Here's the real deal behind China's interbank liquidity squeeze

Shibor jumped 7.66% overnight.

According to Bank of America Merrill Lynch, the interbank liquidity squeeze started two weeks ago and continues this week with overnight Shibor jumping to 7.66% on 19 June from 5.60% on 18 June. 

"Note before the squeeze 7-day Shibor had been around 3.3%. The PBoC signaled its tough stance by issuing RMB4bn PBoC bills this week and refrained from injecting extra cash into the system," said BofAML.

Here's more:

What really happened?
There are many factors behind the interbank liquidity squeeze that might be cited, but we believe that the ultimate reason is the central bank’s tough stance as the PBOC can practically provide unlimited liquidity to ease every squeeze if it wishes to. So why has the PBoC refrained from adding cash to the system in this instance?

As more information becomes available, it seems that the PBoC and some other regulators could be taking the opportunity of the tight funding conditions to ‘punish’ some small banks which had previously taken advantage of the stable interbank rates to finance their purchase of higher-yield bonds.

While part of these “carry trades” did involve WMPs or other shadow banking activities, most of those “carry trades” might be just arbitrage on the part of banks and a few other financial institutions with access to interbank markets.

Costs and benefits of this “liquidity squeeze movement”. While the surge in Shibor could punish institutions engaging in risky carry trades and facilitate the bond market housing cleaning, it will undoubtedly disrupt both the financial markets and the real economy if the liquidity squeeze lasts too long.

Since last week, we have seen incomplete sales of government bonds and the jump in discount rate of bankers’ acceptance, which is an important funding source for SMEs. Small-to-medium banks’ lending could be slowed and they are offering WMPs with higher yields to attract funding. Some people might believe that the interbank liquidity squeeze is negative for shadow banking growth, but it spurs banks to issue WMPs to raise cash.

The biggest costs of volatile Shibor is a possible loss of confidence in China’s financial reforms which are supposed to liberalize interest rates and setting Shibor as new benchmark rates for financial markets. The sudden surge in Shibor and the liquidity squeeze for banks might suggest that China has no clear financial reform roadmap.