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09/28/2013

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Tight Interbank Liquidity TestsChina's Delicate Dance Between Bank Discipline And Stability
Beijing Contact:
Qiang Liao, PhD, Beijing (86) 10-6569-2915; qiang.liao@standardandpoors.comLiang Zhong, Beijing (86) 10-6569-2938; liang.zhong@standardandpoors.com
Singapore Contact:
Ritesh Maheshwari, Singapore (65) 6239-6308; ritesh.maheshwari@standardandpoors.com
Table Of Contents
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Tight Interbank Liquidity Tests China's DelicateDance Between Bank Discipline And Stability
China's interbank liquidity appears to have dried up abruptly. The weighted average of the overnight borrowing rateamong the country's banks soared to 13.8% on June 20, a jump of 610 basis points (bps) from a day earlier or 1,050 bps from a month ago. The rate eased to 9.0% on June 21 but still remains high. Standard & Poor's Ratings Services believes that the spike in costs mainly stems from the central bank's policy stance of curbing some Chinese banks'excessive expansion through wealth management business, and the associated dependence on interbank borrowing forliquidity. Indeed, the People's Bank of China (PBOC) has not intervened to alleviate interbank borrowing rate pressure,as it has done in the past.Despite the short-term volatility in liquidity, the Chinese economy and banking sector continue to have excessiveliquidity. The rapid rise in interbank borrowing rates is likely to be temporary as China's banks will gradually adapt tothe new setting by adjusting their asset portfolios. Furthermore, we believe the PBOC will find a balance betweendisciplining interbank activities and safeguarding financial stability. But such a well-meaning approach, thoughmoderate, could have unintended consequences in the longer term on China's slowing economy, particularly on banks'asset quality and profitability.
Overview
We expect the recent liquidity tightness in China's interbank market to persist toward the end of June 2013,and gradually ease afterward, assuming the central bank continues to play a passive role.
In our view, the PBOC has avoided intervening in the interbank market because the central bank intends tocontain aggressive growth of WMPs as an alternative channel for banks to increase credit disbursal.
We don't expect the currently tight interbank liquidity to significantly undermine Chinese banks as we expectthe borrowing rate to gradually ease.
Tightening Liquidity May Curb Rampant Growth Of Wealth ManagementProducts
The PBOC has been the main actor missing from the action in recent weeks. It has not injected liquidity to alleviate thepressure on the overnight interbank borrowing rate, which has surprised markets considering its past interventionistapproach. This inaction, in our view, is the key reason behind the recent tight interbank liquidity.Nevertheless, a confluence of multiple factors has also played out to tighten market liquidity. These include: (1) slowercapital inflow because of the Chinese government's crackdown on hot money since early May 2013 and a possiblereversal in capital flow since the U.S. Federal Reserve's recent indication to taper off quantitative easing; (2) growingpressure for statutory reserve placement as a high proportion of banks' wealth management products (WMPs) had been structured to mature toward the end of June; (3) periodic transfer of temporary fiscal deposits from commercial banks to the central bank; and (4) rising precautionary liquidity holdings of the whole sector amid PBOC's inaction and
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rumors about some aggressive banks being caught off-guard.While the pattern of capital flows, WMP-related fund flows, and movement of fiscal deposits will affect interbank market liquidity supply/demand, the central bank can always intervene through injecting or absorbing liquidity to limitvolatility in interbank borrowing rates. But this time, the PBOC has so far chosen not to intervene. Why?We believe this is because the central bank intends to contain aggressive growth of WMPs as an alternative channelfor banks to increase credit disbursal. In our view, the PBOC is signaling to the market that it will not endlessly toleratesome banks' reckless liquidity management and overdependence on the interbank market for facilitating their assetexpansion off-balance sheets.The interbank business is a key tool for Chinese banks to manage temporary liquidity demands associated withWMP-related fund flows. Chinese banks use WMPs mainly to shuffle assets and liabilities into or off their balancesheets. This enables the banks to grow assets while satisfying tight regulatory requirements such as a loan-to-depositceiling ratio of 75% and new loan growth quotas. These WMPs are structured so that they will typically mature towardthe end of accounting periods. Banks can then record funds from such WMPs as deposits on balance sheet, enablingthem to meet the loan-to-deposit requirement. Thus we view such WMPs as "deposits in disguise" (see article titled"Why Shadow Banking Is Yet To Destabilize China's Financial System," published March 27, 2013, on RatingsDirect).But the flip-side of this accounting trick is that the banks will periodically face temporary strain in liquidity to satisfyChina's conservative deposit reserve requirement of 20.5%. Banks with thin liquidity buffers on the balance sheet have been relying on interbank borrowing to provide temporary liquidity relief. From a bank's perspective, this solutionmakes more sense than selling down noncash assets because it will issue a new batch of WMPs to replace maturingones. Such issuances will automatically reverse the liquidity need for a statutory reserve placement.Nonetheless, rapid growth in Chinese banks' WMPs and related accounting tricks have obscured a true picture the banks' leverage and raised their vulnerability to adverse shocks in the economy. Growth in interbank exposures has been explosive, more than tripling from that at the end of 2010. Banks are consequently exposed to growing contagionrisks, particularly among small to midsize banks which could be vulnerable to a slowdown in China's economy.
Liquidity Strain Will Ease After A Few Weeks
We expect the tight liquidity in the interbank market to persist toward the end of June 2013, and gradually easeafterward, assuming the central bank continues to play a passive role. In fact, interbank borrowing costs for longermaturities have risen less than overnight rates in recent weeks (see charts 1 and 2). In particular, the three-monthinterbank borrowing rate is relatively stable and there is thin transaction volume for this class. This suggests that: (1)there is not much market concern about liquidity in the slightly longer run (about three months or more); and (2) theelevated borrowing rates are not because of a perception of rising credit risks of counterparty banks.
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Tight Interbank Liquidity Tests China's Delicate Dance Between Bank Discipline And Stability

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