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Beijing’s crackdown on shadow banking sunk global markets in late June. Here’s what you need to know.
HONG KONG — A credit crunch in mainland China sent markets reeling this week.
Banks were suddenly clamoring for cash. As a result, the interbank lending rate spiked, making it very expensive for banks to borrow, adding to the likelihood that they won’t be able to pay their bills. It’s a risky situation that could expose economic weak spots and potentially trigger loan defaults.
The crisis could have been eased had China’s central bank agreed to pump additional liquidity into the economy. But the People’s Bank of China brushed off pleas do so, apparently to crackdown on excessive lending that has dramatically increased the price of assets like real estate.
After years of allowing easy credit to slosh through the economy, it seems Beijing is finally ready to put the brakes on risky lending and cut down on bad debt.
Why is this happening now, and what’s the likely outcome?
GlobalPost called Professor Zhigang Tao, associate dean of the Faculty of Business and Economics at the University of Hong Kong, to make sense of China’s sudden credit squeeze.
This Q&A has been condensed and edited by GlobalPost.
What exactly is happening?
[In China], the interbank lending rate is the rate that smaller banks pay to the bigger banks for loans. As this rate goes up, that indicates there is a shortage of credit.
[This week, the rate soared as high as 28 percent for a single trade, with a weighted average of more than 11 percent on June 19.]
What’s the background?
The bigger picture is that China has been maintaining a low interest rate environment. In reality, China should have a higher interest rate. If you look at the economic growth rate in China it is much higher than the rest of the world.
Macroeconomics tells you that when you have a high growth rate, you should have a higher interest rate to cool it off. Whenever you have this low interest rate policy, the demand for loans is very high.
[To prevent the economy from overheating], the People’s Bank of China sets a loan quota. The bigger banks — which are generally state-owned enterprises — get much bigger quotas than the small banks.
The smaller banks are marginalized, but they have been very creative in making wealth-management products, which effectively borrow money from big banks at a low interest rate, and then lend it to corporations at a high interest rate.
Small banks are the middleman. This is shadow banking.
What caused the credit squeeze?
The People’s Bank of China has a regulation on how much you can lend depending on how much [reserves] you have. Every year there are two dates at which they have to report their loan amount and deposits data to the PBOC. One is at the end of June, one is at the end of the year.
It’s this part that’s tricky. The small banks may have lent out a lot of money, but they don't have a lot of branches, so they don't have a lot of deposits. To make up for the shortfall, they borrow from the interbank lending system to cover themselves for the next 10 days.
Why is this happening this year?
It’s just a continuation. Two years ago the same thing happened — there was a spike in the interest rate.
The PBOC has been really stringent in enforcing its policy. They want to deal with this real estate bubble, because they are worried about asset bubbles. And they don't want shadow banking.
What’s the problem with shadow banking?
The PBOC has been really cautious about shadow banking for two reasons.
One, much of these wealth management products is based on investment in the real estate market, which is risky because [prices have soared and] the Chinese government realizes this could be a bubble.
The other reason PBOC doesn't like shadow banking is that it’s below the radar. Basically PBOC can’t figure out where you really invest, where you really lend. So the PBOC may be tough this time to teach these small banks a lesson, to say “you guys shouldn’t take so much risky investment.”
This crackdown is causing volatility in global markets. Is it a good idea?
Basically I think it’s right, but maybe the measure is too drastic.
It sounds very scary but look, small banks, they just need to borrow money for 10 days [i.e., until the end of June]. In the worst case, a small bank could say, “I don't have enough deposit compared to my loans. What will the PBOC do? What will the punishment be?
Maybe the chief executive will be replaced. But it’s hard to see a series of defaults in China.
What’s likely to come of this?
In the long run, I think it’s good news because China got into this situation precisely because the rest of the world economy is in bad shape, and China is doing well, and China has to spend a lot of effort to deal with this hot money. Now this problem will be disappearing.
What are the Chinese government’s best options in this situation?
I think they understand the extent of the problem [with shadow banking]. And they are taking measures to address this. Ultimately, the government is rich and I don't think this is going to be a very serious problem given that they’re already paying serious attention.