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June 7, 2013

Daily Not

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Chinas liquidity

Chinas interbank rates

this than just a spike in

pressures. The authoriti

close to exhausting thei

One could argue that a

command economy is a

owned banks, which hol

relieve a potential seize

the emergence of such

the likely outcomes for

Chinas interbank rates

of 2012. It is customary

next week sees the thre

explanation behind the t

Chinese banks are oper

mounting. Chinas curre

a high of 10% in 2007.

domestic liquidity condit

SHIBOR 7-day rate

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2

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8

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6/7/2007 6/7/2009

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tress more than a holiday ph

have shot up ahead of the Dragon Boat Fest

ash demand for the holiday. Banks are faci

es have scope to alleviate bank liquidity stre

ability to use the banks as an ATM to finan

alysing the possibility of bank liquidity stres

waste of time. The government has direct c

d high levels of required reserves, so it coul

up in the interbank market. But while this m

tress tells us a lot about the state of the ec

sset markets.

have shot up in the last few days to the high

that demand for cash rises ahead of public

e-day Dragon Boat Festival. But this is unlik

ightening of interbank liquidity.

ating in an environment where liquidity pres

nt account surplus has fallen to just 2.6% of

his means that capital flows have become a

ions in Chinas managed exchange rate syst

6/7/2011 6/7/2013

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always intervene to

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ures are about to start

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more important driver of

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um Quarterly flows

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2 Daily Note - June 7, 2013

capital outflows is much higher than capital inflows despite Beijings efforts to encourage the

latter. The reason is that whatever policy route the authorities take domestic money is likely

to go for the exit.

China is currently losing growth momentum fast after only a brief recovery from its cyclical

hard landing at the end of 2011 and first half of 2012. Growth concerns drove domestic

capital out of the yuan last year at the highest rate on record. Most of the outflows were into

foreign currency at domestic banks, but Chinas capital controls are notoriously porous and

the smart money is getting more sophisticated.

If the authorities decide to go for growth and engineer another stimulus, inflation is likely to

rear its ugly head very quickly. The global financial crisis marked the end of the road for

Chinas export-led growth model. Unless there are structural reforms, just throwing money at

the economy will produce inflation and bubbles rather than sustainable growth as happened

after Beijings gigantic post-2008 stimulus. But this could well induce not just capital but also

current account outflows.

Chinese households have two thirds of their financial wealth in interest-bearing deposits.

Accelerating inflation hurts their real wealth. Moreover, last time around Beijing went for

administrative control in its efforts to curb the overheating rather than raising interest rates

and thus didnt provide households with an offset. Accelerating inflation is also likely to drive

domestic capital out. Moreover, a domestic stimulus in the face of still weak external demand

is likely to further diminish the current account surplus if not turn it into deficit.

The other option is for the authorities to ease capital controls. Indeed, since the end of last

year they have made concerted efforts to entice capital in by raising the foreign investor and

offshore yuan quotas. In fact May saw the largest increase in the scheme that raises offshore

yuan to invest in the mainland bond and equity markets since December 2012. The move

was not just aimed at boosting the sagging domestic equity market, but also importantly to

support bank liquidity. Chinas banks may have been insolvent for a long time, but as long as

they were liquid the excess investment show could go on.

The problem is that to place the economy on a sustainable growth path, China will have to

open up outflows as well as inflows. Beijing made a more concrete commitment to allow

Chinese people to invest abroad a few weeks ago. It will provide a concrete timetable by the

end of this year. But if China opens up the capital account fully, outflows in search of higherreturn amid weaker and more volatile Chinese growth are likely to outweigh inflows.

Rising domestic liquidity pressures suggest that Beijing is likely to have to cut the banks

required reserves ratio this year. At the same time, they could well raise domestic deposit

rates as well which will be a necessary rebalancing measure until the market is allowed to

set interest rates fully. Banks will bear the brunt of the structural adjustment China faces over

the next few years. They will embark on a quest to raise capital abroad, but investors should

be wary of the risks this will involve.

Diana Choyleva