The fallout from Baoshang Bank’s default is far from contained. As counterparty solvency risks have contributed to tightening interbank market conditions for smaller banks, with growing evidence of funding stress, the key risk for China’s economy is a contraction of credit from smaller banks and non-bank financial institutions (NBFIs), which may also contribute to a selloff in fixed income markets.
In this note, we use all available data resources to explain the potential consequences of the contraction of shadow banks, which was already ongoing under Beijing’s deleveraging effort in 2018, and now looks set to intensify, weakening overall credit growth and cyclical momentum in the economy later this year. Even if the PBOC responds with additional liquidity assistance and monetary easing measures, the bank does not want to remove counterparty risk from the interbank market, and a slowdown in shadow banking growth appears inevitable.
