What happened with the “cash crunch” in China two weeks ago?

While there have been many explanations for why the People’s Bank of China (temporarily) allowed (easy) credit to dry up, I think Mark DeWeaver has a very plausible and well-reasoned explanation.  Mark wrote the foreword to my book and is the author of Animals Spirits with Chinese Characteristics.

Below is his op-ed published two days ago in The Wall Street Journal.  Be sure to check out his predictions for why this solution probably will not stick:

Beijing’s War on Shadow Banking

China’s central bank cracks down on credit that is not under the government’s control.

On June 20, China’s central bank precipitated a major credit crisis by withholding funds from the nation’s cash-starved banking system. The People’s Bank of China’s refusal to act as liquidity provider of last resort froze lending in the interbank market. Overnight rates, which had been as low as 2.1% in early May, exploded, closing at a record 13.4%.

As rumors swirled about the solvency of China’s state-owned banks, some commentators began talking about a Chinese “Lehman moment.” But the crisis passed and the overnight interbank lending rate quickly came back to earth. By July 4, it had fallen to 3.4%.

Trouble in the interbank market had been brewing since early June, when Beijing began a crackdown on illicit inflows of foreign exchange, previously a major source of growth in the local money supply. The demand for yuan also began rising, as Chinese banks prepared for their June 30 book closings and their customers for their first-half tax payments.

The result was a growing imbalance between the supply of and demand for credit. As rumored large-scale interventions by the People’s Bank of China repeatedly failed to materialize, commercial banks realized they would have to fend for themselves. Lenders hoarded cash to guard against potential counterparty defaults, and the normal flow of funds among financial institutions quickly dried up.

The central bank’s immediate objective seems to have been to rein in China’s “shadow banking” system, which has grown rapidly in recent years and now accounts for a significant share of total Chinese credit. Shadow banking in China involves lightly regulated products that allow savers to earn more than the official deposit rate while providing financing for “subprime” borrowers.

Generally the funding is relatively short-term, which makes the business highly sensitive to liquidity conditions. Shadow lenders require inflows of new money to pay off maturing obligations. These typically come either directly from the banks—for example, via their “wealth management products”—or from entities with access to bank financing such as state-owned enterprises.

There may be a larger political game going on. The People’s Bank of China is not an independent central bank, so the order to turn off the credit spigot must have come directly from the Politburo. The central bank’s surprise attack on bank credit must therefore be understood in the context of the leadership’s current focus on improving economic efficiency. This objective will be impossible to achieve unless the central government can overcome resistance from the powerful local interests that benefit from the status quo. The Politburo’s goal may have been to starve opponents of reform into submission.

Local governments appear to be the central bank’s real targets, because they rely heavily on shadow financing to subvert Beijing’s reform initiatives. Shadow funds flow directly into local government projects that the central government views as wasteful, and the funds benefit localities indirectly by pushing up land prices. As long as this money keeps flowing, over-investment in infrastructure, heavy industry and real estate will continue unchecked and Beijing’s vision of a new economy driven mainly by consumer demand and productivity growth will be impossible to realize.

The credit crunch occurred a few days after the launch of the Communist Party’s new “mass line” campaign, which seeks to make the party more sensitive to the needs of the people by circumventing official government and party hierarchies. This idea goes back to Mao Zedong, for whom the goal was to realize “democratic centralism” and bypass bureaucratic factions that threatened his agenda. Going directly to the “masses” was a way to attack the opposition from the outside—to “bombard the headquarters” in a famous slogan of the Cultural Revolution era.

In Mao’s time, bombarding the headquarters meant unleashing a reign of terror. Today the leadership has turned to less violent means. The central bank’s strike against shadow banking will undermine today’s vested interests in a way that Mao could scarcely have imagined—simply by cutting off their financing.

There are two problems with this approach. First, the central bank’s policy will result in considerable collateral damage. Small- and medium-size private firms will be particularly hard hit. They tend to be ineligible for bank loans and often depend on shadow financing to make ends meet.

Second, attacking anti-reform factions will not be enough to generate real reform. Without radical changes in the economic role of local governments, they will quickly return to business as usual once the fallout has cleared.

The People’s Bank of China may have won a battle, but the Politburo is far from winning the war.

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