4 culprits behind China's interbank market tightness revealed

The sharp decline in FX inflows is one.

According to Bernstein Research, the liquidity condition in China's interbank markets in June was significantly tighter than at any point in recent years.

In fact, the biggest financial news to emerge from China in June was the sharp increases in SHIBOR rates, with the short-term SHIBOR and repo interest rates reaching all-time high levels. While rates subsided towards the end of the month, they remain at elevated levels.

Here's more from Bernstein:

We believe the tightness in the interbank market was driven by a confluence of events, both structural and seasonal: 1) a sharp decline in FX inflows in June, 2) a three-day holiday (the Dragon Boat Festival) in midJune which led to the banks boosting their cash reserves beforehand,

3) the typical quarter-end posturing (i.e., window dressing) of the banks' balance sheets and 4) media reports of certain banks having difficulty repaying interbank loans.

While spikes in SHIBOR have been observed many times in the past, what caused rates to climb to all-time high levels was the central bank's unwillingness to ease the tightness either through a RRR cut or via open market operations. In fact, it issued central bank bills to withdraw liquidity in the first 3 weeks of June.

We believe this signaled the central bank's intent to impose market discipline on the banks with high exposures to the interbank market, such as the small banks. In addition, we believe the central bank aims to encourage the smaller banks to improve their liquidity management of this business.

For the month of June, short-term SHIBOR rates (e.g., overnight and 7-day) peaked at levels that were alltime highs. The overnight SHIBOR rate hit a peak of 13.4% on June 20th, the highest level ever while the 7-day SHIBOR rate peaked at 11.0% on the same day, also a record-high level.

During the final 10 days of June, SHIBOR rates eased from the record levels but remained at elevated levels

• The overnight and 7-day SHIBOR interest rates finished the month of June at 4.9% and 6.2%, respectively.
  • The 3-month rolling average of overnight SHIBOR increased by 150bp during the month of June as a result of the liquidity tightness reported in the interbank market.

During the month of June, we also saw the 3-month SHIBOR rate increase, from 3.9% to 5.4% (peaking at 5.8%). Prior to June, the 3-month SHIBOR rate never moved more than 5bp from its year-end 2012 levels during the first five months of the year.

Following the tight liquidity situation at the end of June, however, the 3-month SHIBOR climbed to the highest level since late 2011.