Editor’s Note: we thank Professor Ning Zhu for giving us the permission to translate this article into English and publish both the Chinese and the English versions on www.ChinaUSFriendship.com; the article was first published on http://www.ftchinese.com/story/001051126, 2013-6-28.
Recently China had a domestic "cash crunch" event, which not only constituted a major impact for banks and financial institutions, but also caused a great upheaval in the A-share stock market and attracted worldwide attention from many investors and regulators. In a certain sense, the volatility of the past week was led by the central bank and the "financial crisis" could generally be controlled by the central bank. Just like controllable nuclear fusion and nuclear explosions, a controllable financial crisis on the one hand can fully expose its power and hazards to all kinds of market participants, while on the other hand it can guarantee that this "financial crisis" does not pose a real threat to the operation of the economy and the stability of the financial system.
Whether the controllable financial crisis this time has reached the intended purpose of the central bank or not, and regardless of how worried and dissatisfied the market was with the central bank’s ways and means of communicating to the market, an undeniable fact is that the traditional stress test clearly is not able to adequately reflect the contingency risks that the current Chinese banking and financial systems are facing; the liquidity and stability of financial institutions are far less steady than what the financial institutions themselves and the regulators imagined, while China's financial system may be much more fragile than originally estimated.
But this discovery seems to lead to a number of paradoxes. And among the many paradoxes the most difficult aspect for people to understand is the ample liquidity at the macro level and the scarce liquidity at the micro level.
On the one hand, from 2002 to 2010, the Chinese social financing (translator’s note: in the past, the main channel of social finance was the renminbi (RMB) loans granted by commercial banks; in recent years, direct financing has developed rapidly; non-bank financial institutions have increased their financing functions, banks and other financial institutions have provided innovative forms of financing to the community, and private financing and private equity funds also have grown, so that the size and structure of China's social financing underwent significant changes) expanded from 2 trillion yuan (1 yuan is about US$0.163) to 14.27 trillion yuan with an average annual increase of 27.8%, which was 9.4 percentage points higher than the average annual growth rate of RMB loans over the same period. In 2010, the ratio of social financing to GDP was 35.9%, which had increased 19.2 percentage points in comparison with the 2002 value. The broad measure of money supply (M2) doubled in just the past five years from more than 50 trillion to today's more than 100 trillion. Liquidity cannot be said to be inadequate.
On the other hand, the financing problems of small and medium enterprises (SMEs) have continued to plague the Chinese economy for some time. With the development of the problems, the financing platforms of local governments and some local state-owned enterprises also reported varying degrees of fund shortage. But, this time, even the always well-off banks, which find it embarrassing to talk about their ample liquidity, are exposed to funding liquidity constraints. We really cannot help but worry about China's economic and financial systems.
The controllable "financial crisis" this time may just expose a number of closely linked risks in China's financial system. And these risks precisely explain why the financial system showed an alarming "money shortage” in an environment awash with liquidity.
First, the speculative assets have exhausted a lot of money and liquidity. Since the past year, the social financing and money supply contribution to the economic growth have become smaller and smaller, which confirms the worries of all concerned about new financing being mostly used in the financial sector, in particular for investing in real estate and in sectors of trust schemes and financial products with expected high returns. Social finance is increasingly being used for chasing short-term returns on investment, rather than for promoting sustained economic development.
Second, the liquidity of speculative assets is often poor. Whether the repeated investment projects are in the real estate sector, the financing platforms of the local government, or the overcapacity sectors, the cash flow is weak, and the liquidity is poor. If it were not so, these investments would not have been forced to pay much higher rates than the bank interest rates for financing. Until the systemic liquidity tightens, the only means these projects can use to ease the lack of liquidity is to promise the investors higher yields and longer repayment periods, in order to address the immediate problems of unsustainable funding. To some extent, that is the time-tested borrowing for repaying, namely, Bernard Madoff's “Ponzi Scheme” to make the pie larger and larger.
Furthermore, speculative assets have close correlations between them. Whether they are the real estate developments, the financing platforms of the local government, or the numerous trust schemes and financial products, their cash flow and liquidity are often closely bound together. When liquidity dries up, this high degree of correlation not only has brought great difficulty to the businesses which are trying to borrow money and to the financing platforms of the local governments, but also fully exposes the lenders to the risks of borrowers’ lack of liquidity. In one night, many banks suddenly awakened to the fact that their risk models and preparations might have overlooked the possibility of an occurrence of simultaneous default of a variety of assets, and they in that moment simply did not have enough money to deal with the situations of even a hint from the depositors questioning their deposit safety and a run on the bank. This is why many banks in the past week staged a “shortage of money”, and why many financial institutions faced extinction in 2008.
Finally, the values of the speculative assets are extremely sensitive to liquidity and added excess liquidity (AEL). After experiencing rapid credit expansion and liquidity injections over the past few years, all the scales of speculative assets are no longer the same as before. Not just the tightening of liquidity, even an AEL shortage is sufficient to cause a collapse of the “cash absorbing” speculative asset prices. Even more frightening is that, as the funders of these speculative assets, commercial banks do not have much capability to discuss and decide about their own liquidity. The gate of systemic liquidity is controlled by the central bank; even the commercial banks themselves do not know when the window of opportunity will be closed, or Pandora's Box may also be opened at the same time.
The credit crunch this time, no matter how the market eventually reacted and the central bank ultimately dealt with it, at least has played three important roles. First, it reminds all market participants that in the case of the flood of liquidity it is also possible to have an outbreak of a financial crisis like the Black Swan Event (translator’s note: simply put, a Black Swan Event is very unusual and very difficult to predict, usually caused by a negative market reaction chain). Second, the market will not only rise, the government will not and cannot provide implicit credit guarantees to pay for irresponsible investment behavior; Finally, many things can occur unknowingly, risk may emerge at the most unprepared time, whether one is ready or not.
If last week's market shock can really achieve the above three objectives, then the "cash crunch" this time would not be all wasted.