Credit crunch is a lesson well learnt for the central bank, lenders and policymakers

My mother called me on June 24, asking for my advice on a financial product.

It was a one-month bond package offered by a national bank. The annualized rate stood at 11 percent, with the entry amount of 1 million yuan.

"What a high return rate!" she exclaimed. "Just a month or two ago, it was about 5 percent. But should I buy it?"

I could feel her hesitance. My feeling was confirmed after she told me that she heard some news that banks were running out of cash and were defaulting.

Apparently, she was upset by the worst credit crunch hitting Chinese lenders in years, if not decades. Rumors that big banks would be unable to repay their debts shook retail investors' confidence to such a degree that they started preferring cash to other forms of investment.

But I told her to go ahead and assured her that I didn't see any uncontrollable risks of default. My feeling is that the credit crunch is likely to come to an end in just a few weeks, after capital flows to lenders are restored.

The liquidity squeeze, which has jolted the stock and bonds markets, is not because banks are really short of money. In fact, China has the world's largest amount of liquidity in a broader sense.

The severe capital shortage is a result of capital misallocation by commercial banks. Seasonal liquidity changes and an unexpected capital outflow have worsened the situation. The last straw came after the central bank said it would not intervene.

Of course, commercial banks should be blamed for this mess. They took it for granted that the financial market would always be awash with money.

The central bank has received a standing ovation for not shoring up liquidity massively this time around. This will definitely teach commercial banks a lesson and force banks to reduce their leverage and speculation.

But the central bank, and other economic policymakers as well, should also learn a lesson.

The credit crunch reflected structural problems haunting financial systems.

The existence of a double-track banking system, coupled with double-track interest rates, is one of the root problems causing this round of credit crunch.

China has two groups of lenders. One group consists of State banks, which can easily collect funds through low-rate deposits and inter-bank funds. But they are subject to strict regulation and supervision. For example, they are not able to freely decide at what rates they can lend and collect deposits, as the central bank sets the limits for the benchmark rate.

The other group of lenders is what is called shadow banking, represented by trust funds. Their financing ability is much weaker compared with State banks. But shadow bankers are known for their tricks of bypassing the central bank's rate limits.

This can be shown by a disparity between the rates offered by State banks and trust funds before the credit crunch.

In May, short-term financial products offered by banks with an entry amount of 100,000 yuan ($16,266, 12,452 euros) stood at 5 percent, at best. But trust funds could offer 8 percent.

Banks have money, while trust funds, although short of funding sources, can offer better return rates. As capital always pursues profit, a marriage between banks and trust funds becomes a matter of course.

Banks frantically lent to trust funds all these years, as can be seen in the sharp increases in new trust funds. In 2012, it was around 4.5 trillion yuan, accounting for one-quarter of the total social financing scale.

The two-track system accelerated the capital flow from banks to trust funds. Such lending doesn't need to be always guaranteed by reserves. So banks kept borrowing from inter-bank and deposit markets, where rates are usually low, to lend to trusts, only to find that the money pool drained up and they misallocated the maturity dates of loans.

That raises the question of whom do the trust funds lend to. The answer is local governments. Trust funds have replaced local government financing vehicles, often known as LFGV, and local bonds to become the fastest-growing carrier of local debts. About 30 percent to 40 percent of such funds have been related to local government debts.

Banks can also lend to local governments. But since they are subject to strict supervision and lending quotas, they bypass the limits via trust funds.

That said, the picture of this round of credit crunch is now more or less clear. Lured by unchecked local debt markets, banks and shadow banks, separately and through a marriage, went on a lending spree that, coupled with seasonal factors such as middle-year settlement needs as well as the central bank's hands-off approach, resulted in an usual demand for short-term capital.

This can be avoided if local debt growth is checked and if banks and shadow banks are integrated into one system. And those are imminent tasks facing top policymakers.

The author is a financial analyst in Shanghai. Contact the writer at michaelzhoufeng@gmail.com

(China Daily European Weekly 06/28/2013 page13)