Deleveraging Is Devilish Hard: Just Ask The PBOC

by: Craig Pirrong

The WSJ has a very long and interesting article about the PBOC's ham-fisted handling of the liquidity crunch of the past weeks. The central bank was trying to send a signal that it wanted to restrain credit growth, especially in the shadow banking sector, but things got out of hand:

Since early June, the PBOC has sought to force Chinese banks to redirect their lending away from shadow bankers—a mélange of trust companies, pawnbrokers, leasing companies and others—whose lending is putting further stress on an economy already slowing, economists say.

To achieve this, the central bank withheld cash from the interbank market, essentially twisting the arms of traditional bankers to force them to change their lending practices.

On June 20, China's leaders feared the credit squeeze was getting out of hand. Overnight interest rates at which banks borrow from each other spiked to as high as 30% that day. A rumor circulating in Shanghai that Bank of China had defaulted on an interbank payment was given more credence when a Chinese newspaper, the 21st Century Business Herald, reported the alleged default on its website around 6 p.m. According to the newspaper, Bank of China defaulted during that afternoon, "deferring transactions for half an hour due to a fund shortage."

But shadow banks are holding a large amount of assets. How are those assets going to be funded? Does the PBOC want banks to bring them on their balance sheets? Really? If not, where will they go? Another reason that the PBOC's crackdown was not credible last month, and hence will be unlikely to have disciplinary effects going forward.

Deleveraging is hard, because leverage funds assets. To reduce leverage, you have to reduce the assets, or find equity to finance them. How? Dump them, leading to fire sales and substantial declines in asset prices that spill over and harm the balance sheets of banks and other institutions? If not, where is the equity going to come from to hold these assets?

The PBOC is probably right in its diagnosis that China is over-leveraged and that the leverage is particularly fragile. But making the diagnosis is one thing. Finding the cure is something different altogether. The PBOC has found that cutting off funding to shadow banking isn't feasible, because the assets it holds have to go somewhere. And if a lot of those assets are bad -- which is likely the case here -- it's truly a challenge.

Extend and pretend is the path of least resistance, meaning that the problem is deferred, and likely to metastasize. Meaning that even the most clever central banker is likely to find it very difficult to wean the financial system off cheap credit. There is a path dependence here that makes that task very, very difficult. So it's likely that we haven't read the last story about a liquidity crisis in China.