China’s Liquidity Finger Trap

China’s markets may look a bit stinky right now, but the global bull market should continue. Photo by ChinaFotoPress/Getty Images.

Chinese stocks continued their bumpy ride Monday, with the Shanghai Composite Index falling over 5%. The index is now down over 15% for June, and investors are jittery over a spike in interbank funding costs, which fueled rumors of a credit crunch. But tight interbank funding appears more of a political issue than economic, and a close look suggests it should prove temporary. The financial system and economy may feel some growing pains, but Chinese troubles shouldn’t derail this global bull market.

China’s issues stem from a huge credit expansion. Total financing grew roughly 52% y/y from January through May. Most of that increase came outside traditional bank lending, in what’s known as shadow finance—a spooky-sounding term for common products like commercial paper, corporate bonds and other off-balance-sheet lending vehicles. The latter comes primarily through “wealth management products” (WMP), which Chinese banks offer as a high-yielding alternative to traditional deposits, which fetch artificially low interest rates. WMPs generally have a high degree of illiquid underlying assets and are widely assumed to be over-concentrated in nonperforming local debt.

Many WMPs mature and are rolled over every three months, and several come due in late June/early July. Chinese banks depend heavily on wholesale financing, so when the overnight Shanghai Interbank Offered Rate (SHIBOR) jumped above 7% last week, some folks feared banks wouldn’t be able to raise enough cash to roll over maturing WMPs, causing the supposed credit bubble to burst—China would have a Lehman moment. But that’s a very low probability, in our view. China has $3.4 trillion in foreign currency reserves, and its financial system is closed and entirely state-run. The government has ample firepower to rescue banks when necessary, as it has many times in the past.

Yet some observers suggest this time is different, as China’s central bank (PBOC) has so far resisted banks’ requests for huge liquidity injections. A PBOC statement issued last week said liquidity appeared “reasonable,” suggesting huge cash influxes aren’t in the offing, and essentially told the banks to clean themselves up. In our view, this is more likely a political ploy than a paradigm shift—which likely makes China’s supposed funding squeeze temporary.

For months, officials have telegraphed concern over rapid credit expansion and the quality of loans in WMPs. Though they deliberately expanded shadow financing last year, it didn’t happen the way they intended. They wanted to improve small- and mid-sized firms’ access to credit so the private sector could become China’s economic engine—and since state-run banks wouldn’t lend to private firms, they had to open other channels. But when the government failed to define legitimate private lending, private firms remained credit-starved, while local governments (and the corporations they run) received and deployed huge sums on infrastructure projects. The government has largely classified these projects as “unapproved,” and most suspect they’re unprofitable—a not-so-great addition to municipalities’ already sizeable debt load.

Plus, officials still want to maintain some control over money supply—something they've historically accomplished through strict loan quotas. But they can't cap shadow financing the same way they could cap state-run bank lending, so they have to find other ways, like stricterregulations,to tighten the reins. In March, the government announced new WMP rules, including stricter caps on illiquid investments and higher quotas for bonds and money-market funds. Banks have until yearend to comply, but since the new rules likely diminish WMPs’ returns (and, hence, banks’ potential profits), they’ve been rather slow to act. By letting SHIBOR spike and showing banks the potential consequences of runaway off-balance-sheet lending, the PBOC’s sending a clear message: Lending off balance sheet willy-nilly has consequences. If banks aren’t more judicious, the PBOC won’t support them with unlimited liquidity. It’s a shot across the bow.

At the same time, officials understand maintaining financial stability is tantamount to maintaining social stability. They have every incentive to relax once they’ve made their point. In fact, they’ve reiterated their commitment to moderate credit expansion and intervened with some small targeted liquidity injections in recent days, which has helped ease some of the strain. That strain should ease further after June 30, as banks have hoarded cash in order to meet quarter-end capital requirements.

In short, we expect interbank funding pressures to wane in the near term. However, we wouldn’t be surprised if credit tightened from here. Officials have been very vocal about their plans to shift the economy away from export- and infrastructure-led growth and toward domestic consumption and services. That likely means urban developers don’t get as much easy money looking forward—the days of directing savings into infrastructure projects with a high ROI are numbered. Growth likely slows, too—officials can’t pull levers to get fast service sector growth the same way they could to get faster infrastructure-led growth. Instead, they have to free the financials system to allow capital to flow to private businesses, which requires surrendering economic control and accepting slower growth over time. It also requires creating a transparent system with clear, well-enforced rules and property rights—likely a very long process that sees a good deal of give and take. The government has lowered the growth target to 7% for the next 10 years—and officials think even that might be difficult to maintain.

However, that slower growth is likely more sustainable growth. It means China’s moving to a more market-oriented system—a long-term positive. Moreover, global markets don’t need gangbusters Chinese growth to continue advancing. Even with a slower growth rate, China still contributes a ton to global trade and GDP. Volatility could very well continue in the short term as investors chew over a potentially less accommodative Chinese government, but many other drivers, like a robust US private sector, should continue pushing global stocks higher over time.