China's inter-bank liquidity shortage

The shortage of liquidity in the inter-bank market in China has sparked off a fear of "monetary famine". This seems rather odd when the national savings rate is 50 per cent of GDP and even though growth is slowing, it is still one of the fastest growth rates in the world.

We have to go back to the 1959 Radcliffe Committee on the Working of the Monetary System in the UK for the controversial view at that time that it was the liquidity of the system that determined spending behaviour, rather than the interest rate.

The Radcliffe Committee also held the view that the central bank can influence the state of liquidity.

In other words, it is not the quantity of money that determines spending, but the velocity of turnover of money, which the central bank should influence.

Since then, the debate has raged between different tools that the central bank can deploy to influence the real economy, through price intervention (interest rate or exchange rate), through quantitative intervention, or intervening in liquidity of the system as a whole.

One lesson of the recent crisis is better understanding that there is a difference between individual institution liquidity and system liquidity. Individual liquidity does not add up to system liquidity.

There was a puzzle in the run up to the current crisis.

In 2007, despite adequate capital levels, many banks experienced difficulties in obtaining liquidity because according to the Basel Committee on Bank Supervision (BCBS) analysis, "they did not manage their liquidity in a prudent manner".     

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