers are looking to rein in excessive bank lending， especially in the sector of shadow banking （all non-bank financial institutions providing trust loans， private funds， private financing， hedge funds， etc.） to prevent financial bubbles.

Professor David Daokui Li from the School of Economics and Management of Tsinghua University notes that the credit crunch evidences how urgently needed financial reform has become. “Over the past few years， China’s financial institutions saw rapid expansion， which was coupled with considerable quantities of hidden bad assets，” he explains. “A restructuring process is required to revitalize funds， or the destructive spiral of banks filling in fund vacancies caused by bad loans with new loans will continue.”

“The bright side of the sharp lending rate hike in the monetary market is that it warned Chinese banks to reform their business modes，” remarked Zhou Xiaochuan， governor of China’s central bank， at the 2013 Lujiazui Forum at the end of June in Shanghai.

Likonomics

From a deeper perspective， June’s credit crunch reflects the Chinese government’s stance on economic reform. According to Chris Leung， a senior economist with DBS Bank Greater China Region， the recent measures taken by China’s central bank and supervising authorities all aim to reform the economic structure and indicate that the government is willing to endure short-term pain for long-term gain.

Over the past months， the central government hasn’t taken any stimulus measures despite surging calls from various sectors. This is because it has deemed that stateled investment cannot lead to sustainable growth. Last May， Chinese Premier Li Keqiang stressed in a telephone conference， “Limited room is left for the country to achieve this year’s growth goals through stimulus policies and government investment. We must depend on market mechanisms.”

British investment bank Barclays Capital even coined the term “Likonomics” to describe China’s likely economic path under a cabinet led by Premier Li Keqiang. Avoidance of stimulus， deleveraging， and structural reform have been identified as the three key“pillars” of Likonomics.

In its report， Barclays concluded that although two of the three pillars of Likonomics – “stimulus avoidance” and“deleveraging” – are likely causing China’s current suffering， they remain crucial pieces of the country’s structural reform. Likonomics is just what China needs if it wants to achieve sustainable development and maintain a 6 to 8 percent annual growth in the coming decade.

When China’s central bank began to provide liquidity support for some financial institutions that qualified， the interbank rate dropped back below 5 percent. The panic stirred by the credit crunch faded away， yet concerns about China’s future economic reform continue to grow.