Why China is purposely pushing its banking system to the edge of a crisis

There's been a lot of talk about SHIBOR (China's version of LIBOR) and how it's been spiking lately, indicating that liquidity is very tight in China's banking system.

Rates began spiking before the Dragon Boat festival earlier this month. While rates appear to have peaked, they remain at elevated levels.

The People's Bank of China watched in silence for several days before injecting a targeted 50 billion yuan into markets last week. This inaction from the PBOC made markets very nervous.

But a statement from the central bank last night stating that "overall bank liquidity conditions are at a reasonable level", and that banks should "prudently manage liquidity risks that have resulted from rapid credit expansion," caused the Chinese stock market to hemorrhage.

We previously noted that the central bank was punishing banks that that had taken advantage of stable interbank rates to fund their purchase of higher-yield bonds. And that Chinese policymakers are trying to channel liquidity into sectors that will help drive growth.

"As such, the statement confirmed market speculation that the cash squeeze is being tolerated by the PBoC as a warning to banks to curtail their aggressive lending practices and reduce risky activities in the shadow banking market," according to Stephen Schwartz and Carrie Liu at BBVA Research.

In a new report titled 'China — Doctor Li Keqiang's surgery,' Stephen Green writes that "via higher interbank rates, the PBoC is telling banks they need to source their own liquidity, reduce their reliance on such products [WMPs], and not expect the PBoC to bail them out when they face a cash squeeze."

China's Xi-Li leadership appears committed to reforms and willing to accept slower growth and short-term hits to ensure the longer-term health of the economy.

So the question on everyone's mind is how much of a liquidity crunch will the Chinese central bank tolerate.

"Surgery is meant to cure, not kill, the patient – and while some pain is inevitable, we firmly believe the PBoC is in control," said Green.

The central bank can address a severe cash crunch through various tools. It could reverse repo transactions, cut the reserve requirement ratio, add liquidity through short-term liquidity operations (SLOs), though this tool has yet to be used.

"Immediately there are gonna be convulsions, which they're going to address in the short-term with re-injections of capital," Arthur Dong, professor of strategy and economics at Georgetown University told Business Insider.

"In the longer term the senior party leadership has pretty much sent the signal, and they're sending it through the PBoC as well as through their banking systems, that the day of wine and roses, the days of free and unlimited capital are over."

We previously argued that some of the rhetoric comparing it to the run up in rates prior to the Lehman crisis and the freezing of interbank liquidity in the U.S. are exaggerated. Green also thinks such comparisons are "unhelpful."

'This is not a run on liquidity caused by a credit event. Instead, we believe it is a deliberate policy meant to de-risk the interbank system," he writes.

What's more overall interbank lending accounts for just 8% of total banks' assets and isn't as significant in China as it is in developed markets.

"Also since China's interbank market is not as important to Chinese banks' funding as in developed markets, inflicting pains here may just be an affordable experiment from the vantage point of policymaker," writes Societe Generale's Wei Yao.

Markets should expect interbank rates to be elevated till July.

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