Financial industry in the spotlight

A1 The most important problem for China is not necessarily liquidity itself, but the lack of an efficient link between savers and borrowers. There are distortions in the system, which can create excess liquidity in some parts of the economy, while there are shortages in others. The recent events have highlighted the problem as the authorities have stepped in to tackle excesses in the financial sector, which created a liquidity problem.

A2 Many sectors in the Chinese economy have experienced increased debt levels, which are unsustainable, but a rapid withdrawal of liquidity will put them in severe difficulties. The so-called shadow banking system is likely to contract if the authorities squeeze liquidity, and many companies are relying on this for financing, so they may face a serious shortage of funds.

A3 The so-called shadow banking system in fact is a form of marketization of a large part of the financial system to escape the controls on interest rates and lending imposed by the government. The authorities need to bring this shadow banking system into proper regulatory control while at the same time ensuring that reforms across the whole banking system give a stronger role to the market, especially through interest rate reform and proper risk oversight.

Wendy Chen economist at Nomura Securities Co

A1 China experienced a liquidity squeeze in June, as evidenced by the surging interbank market rates, and we believe that policy tightening was the main reason behind it.

For instance, the seven-day repurchase rate - an indicator of interbank funding availability - rose to a peak of 11.2 percent on June 20 from an average of 3.5 percent in May.

Since mid-March, the government has introduced a series of tightening measures in the shadow banking sector to contain financial risks.

Moreover, China's State Administration of Foreign Exchange announced measures on May 5 to contain speculative capital inflows, which should have reduced capital inflows into China.

In our view, the liquidity squeeze suggested that the cumulative effects of those measures have kicked in.

A2 The non-bank financial industry, such as the trust industry, is most vulnerable after its fast expansion in recent years. Trust companies and credit guarantee companies pose high risks to China's financial sector.

The trust companies quickly became the second-largest group of non-bank financial institutions in terms of assets under management, or AUM. China's trust funds saw AUM totaling 7 trillion yuan ($1.1 trillion) in 2012, from 1.2 trillion yuan in 2008, exceeding both the insurance and mutual fund sectors.

The flourishing of the trust industry in the past years was mainly driven by the demand of local government financing vehicles and property developers, as the government tightened controls on banks' exposure to those two sectors due to concerns of increasing bad debt.

With access to bank loans curbed, they simply turned to the bond market and trust companies for financing. Property and infrastructure projects are the main destination for funds raised by trust companies.