There was very big news about China’s interbank market which passed almost unnoticed in the United States a few days before Christmas. That’s largely because the news about Fed Chairman Bernanke’s decision to taper (such as it was) overshadowed every other bit of economic news. But the overshadowing is very unfortunate because that news out of China was in fact of vastly greater importance than Chairman Bernanke’s news.
As it happens, China’s news came out on the same day that NBC broadcast on prime time the classic Christmas movie, “It’s a Wonderful Life.” The coincidence is relevant because what happened to George Bailey in the movie is in microcosm what’s happening in China. The end result for China however, might not be as heartwarming as the ending of that holiday movie was.
Interbank rates are not a common topic for even business reporters. Thus, when major moves occur in interbank markets, they are not usually mentioned even on light news days. However, if the year end liquidity squeeze in China becomes habitual, then the spillover effects onto the rest of China’s economy would make it front page news.
The interbank market is inarguably the freest market in China. Like in any country, banks in China borrow from each other when they are temporarily short of cash. Usually, this cash shortage lasts only overnight. These overnight borrowings don’t come for free of course. The rate that is charged for such borrowings is determined by basic supply and demand for such cash. Thus, this nightly rate provides a gauge for cash needs in China. The more such needs exist, obviously the higher the overnight rate will be.
It was therefore of very great importance that on December 20, it jumped to an annualized rate of 8.2%, the highest level since the previous liquidity shortage over the summer. China’s central bank did what it had when cash is in short supply, it entered into the market. This time it did to the tune of $50 billion in three days. For comparison, remember that Chairman Bernanke has “tapered” down to $75 billion per month.
The primary reason for the two liquidity crunches this year is not hard to determine. Market professionals have long been concerned about the asset quality of China’s banks. This year’s defaults in the Chinese banking system seem to justify those concerns. As a result of those defaults, banks have fewer liquid assets with which to meet depositor needs. It’s as simple as that.
And to relate it back to “It’s a Wonderful Life,” this was exactly George Bailey’s problem although admittedly, China cannot blame it on Uncle Billy. China will also not have the assistance of Sam Wainwright and George’s other friends to save its banks.
However serious the situation sounds, and it is indeed very serious, it is not dire. Actually, the move in the interbank rate is a net good thing. The road to capitalism is never a smooth one. There is no such thing as a stable free market. Show me a stable market and I’ll show you a governmentally over-regulated market.
China’s interbank market is doing precisely what it should. It’s having interest rates reflect risk. It’s long overdue but very welcome. It means China continues to ease on down the road to capitalism. It’s a rocky road but the only road we’d want China to be on.
On a tangentially related end note, can you believe those knuckleheads in Hollywood are planning a sequel to “It’s a Wonderful Life”? Ridiculous, isn’t it?
Michael Justin Lee, CFA, is with the University of Maryland’s Center for East Asian Studies and its faculty of finance. He is the author of “The Chinese Way to Wealth and Prosperity” (McGraw-Hill, 2012) and Chief Snark at www.CapitalistSnark.com.