Worries About Chinese Banks Are Overwrought

NEW YORK ( TheStreet) -- Apparently, Chinese authorities are investigating what's behind late-June interbank funding rate spikes and equity volatility.

Our advice: Look in the mirror.

Here's why. As banks hoarded cash in June for quarter-end reserve requirements, the Shanghai Interbank Offered Rate (SHIBOR) rose. When the central bank didn't inject liquidity, rates skyrocketed, fueling rumors of a credit crunch and bank insolvency. The longer the People's Bank of China stayed silent, the more investors fretted a bursting credit bubble and global contagion.

In our view, worries were and remain overwrought. Chinese authorities likely engineered this "crisis" to rein in off-balance-sheet bank lending. Moreover, with $3.4 trillion in foreign currency reserves and a closed, state-run financial system, China has ample bank-bailout firepower -- and every incentive to intervene, given that financial stability equals social stability. This wasn't a financial crisis -- it was political.

Chinese officials weren't pleased when aggregate financing rose 52% year over year from January through May -- a bigger-than-desired money supply increase. Historically, China has controlled money supply and growth through strict loan quotas, but those levers lost efficacy after China partially deregulated financing last year, targeting increased funding for small and mid-sized businesses.

Those efforts haven't yet borne fruit, as SMEs are still wary of securing private loans (the line between legitimate financing and "illegal fundraising" -- punishable by death -- isn't clear), but banks used the more flexible rules to issue more trust and asset-backed loans, packaging and selling them to investors as wealth management products. WMPs, which yield substantially more than traditional deposits, are important sources of investment income for Chinese citizens and key profit sources for banks.

However, most WMP lending seemingly funded unapproved (and likely unprofitable) infrastructure and real estate projects controlled by China's local and regional governments. In March, regulators tried to clamp down through stricter WMP regulations, including capping illiquid investments to 35% of each WMP or 4% of total bank assets. Banks had until year-end to comply but were slow to adapt. Total financing rose another trillion yuan ($163 billion) in June's first 10 days. So officials got tougher, seemingly letting SHIBOR rise to add market pressure to force banks to clean up balance sheets.

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