What you need to know about China's credit crunch

It is getting uglier.

According to UBS analyst Tao Wang, over the past 10 days, China’s short-term interbank interest rate rose to near record highs, coming down only somewhat in the last couple of days. The market now expects liquidity tightness to last a few weeks longer and rates to remain significantly above the pre-June levels.

We think the drop in FX inflows in May and the holiday demand as well as unseasonal tax-related liquidity demand in early June can explain only part of the recent liquidity tightness. The rest can be explained by banks’ aggressive credit expansion in early June and the PBC’s decision to not backstop banks’ every demand for liquidity.

Here's more from UBS:

Banks have perhaps misjudged the PBC’s policy direction earlier. With the economic data disappointing and inflation low, many in the market had expected the PBC to keep liquidity flowing or ease monetary condition further. However, with the central government apparently more tolerant for slower growth and concerned about financial risks, the PBC seemed to be keen to keep a “prudent” policy stance.

The central bank did not carry out reverse repos or initiate short-term liquidity operations as many expected when rates shot up and even faced with a reported case of near default in the interbank market. After the holiday ended last Thursday, PBC again surprised the market by not actively injecting liquidity. By now, market expectation of a quick return to “normal” abundance of liquidity has diminished.

The PBC has made it clear in the past 10 days that overly-rapid credit expansion would not be accommodated and banks may have to scale down their credit growth plans and manage their own liquidity more prudently. Moreover, regulators are reportedly preparing steps to clean up interbank activities – some banks have used interbank transactions with banks and non-bank financial institutions aggressively to fund their lending or offload their loans – which could cause some unwind of such activities and lead to additional liquidity tightness.

We think the PBC is right in trying to rein in credit growth and warn banks to properly consider liquidity and counter-party risks. We also think the regulators would be right in cracking down on reckless interbank- and other type of regulatory arbitrage through which banks increase leverage, hide loans, bad assets and risks. These actions would force banks to either increase risk weighting, which consumes more capital that they may not have, or more likely, bring some of the off-balance sheet credit onto the balance sheet and crowd out other loans. Managed well, such actions should lead to a gradual slowdown in credit expansion and a reduction in financial risks.

How much might credit be affected? For example, our bank analyst Irene Huang estimates that about RMB 2-3 trillion in bank credit may have been hidden in various interbank assets. If half of the credit were to be brought back to the balance sheet this year, this could lead to a drop in new credit by 1-1.5 trillion. As a comparison, total social financing (TSF) increased by almost 16 trillion in 2012 and 9 trillion in the first five months of 2013. In other words, with proper policy actions, China may well be able to keep TSF increase at about 16-17 trillion this year, which would mean keeping TSF growth at about 17-18% y/y, still sufficient to support a nominal GDP growth of 10% but slower than the 20% pace in 2012 and 22-23% pace so far.

But can this be managed smoothly or will it lead to a credit crunch and jeopardize this year’s growth, or worse, triggering a mini crisis? In our earlier research this year, we had pointed out that a high probability risk this year would be a liquidity crunch resulting from regulatory tightening or unstable funding in shadow banking.

We think the risk of a credit crunch has definitely increased over the past two weeks. While overall liquidity is still abundant, and the PBC still has a lot of tools to use if it deemed necessary, accidents could happen in the process of changing liquidity provision or cleaning up interbank activities. This is especially so when much of the credit expansion so far has been hidden off balance sheet and often under multiple layers of transactions, liquidity is unevenly distributed, and interbank transactions have made the system highly linked. Therefore, the central bank and other regulators must tread very carefully in the coming months in managing the process to try to minimize the risk of unexpected break in the liquidity chain or unwanted credit crunch.