Chinese Banking Liquidity Crisis of 2013

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The Chinese Banking Liquidity Crisis of 2013 was a sudden credit crunch affecting China's commercial banks evidenced by a rapid rise on 20 June 2013 in the Shanghai interbank overnight lending rates to a high of 30 percent from its usual rate of less than 3%. [1] The ensuing panic affected gold markets and stock. [1] China's regulation of the foreign exchange market had caused a decline in inflow of cash. [1] On 19 June 2013, instead of injecting additional funds and easing its monetary policy, China's central bank People's Bank of China (PBOC) told commercial banks to "make full use of incremental funds and revitalize stock options." [1] On 24 June 2014 the PBOC told commercial banks to "control the risk associated with credit expansion" effectively increasing the scrutiny of shadow banks' lending practices. This resulted in a sudden shortfall in the cash market resulting in short term repo rates in excess of 25%. [2] In effect China was using market forces to manage the economy.

Contents

Context

China's 2008 monetary stimulus package contributed to China's subsequent economic boom. By 2011 China's local government debts was already under scrutiny from national regulators. There were concerns even that the "massive, shady trade" [3] in over-the-counter credit could place China's financial security and social stability, at risk. [3] By 2011 half of the loans in China were in shadow banking with no regulatory scrutiny. In March 2013 Li Keqiang, an economist by training, was elected as Premier. In 2010 Li Keqiang had called for a global governance structure that was "more reflective of the changes in the global political and economic landscape." [4] By 2013 China was concerned about shadow banking, which includes hedge fund, private financing, trust loans, private funds and other non-bank financial institutions. [1]

A Bank of America Merrill Lynch Global Research report published in January 2014 cautioned that "local government financing vehicles and shadow banking" remained a concern and if not addressed could lead to costly defaults. [5]

Market Reaction

Following PBOC intervention in June 2013, the loss of liquidity from shadow banks caused the blue-chip Shanghai Composite Index (CSI300) to plummet 5.3% the largest daily decline in nearly 4 years. [6] As result, the credit rating agency Moody's issued a warning on Chinese and Hong Kong debt obligations. [7]

PBOC Reaction

Following the market's reaction, the PBOC refused to inject additional funds to cover the liquidity shortfall implying a dramatic policy change from rapid growth to quality growth. Analysts predict the sudden tightening of lending rates served as a warning to overzealous banks to control their lending practices. [8]

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The money market is a component of the economy which provides short-term funds. The money market deals in short-term loans, generally for a period of less than or equal to 365 days.

Fractional-reserve banking banking system where bank holds reserves equal to fraction of deposit liabilities

Fractional-reserve banking is the most common form of banking practised by commercial banks worldwide. It involves banks accepting deposits from customers and making loans to borrowers, while holding in reserve an amount equal to only a fraction of the bank's deposit liabilities. Bank reserves are held as cash in the bank or as balances in the bank's account at the central bank. The minimum amount that banks are required to hold in liquid assets is determined by the country's central bank, and is called the reserve requirement or reserve ratio. Banks usually hold more than this minimum amount, keeping excess reserves.

An open market operation (OMO) is an activity by a central bank to give liquidity in its currency to a bank or a group of banks. The central bank can either buy or sell government bonds in the open market or, in what is now mostly the preferred solution, enter into a repo or secured lending transaction with a commercial bank: the central bank gives the money as a deposit for a defined period and synchronously takes an eligible asset as collateral. A central bank uses OMO as the primary means of implementing monetary policy. The usual aim of open market operations is—aside from supplying commercial banks with liquidity and sometimes taking surplus liquidity from commercial banks—to manipulate the short-term interest rate and the supply of base money in an economy, and thus indirectly control the total money supply, in effect expanding money or contracting the money supply. This involves meeting the demand of base money at the target interest rate by buying and selling government securities, or other financial instruments. Monetary targets, such as inflation, interest rates, or exchange rates, are used to guide this implementation.

The reserve requirement is a central bank regulation employed by most, but not all, of the world's central banks, that sets the minimum amount of reserves that must be held by a commercial bank. The minimum reserve is generally determined by the central bank to be no less than a specified percentage of the amount of deposit liabilities the commercial bank owes to its customers. The commercial bank's reserves normally consist of cash owned by the bank and stored physically in the bank vault, plus the amount of the commercial bank's balance in that bank's account with the central bank.

A money market fund is an open-ended mutual fund that invests in short-term debt securities such as US Treasury bills and commercial paper. Money market funds are managed with the goal of maintaining a highly stable asset value through liquid investments, while paying income to investors in the form of dividends. Although they are not insured against loss, actual losses have been quite rare in practice.

