Is this the beginning of a liquidity crisis in China which I have long suspected? 

Eoin Treacy's view

Thank you for the above article which raises some interesting points about the Chinese shadow banking system and liquidity in the financial sector generally. Here is a section:

China’s smaller lenders faced tighter liquidity this week as benchmark money market rates climbed to the highest level since April 2015, reflecting a mix of technical factors including cash hoarding for quarter-end regulatory checks. By letting borrowing costs rise, the People’s Bank of China may have been sending a warning to over-leveraged lenders, according to Banco Bilbao Vizcaya Argentaria SA. The central bank has been known to allow short-term jumps in money market rates to discourage excessive borrowing.

“The PBOC wants to warn the smaller lenders not to play the leverage game excessively,” said Xia Le, chief economist at BBVA in Hong Kong. “It’s a tug of war between the central bank and the financial institutions.”

This article by Christopher Langner for Bloomberg may also be of interest. It highlights how the conditions for what will be accepted as collateral in repos was changed on Tuesday. Here is a section:

On Tuesday, it also transpired that the China Securities Depository and Clearing Corp., which oversees exchange-traded notes, plans to allow financial institutions to use only AAA-rated company securities as collateral for short-term loans. (In China, banks tend to be a bit more generous than their Western counterparts, which typically only accept their own government's debt as collateral.)

One of the most recent times regulators tightened repo regulations was in December 2014, and the bond market pretty much froze. Then, banks were told they could only accept bonds rated AA or higher. That's since become something of a moot point: Thanks to the financial discipline of Chinese borrowers, about 95 percent of corporate debentures can be used as a guarantee for interbank borrowings. The new requirement means at least half of these securities will no longer qualify. Whether that played a part or not in this week's interbank defaults isn't clear. But you can bet it will in future.

China has been running easy monetary and fiscal policies for at least the last few years and it could be argued the building boom over the last two decades has been predicated on easy access to risk free capital. As the country transitions to a model less dependent on infrastructure and exports and more focused on domestic demand and innovation it needs to develop a more robust financial system. The fact it is doing so in such a short period of time is a recipe for volatility and overleveraged players are likely to be put under pressure. So long as the central bank is willing to continue to inject liquidity as needed then the risk of a crash is diminished. The weakness of the Renminbi over the last few years, albeit reasonably modest, reflects the ongoing transition and the wider effects it is having on the economy. 

Additionally the internationalisation of the Renminbi, opening up of markets and desire to attract foreign capital can all be seen as a means of risk diversification. By allowing foreigners invest domestically the credit risk is shared internationally suggesting, in the event of a problem, China may be more likely to receive international aid and will not bear the burden on its own. 

The country’s CDS spread has been contracting steadily for six months and at 85 basis points is not signalling heightened demand for protection. 

The government bond yield has been influenced by the opening up of the futures market last year which initially caused a surge in bullish interest and was followed by a decline which is now affecting the shadow banking system because the 10-year yield has risen from 2.64% to 3.4% since October. 

The Shanghai A-Shares Index has been holding a progression of higher reaction lows since early 2016 and a sustained move below the trend mean would be required to question medium-term scope for additional upside. 

The FTSE Xinhua A600 Bank Index pulled back sharply today and is now testing the region of the trend mean. It needs to bounce soon if the medium-term upward bias is to be given the benefit of the doubt.