28 June 2013 09:55 [Source: ICB]
The central bank steps in to mitigate soaring interbank lending rates, but a major policy shift may finally be at hand. This will have major implications for the petrochemical sector
It had seemed almost unconceivable that China could suffer a financial sector crisis because of the strong belief that the government would always step into help.
But just briefly, from 19-20 June, a systemic financial crisis looked as if it was possible as interbank lending rates soared to a record high of 28%.
Nobody broke a sweat, however, because on every occasion that this had happened in the past, China's central bank, the People's Bank of China (PBOC), had stepped into help.
But the PBOC largely refrained from intervening as the liquidity crisis worsened on 19-20 June, noted Fitch. "State banks are the primary beneficiaries of foreign-exchange inflows, and the drop in these flows is a key reason why recent tightness is being felt even among the largest lenders in the country," said the ratings agency.
On 21 June, the PBOC injected more liquidity into the system, bringing the immediate crisis to an end.
And the following week, China's equity markets were extremely volatile as the PBOC made it clear that it would provide ample liquidity in future, but only to banks with healthy balance sheets and to "promising projects", which is likely to only mean projects that fit into China's new economic growth model.
The Financial Times, in a view shared by many commentators, described the PBOC's lack of intervention on 19-20 June as the firing of "a warning shot" at China's lenders, in a 22 June article.
The deliberately engineered turmoil is also widely viewed as a further indication that the government is determined to reform the financial system.
"I believe the new Chinese regime is taking an extremely conservative stance to avoid digging themselves in the same debt hole that Japan dug in the 1980s," said a source with a Malaysia-based chemicals trading and distribution company.
"The government has been adjusting their policy to limit the amount of hot money entering the financial system and preventing the [further] expansion of the growing investment bubble," said the source. "They seem determined to restrict the investment sector's contribution to China's economy. I believe it is much too soon politically for the new government to change their stance on their stated policies."
Thus, even if no further warning shots are fired at lenders, via allowing interbank lending rates to soar, it seems likely that a hoped-for interest rate cut late this year, which would have boosted chemicals buying and trading activity, will not happen.
Neither will there be a reduction in the bank-reserve requirement - the percentage of funds that the state-owned banks have to aside against their loan books.
Lowering the requirement would boost the availability of loans. Instead, it seems more likely that lending conditions will be further tightened.
Additional measures to control the shadow banking system also seem likely. The broad measure of China's money supply, M2, surged by 15.8% in the first quarter of this year, even though official lending was tightened.
"It is not that there is no money, but the money has been put in the wrong place. The banks are short on cash, the stock market and small- and medium-sized enterprises (SMEs) are short on cash, but there is ample money supply in the market," said Xinhua, the government news agency, in a commentary on 23 June.
"Many large companies are still spending heavily and making large purchases in wealth management products [part of the shadow-banking system]. There is also a lot of hot money seeking speculative investments and private lending is still widespread," Xinhua added.
CREDIT ALLOCATION EFFICIENCY
If China's government succeeds in its objective of improving the efficiency of credit allocation, this will help China's hard-pressed SMEs access greater quantities of credit at lower interest rates.
The SMEs are also being squeezed by high labour costs, labour-supply shortages and deflation. It is the SMEs which make up the bulk of chemicals and polymers buying in China.
But the PBOC has a battle on its hands against the vested interests that want to prevent reform of the lending system.
Volatility seems likely to continue as a result of uncertainty and anxiety surrounding China's change in economic direction. "I think the main approach to purchasing is going to remain hand-to-mouth because of all the uncertainty," said a Singapore-based polyolefins trader.
And the speculative activity that has provided a huge support for petrochemicals demand growth during 2009-2010 in particular isn't going to come back.
"I think that there could be a further decline in trading activity and certainly no return to the heady days of 2009-2010," added the polyolefins trader.
A further risk is that as China further tinkers with credit availability, mistakes could be made.
Reining in the growth of shadow finance by constraining the liquidity available to fund new credit extension could lead to policy mis-step or unintended consequences, said Fitch in the 21 June press release.
Other commentators have warned that smaller manufacturers could go under as credit defaults ripple through the financial system.
China, as it forges ahead with reform, might also struggle to achieve its 7.5% GDP growth target for 2013. Growth of around 6% is now being forecast by some economists, but even this number could be hard to achieve as the overall economic reform process accelerates.
And there is another potential problem for the polyolefins industry in particular: oversupply resulting from misallocation of bank lending that has already taken place.
"New capacities will only increase as bank funding is heavily driven towards that area, in many cases due to the fact that the heads of petrochemical companies were all government officials in the past," said the source with the Malaysia-based chemicals trading and distribution company.
"An incredible number of projects are already in progress with even more on the horizon. However, domestic demand will severely lag behind this new supply because of the increasing wealth gap and the inability of the middle class to keep up with the growing cost of living," the source added.
Reforms to the lending system, extensive enough to allow consumption to replace investment as the major driver of GDP growth, might also take a long time, he warned.
Additional reporting by Amber Liu in Shanghai
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