China: cause of the market meltdown?

Echoes of Mao in China cash crunch

As China’s credit crunch takes a turn for the worse, the question of why the central bank has permitted market conditions to deteriorate so suddenly and so sharply looms ever larger.

Short-term money market rates surged to more than 10 per cent on Thursday, a record high and nearly triple their level just two weeks ago, after the central bank refused to inject extra funds into the strained financial system.

Analysts have mostly viewed the squeeze in economic terms, as a warning to lenders that they must rein in dangerously fast credit growth.

But in the midst of the extreme market stress, a statement issued late Wednesday by the central bank raised the possibility that politics are also playing an important role.

Bankers had been calling for the central bank to ease the pressure and a few investors had even predicted that it might cut interest rates. Instead, the People’s Bank of China ordered a thorough implementation of the new “mass line education” campaign launched this week by President Xi Jinping – a campaign that in its propaganda-style and potential scope carries echoes of the Mao era.

The Communist party cadres that run the central bank were told to attack the “four winds” of “formalism, bureaucracy, hedonism and extravagance”, as demanded by Mr Xi.

“It is quite possible that the central bank’s policies have some connection to Xi’s campaign,” said Willy Lam, an expert on Chinese politics at the Chinese University of Hong Kong. “It seems to be much more serious than the short anti-corruption campaigns launched by Hu Jintao and Jiang Zemin [Mr Xi’s predecessors over the past two decades].”

In monetary policy terms, the central bank could certainly be said to be waging war on hedonism and extravagance. The seven-day bond repurchase rate, a key gauge of liquidity in China, surged 270 basis points to more than 10.8 per cent on Thursday – a punitively high rate that could force cash-hungry banks to call in the riskiest of their loans.

“There are definitely political calculations,” said Ken Peng, an economist with BNP Paribas. “The senior leadership is much more worried about ‘correcting behaviour’ and political considerations than just protecting their 7.5 per cent growth target.”

Unlike the cash crunch that occurred in developed markets when the global financial crisis erupted in 2008, the squeeze in China has been almost entirely self-inflicted, a deliberate move by the central bank.

Market players had hoped the central bank might inject extra cash in the economy at a scheduled auction on Thursday. But it rebuffed the pleas for help, putting more pressure on overstretched lenders.

Concerns about financial risks appear to be the immediate trigger for the central bank’s actions. A surge in credit growth at the start of this year, despite a slowdown in the economy, has alarmed regulators.

The central bank wants to send a message to banks to be more cautious in their risk control and to improve their own liquidity management

- Peng Wensheng, China International Capital Corp

The overall credit-to-gross domestic product ratio in China has jumped from roughly 120 per cent five years ago to closer to 200 per cent today, an indication of rising leverage throughout the economy.

Song Yu, an economist with Goldman Sachs, said the tightening was “aimed at preventing the leverage ratio from reaching an even higher level”.

With money market rates soaring, interbank rates have also shot up over the past two weeks. This has punished lenders that have used their privileged access to the stable, central bank-controlled interbank market to fund purchases of risky, high-yielding bonds.

“The central bank wants to send a message to banks to be more cautious in their risk control and to improve their own liquidity management,” said Peng Wensheng, an economist with China International Capital Corp. “It is saying that you cannot expand credit as you like, and then simply rely on the central bank to back you up.”

But the risk of dangerously fast credit growth in China is not new. The biggest change over the past half year has been political, with the ascension of Mr Xi as the country’s new paramount leader.

Zhou Xiaochuan, central bank governor, is believed to have a good personal relationship with Mr Xi. Both are “princeling” sons of Communist revolutionary leaders. Mr Zhou had been expected to retire this year, having reached the mandatory retirement age, but Mr Xi allowed him a special dispensation to remain in office.

Mr Xi’s campaign against the “four winds” was officially announced on Tuesday. The order that central bank cadres across China should study and implement the campaign was transmitted less than 24 hours later, ahead of virtually all other government units.