The strain starts to show as China's banks face squeeze

PUBLISHED : Tuesday, 06 December, 2011, 12:00am
UPDATED : Tuesday, 06 December, 2011, 12:00am


For decades China's growth has been powered by investment, and that investment has been financed by the country's banks from their vast deposit base, the captive savings of China's people.

For years the flow of money into bank deposits was so great that it made little difference to the banks' ability to meet their own obligations whether or not the loans they made were actually repaid.

Up to their eyes in liquidity, China's bankers could simply roll over their loans if borrowers ran into difficulty, pushing the problem indefinitely into the future.

Now, however, that fortunate position is beginning to change. According to Charlene Chu and her fellow analysts at Fitch Ratings in Beijing, China's banks are finding themselves facing an increasingly tight liquidity squeeze which could ultimately limit their capacity to finance the economy's continued growth.

Part of the problem is the way China's central bank has chosen to mop up the money that has flowed into China through inward investment and the country's trade surplus.

Traditionally central banks 'sterilise' these inflows by issuing short-term debt. But that's a relatively expensive option. Over the last year the yield on three-month bills issued by the People's Bank of China has averaged 3 per cent. That's a full percentage point more than the central bank can hope to earn on its offsetting holdings of 10-year US Treasury bonds.

As a result, instead of issuing short-term bills, the PBOC has mopped up inflows by ordering the country's commercial banks to set aside a greater proportion of their deposits as reserves, on which the central bank pays an interest rate of just 1.6 per cent.

That's handy for the PBOC, but it poses a problem for China's commercial banks. Whereas central bank bills are liquid and can be sold by a bank in need of ready cash, deposit reserves are completely illiquid, and cannot be drawn down by a bank facing cash flow difficulties.

At the same time as they have been forced to lock up more of their deposits, China's banks have also seen the growth of their deposit base starting to erode.

Over recent years the authorities have consistently kept interest rates low in order to ensure cheap funding for state-backed investment projects. As inflation has picked up, that's pushed the real return on bank deposits deep into negative territory.

In turn, that's prompted savers to start shopping around. An increasing number are withdrawing their money from bank deposits. Instead they are either lending it out directly through China's shadow financial system or they are investing it in the ballooning market for high-yielding 'wealth management products' (see the first chart).

As a result, smaller and medium-sized city and provincial banks have found themselves facing tighter liquidity conditions, which have forced them increasingly to turn to the interbank market to meet their funding needs. That's pushed up their funding costs dramatically. Whereas benchmark interest rates have risen by 1.25 percentage points since September last year, three-month 'Shibor' interbank rates have shot up by more than 3 percentage points.

'For the first time, a large number of Chinese banks are beginning to face cash pressures,' write Chu and her colleagues at Fitch, warning that second-tier Chinese banks will post an operating cash deficit this year.

As the economic cycle turns down, that deficit will limit the banking sector's traditional willingness to support troubled borrowers by rolling over existing loans and to support continued growth by extending new financing.

That could prove a big problem, because as Chu and her colleagues point out, 'China's economy today requires significantly more financing to support the same level of growth as in the past' (see the second chart).

In short, despite China's deep reservoir of savings, the strain of supporting such high rates of economic growth is starting to show.