The Chinese authorities continue to provide the liquidity to financial institutions necessary to maintain stability in the financial system following the tightening of financial regulations this year, says Fitch Ratings.
Nevertheless, a weakening of banks' liquidity and funding profiles has made some of them more vulnerable to a policy misstep or loss of market confidence that triggers a liquidity crunch.
The PBOC has been pumping liquidity into the system in increasing volumes and with greater frequency to make up temporary cash-flow shortages among China's banks. There is increasing evidence of ordinary support through formal channels, such as central bank facilities and interbank lending, aimed at managing financial system risk and controlling financing costs for the real economy.
The People's Bank of China's (PBOC) balance sheet claims on depository institutions - banks, credit cooperatives and finance companies - was over CNY9 trillion (USD1.4 trillion) at end-July 2017, six times that at end-3Q14, when the central bank announced significant easing of monetary policy and introduced a raft of new policy tools to manage system liquidity.
Deterioration in banks' liquidity profiles in the last few years has necessitated a rise in liquidity support. The big four state banks and Postal Savings Bank are still net providers of liquidity to the interbank system, but to a smaller extent than a few years ago.
All other Fitch-rated mid-tier commercial banks now appear to be net liquidity takers. In 2013, all Fitch-rated commercial banks were net liquidity providers.
Liquidity positions have weakened partly as a result of inefficient lending, which has caused a drop in lenders' net operating cash inflows relative to outflows.
Flush with deposits
China has also moved away from having limited investment alternatives, strict caps on deposit rates and loan-to-deposit ratios, as well as very high economic growth - all of which contributed to banks being flush with deposits in the past.
The widening gap between assets and deposits has been filled chiefly by off-balance-sheet wealth management products (WMPs) and interbank borrowing. Mid-tier banks are especially reliant on these sources of funding.
“We estimate that off-balance-sheet WMPs and interbank borrowing made up 43% of mid-tier banks' funding as of end-1H17, compared with 19% at state-banks, contributing to their asset-liability mismatches,” says Fitch.
WMPs and interbank liabilities, both of which have extremely short maturities, are the most likely triggers for market dislocation, even though the authorities have ensured there have so far been few instances of funding disruption.
Systemic stress could also come from a system-wide tightening of liquidity, perhaps as a result of a policy misstep or major event that shakes confidence, such as a large and sustained resurgence in net capital outflows.
In a limited stress scenario, the mid-tier banks that rely most heavily on non-deposit funding and that are net liquidity takers would be more vulnerable to liquidity shortages. The state banks are likely to benefit from a flight to safety, supporting their Viability Ratings.
The authorities have demonstrated their willingness to provide ordinary support to the banking sector through recent liquidity injections, and they still have substantial resources to address deterioration in the banking sector. For instance, liquidity shortages within banks could also be alleviated by drawing down the CNY22 trillion in deposit reserves placed at the central bank.
However, the large and increasing size of the banking system means that the cost of support could be substantial relative to even the sovereign's considerable resources.