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In India, the Statutory liquidity ratio (SLR) is the Government term for the reserve requirement that commercial banks are required to maintain in the form of cash, gold reserves, Reserve Bank of India (RBI)- approved securities before providing credit to the customers. The SLR to be maintained by banks is determined by the RBI in order to control the expansion.

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In financial economics, a liquidity crisis refers to an acute shortage of liquidity. Liquidity may refer to market liquidity, funding liquidity, or accounting liquidity. Additionally, some economists define a market to be liquid if it can absorb "liquidity trades" without large changes in price. This shortage of liquidity could reflect a fall in asset prices below their long run fundamental price, deterioration in external financing conditions, reduction in the number of market participants, or simply difficulty in trading assets.

The shadow banking system is a term for the collection of non-bank financial intermediaries that provide services similar to traditional commercial banks but outside normal banking regulations. The phrase "shadow banking" contains the pejorative connotation of back alley loan sharks. Many in the financial services industry find this phrase offensive and prefer the euphemism "market-based finance".

A credit crunch is a sudden reduction in the general availability of loans or a sudden tightening of the conditions required to obtain a loan from banks. A credit crunch generally involves a reduction in the availability of credit independent of a rise in official interest rates. In such situations, the relationship between credit availability and interest rates changes. Credit becomes less available at any given official interest rate, or there ceases to be a clear relationship between interest rates and credit availability. Many times, a credit crunch is accompanied by a flight to quality by lenders and investors, as they seek less risky investments.

Bank Financial institution which accepts deposits

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The U.S. central banking system, the Federal Reserve, in partnership with central banks around the world, took several steps to address the subprime mortgage crisis. Federal Reserve Chairman Ben Bernanke stated in early 2008: "Broadly, the Federal Reserve’s response has followed two tracks: efforts to support market liquidity and functioning and the pursuit of our macroeconomic objectives through monetary policy." A 2011 study by the Government Accountability Office found that "on numerous occasions in 2008 and 2009, the Federal Reserve Board invoked emergency authority under the Federal Reserve Act of 1913 to authorize new broad-based programs and financial assistance to individual institutions to stabilize financial markets. Loans outstanding for the emergency programs peaked at more than $1 trillion in late 2008."

An overnight indexed swap (OIS) is an interest rate swap where the periodic floating payment is generally based on a return calculated from a daily compound interest investment. The reference for a daily compounded rate is an overnight rate and the exact averaging formula depends on the type of such rate.

The interbank lending market is a market in which banks extend loans to one another for a specified term. Most interbank loans are for maturities of one week or less, the majority being overnight. Such loans are made at the interbank rate. A sharp decline in transaction volume in this market was a major contributing factor to the collapse of several financial institutions during the financial crisis of 2007–2008.

Financial crisis of 2007–08 Global financial crisis

The financial crisis of 2007–08, also known as the global financial crisis and the 2008 financial crisis, was a severe worldwide economic crisis considered by many economists to have been the most serious financial crisis since the Great Depression of the 1930s, to which it is often compared.

China's shadow banking system can be described as credit intermediation involving entities and activities outside the regular Chinese banking system. Shadow banking is fairly common globally; however, in most countries this practice originates from non-banks rather than commercial banks. China's shadow banking system has experienced rapid growth since the global financial crisis.

References

  1. 1 2 3 4 5 Mo, Zi (August 2013), "Credit Crunch", China Pictorial, 782, pp. 60–61, ISSN   0009-4420 , retrieved 8 August 2014
  2. ↑ "China Gambles That A Credit Crunch Can Rein in Shadow Banking". Forbes. Retrieved 3 July 2013.
  3. 1 2 Jia, Li (December 2011), "The Chinese Credit Crunch", News China, archived from the original on 9 August 2014, retrieved 8 August 2014
  4. ↑ Li, Keqiang. "Davos Annual Meeting 2010 – Special Address by Li Keqiang". World Economic Forum. Retrieved 4 June 2010.
  5. ↑ "Crunch Escalates as Money Funds Rival Shadow Banks: China Credit", Bloomberg News, 19 January 2014
  6. ↑ Wildau, Gabriel; Jianxin, Lu (24 June 2013). "China cash squeeze eases, but bank shares take big hit". Shanghai. Reuters. Retrieved 8 August 2014.
  7. ↑ Evans, Rachel (24 June 2013). "Chinese Banks' Bond Risk Rises Most in Asia Amid Moody's Warning". Bloomberg. Retrieved 8 August 2014.
  8. ↑ "Shadow Banking Behind China's Cash Crunch, Xinhua Says". Reuters. 23 June 2013. Retrieved 8 August 2014.
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