Why PBoC must end China's credit squeeze ASAP

It could potentially backfire.

According to BofA Merrill Lynch Global Research, China's interbank credit crunch has been getting worse with media speculation about a moratorium on transfers and cash withdrawals even at some of the largest banks. BofAML also noted that the People's Bank of China must end the credit squeeze soon because of its potential dangers.

Here's more:

We are cautious at the moment and continue to watch the unfolding situation as we believe the biggest risk comes from the PBoC potentially mishandling the situation.

In our view, dealing with banks in breach of regulations should be done by improving prudential regulations rather than engineering an interbank credit crunch which could potentially backfire should banks lose mutual trust.

And they will have to end the credit squeeze soon

That being said, we believe the PBoC and Chinese policymakers will be aware of the potential dangers and take decisive measures to revive the interbank market, to calm investors and to stabilize the economy.

To clarify, we don't expect cuts of benchmark rates or RRR, but we believe the government will have to end the current interbank credit crunch.

Though China bears may appear to be finally vindicated, global investors should still keep in mind that Shibor is not Libor, China is not in crisis yet, in our view and a hard landing is still likely to be prevented.

Markets will likely fall further in the next few days, but we believe this will present opportunities in the market for investors.

Two competing explanations: Tightening or punishing?

There seem to be competing theories to explain the current situation (1) The government was seriously concerned about the overly rapid credit growth facilitated by shadow banking, so it decided to hike Shibor and squeeze interbank lending to slow credit growth;

(2) The PBoC squeezed interbank liquidity to punish banks that had aggressively used short-term interbank funding for longer-term investments. Each theory has different implications.

The first theory predicts the liquidity squeeze will be sustained much longer and interbank rates, even down from the current extreme levels, will on average be much higher than the previous level (3.3% for 7-day Shibor).

The second theory predicts that interbank rates on average will fall back to normal levels (or a slightly higher level) after the squeeze, but the PBoC will not stabilize Shibor and the market should expect a much higher volatility of Shibor.

There might also be some non-economic motivations behind this "liquidity squeeze" campaign. Many people believe that by exposing many problems in the financial sectors, current leaders could put blame on the previous government for any economic problems.