Don't panic: Spike in China's interbank rate is just a 'temporary liquidity phenomenon'

S&P warns rising nonperforming assets are a bigger threat.

The spike in China's interbank rate is a temporary liquidity phenomenon propelled largely by technical and seasonal factors, said Standard & Poor's Ratings Services' today in a report titled, "Credit FAQ: Top-10 Investor Questions On The Chinese Interbank Market And Financial Stability."

Here's more from S&P:

Interbank rates in China spiked in late June, leading some analysts to conclude that a credit crunch, or even a credit crisis, was underway after the fast credit growth in recent years.

The People's Bank of China's (PBOC) decision to not intervene and not quickly and clearly explaining to the market what it was doing, and why, added to the market uncertainty. The seven-day interbank repurchase rate rose as high as 11% on June 20, from about 5% early in June, before falling back below 7% in late June on the back of selected intervention by the PBOC.

"The Chinese authorities are not behind the curve," said Paul Gruenwald, Standard & Poor's Asia-Pacific chief economist. "We believe inaction by the Peoples' Bank of China (PBOC)--thus, letting interbank rates move sharply higher--was a deliberate policy choice aimed at slowing the growth of wealth management products (WMPs) in some banks."

"Despite the significant coverage in the financial media, we feel that a fair amount of confusion remains about the recent events, why they happened, and how we should interpret them," Mr. Gruenwald said.

We believe the bigger risk ahead is how China's financial system will deal with a potentially significant rise in nonperforming assets. Loan-loss provisioning has increased but credit continues to grow quickly, partly backed by widespread implicit government guarantees.

China's policy responses so far this year to slower growth and the interbank market turbulence have been encouraging, in our view. What remains untested is China's policy response to distress in a systemically important financial institution in light of the widespread perception of government guarantees.

"How would the government respond, what would that mean for sector stability, and what are the moral hazard and public finance implications? We believe the Chinese government will have to face such a choice at some point," Mr. Gruenwald said.