What Shibor’s surge says about Chinese financial system

Chinese interbank rates surged ahead of the three-day Dragon Boat festival next week. 

The overnight Shibor, or the Shanghai interbank offered rate, surged to 8.29 percent on June 7, from 5.98 percent on June 6. The seven-day Shibor rose to 6.66 percent, from 5.14 percent.

This is an interest rate used among banks, and it's considered a useful proxy for liquidity in the Chinese credit markets.

What could have caused the spike in Shibor?

First, Demand for cash rises ahead of Chinese holidays like the Dragon-boat festival, New Year holiday, Golden week holiday.

Second, Bank of America's Ting Lu doesn't think this doesn't suggest major problems with the financial system. "In our view, most likely the PBoC failed to anticipate and then failed to respond swiftly to a sudden fall of liquidity supply and seasonal rise of liquidity demand," he writes.

Third, Lu argues that interbank liquidity was squeezed on account of a decline in speculative activities after the government tightened FX curbs. He also cites two other key reasons.

Fourth, one off demand for U.S. dollar, because of State Administration of Foreign Exchange (SAFE's) regulations on foreign exchange inflows and banks’ Forex position management.

Fifth, it could be because of the crackdown on illegal bond trading. " But because it’s not banned for the banks to trade bond between its different accounts, banks may have to find trade counterparties in the interbank market and frictions could arise resulting in rate volatilities."

What are the implications?

Diana Choyleva at Lombard Street Research thinks this is symptomatic of a bigger problem.

She argues that China's current account surplus fell to 2.6 percent of GDP in 2012, down from 10 percent in 2007 and that "this means that capital flows have become a more important driver of domestic liquidity conditions in China’s managed exchange rate system." In fact, she expects China to see more capital outflows than inflows.

If Beijing decides to go for another stimulus, which analysts say is highly unlikely, Choyleva writes that the economy will see "inflation and bubbles rather than sustainable growth" and this could cause capital and current account outflows. 

And if it tries to ease capital controls further and opens up the capital account fully, "outflows in search of higher return amid weaker and more volatile Chinese growth are likely to outweigh inflows."

Bank of America's Ting Lu however doesn't think that this Shibor spike and liquidity squeeze doesn't suggest major problems with the financial system. "In our view, most likely the PBoC failed to anticipate and then failed to respond swiftly to a sudden fall of liquidity supply and seasonal rise of liquidity demand," he writes.

The central bank injected 160 billion yuan into the system this week but he thinks it is unlikely that they will continue multiple open market operations to inject liquidity next week if the Shibor stays high.

Lu and Choyleva also differ on how the central bank might react. Lu doesn't think reserve requirement ratio cuts are likely, because they don't want to "send policy easing signals." Choyleva thinks liquidity pressures could well force their hand. She also thinks they could raise deposit rates.

Societe Generale's Wei Yao has already warned that China is approaching it's Minsky moment.

While some argue that the government controls the state-owned banks and could intervene in case of severe stress, she does think, "the emergence of such stress tells us a lot about the state of the economy and the banks and the likely outcomes for asset markets.

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