The shortage of liquidity in China's interbank market has sparked fears of "monetary famine". This seems rather odd when the national savings rate is 50 per cent of gross domestic product and, even though the growth rate is slowing, it is still one of the fastest in the world.
What is happening? We have to go back to a 1959 government-appointed inquiry in Britain, into the working of the monetary system, for the controversial view at that time that it was the liquidity of the system that determined spending behaviour, rather than interest rates. The committee also held the view that the central bank can influence the state of liquidity.
In other words, it is not the quantity of money that determines spending, but the velocity of turnover, which the central bank should influence. Since then, the debate has raged over the different tools the central bank can deploy to influence the real economy, through price intervention, quantitative intervention, or intervening in the liquidity of the system as a whole.
One lesson of the recent crisis is a better understanding that there is a difference between individual institution liquidity and system liquidity. Individual liquidity does not add up to system liquidity.
In 2007, despite adequate capital levels, many banks experienced difficulties in obtaining liquidity because, according to the Basel Committee on Banking Supervision analysis, "they did not manage their liquidity in a prudent manner".
In 2008, the committee issued two minimum standards for measuring liquidity.
The first, the liquidity coverage ratio, seeks to promote the short-term ability of a bank to survive a period of liquidity stress. The ratio measures the value of unencumbered high-quality liquid assets against the expected net cash outflows over the next 30 days.
The second standard tries to encourage banks to fund their activities with more stable sources of long-term funds. The net stable funding ratio is defined as the amount of available stable funding compared to the amount of required stable funding, which must be greater than 100 per cent. "Stable funding" is defined as the equity and debt financing available over a one-year horizon under conditions of extended stress. The definition is controversial because different banks want different types of assets to be included, because what is liquid may not be stable.
These requirements deal only with liquidity of individual institutions, not system liquidity. There are two types of system liquidity: real-sector liquidity and financial-sector liquidity. The former is measured in terms of the velocity concept of money - how much broad money turns over relative to GDP, the proxy for the real sector. Today, there may be four to eight transactions made between different financial institutions before there is one trade with a non-financial customer. In other words, in modern financial markets, the funding or liquidity needs are huge.
In a market-driven interest rate system, the central bank is the lender of last resort. But when central banks guide interest rates through their open market operations, as they do now, the market may not be clear whether the interventions suggest that the central bank could be a lender of first resort.
This has crucial implications. With minimal state intervention, the central bank only need intervene to restore stability. So when rates become very tight overnight, the central bank may lend, but that is usually at a penal rate, to ensure that those banks that mismanaged their funding will learn quickly to get their liquidity position in order.
In a market where the central bank is often in the market, and where its action has funding implications, to guide either short-term interest rates or long-term bond rates, then banks may be led to think that central banks are there to shape the interest-rate yield curve and therefore there will be little or no interest-rate volatility. This is a mistaken assumption.
If interest rates are, in the long term, determined by the market, volatility in the interbank market is one important indicator of system liquidity. What the recent volatility in the Chinese interbank market tells us is that there are larger demand and supply conditions in the system that are driving such liquidity or illiquidity.
Hence, the volatility implies that banks and, by extension, their borrowers will have to prepare their liquidity position so as not to be caught by the presence or absence of the central bank in the interbank market.
Market-based interest rates are shaped by supply and demand in the market, of which central bank intervention is only one part, but the most important part will be shaped by the larger credit and liquidity behaviour of the banking system and their customers, the real-sector borrowers.
Interest rate volatility is the beginning of market-based interest rate reform. It is a good sign, and a sign that the Chinese financial system is moving in the right direction.
Andrew Sheng is president of the Fung Global Institute