WELCOME to Doctor Li Keqiang's surgery.

It is becoming clear that China's new economic leadership team is willing to accept some short-term pain for long-term gains.

We suspected that Premier Li would want to drive significant reforms. We underestimated, however, his apparent willingness to make policy choices that would risk further downside pressure on the economy. The most obvious evidence was seen in the interbank market last week, when the central bank allowed rates to rise well beyond the market's expectations.

The worst of the liquidity crunch may now be behind us, but we believe interbank rates may stay at elevated levels for a while. We see the People's Bank of China's statement to quell fears of a credit crisis, but it signals no near-term easing. At least for now, this is still just a liquidity issue and the central bank has full control of the situation.

A broad-based easing is unlikely, although emergency support to prevent systemic risk is possible. Liquidity could start to ease more materially in the second week of July, but rates are likely to stabilize at levels above those seen from January-April.



Before we discuss these views in detail, we take a step back to appreciate just how different economic policy is shaping up to be in 2013. So far this year, we have seen:

A stronger Chinese yuan - some 7 percent stronger on a nominal effective basis - even as underlying export momentum has been extremely weak.

Tighter credit conditions for local government investment platforms, which result in slower infrastructure investment growth.

A direct hit to consumption from the government crackdown on banqueting and gift-giving.

An ambition stated by Premier Li at the recent State Council executive meeting to curtail credit to sectors with overcapacity, such as steel and solar power. This is a new policy that could result in bankruptcies if followed through to its conclusion.

Higher interbank rates as a result of the central bank's decision not to inject liquidity when it normally would. The longer this policy lasts, the more concerns about banking-sector stability will be raised. It may cause slower credit growth in the second half.



This surgery will be painful - up to a point. It is negative for short-term growth. This marks a fundamental shift in attitude from Beijing, reminiscent of the days of Premier Zhu Rongji, who oversaw the layoffs of some 50 million workers at state-owned enterprises in the late 1990s.

Even in this new environment, though, we believe the Chinese authorities will want to ensure official growth of 7.5 percent. As the State Council meets in a couple of weeks to discuss the economy's performance in the second quarter, we cannot rule out a move to show it is keen to support growth.

Surgery on the banking system begins here. China's current high interbank rates are the intended result of a central bank campaign to force banks to better manage liquidity and deleverage from certain sectors. Comparisons with the Lehman-related freezing of interbank liquidity in the US in 2008 are unhelpful. This is not a run on liquidity caused by a credit event. Instead, we believe it is a deliberate policy meant to ease risk in the interbank system.



What happened on June 20-21? What did the People's Bank of China do?

After the overnight repo rate spiked to 30 percent and there was talk of the interbank market freezing up, 21st Century Business Herald newspaper reported that a large national bank had failed to meet a payment on June 20 and that the central bank had injected 400 billion yuan (US$65 billion) via repo transactions with certain big banks. The bank named in the report denied a failed payment, and 21st Century subsequently withdrew the report and apologized. There was no confirmation of any central bank liquidity injection.

Given the decline in rates late on June 20, however, something seems to have happened. After the overnight repo rate peaked at 30 percent, it finished the day at 4.3 percent. Rates became a little less volatile the next afternoon and moved lower. The overnight rate on June 21 ended the day at 8.7 percent, sharply off the highs. Bloomberg reported that the central bank had injected liquidity into a small number of institutions.

In a statement issued on Tuesday ,the central bank admitted that it had provided liquidity to some institutions while banks with sufficient liquidity also began to lend money in the interbank market. The decline in rates suggests that the central bank does not want rates to fall back to low levels and it still wants a functioning interbank market.



What does the People's Bank of China hope to achieve through higher interbank rates?

The bank's campaign appears to be focused on smaller shareholding banks, which are particularly reliant on short-term interbank lending for their long-term liquidity needs.

Despite the 75 percent loan-deposit ratio limit, it is clear from their balance sheets and outstanding wealth management products that some smaller banks run the de facto ratio above 75 percent.

Such wealth management products tend to be short-term in nature, but they finance long-term assets. In an ideal world, the bank would not need to source liquidity when the product matures since it would be quickly reissued and the funds would remain under the bank's control. However, there are clearly risks, and it appears that some banks have been relying on interbank liquidity to tide themselves over during periods between redemptions and reissues.

The higher interbank rates are telling banks they need to source their own liquidity, reduce their reliance on such products and not expect the central bank to bail them out when they face a cash squeeze. Banks will be under pressure to issue longer-term products to overcome liquidity pressure. Banks will also likely choose to raise rates on those products.



Just how much pain is the central bank willing to inflict?

Surgery is meant to cure, not kill, the patient.

While some pain is inevitable, we firmly believe the central bank is in control. It has numerous tools at its disposal to respond to excessive tightness. It could launch reverse repo transactions, cut the reserve requirement ratio or provide liquidity through short-term liquidity operations. At the end of the first half, the interbank market will be under pressure. Liquidity injections are likely.



What do these actions mean for broader credit growth?

The answer to this depends on how long the current tightness lasts. In the short run, higher interbank rates could feed through to slower lending as banks hoard liquidity. Interbank rates are likely to feed through to draft discounting rates and bond funding rates, suppressing demand for funds. Bloomberg has reported that several companies have postponed bond issues.

Banks issuing higher-yielding wealth management products will attempt to pass on the higher costs to their clients. This will deter marginal borrowers, so first-half growth in the "shadow banking" system should also slow.

Slower credit growth at a time when the economy is weak is certainly a new policy stance for Beijing. We believe the authorities are now willing to tolerate slower near-term growth in exchange for higher growth potential in the medium- to longer-term.

The imbalanced structure of China's current credit model - which strongly favors top-tier corporates and state-owned enterprises - is having a diminishing impact on growth as credit increases. This imbalanced model is based on banks having a guaranteed margin within a policy-driven interest rate system.



What is next for interest rate reform?

Recent State Council announcements and a recent speech by central bank's Monetary Policy Committee advisor Chen Yulu have raised expectations of another move toward interest rate reform in the near future. This would most likely be raising the upward limit on deposit rates and lowering the floor below the benchmark loan rates.

This would have the effect of raising deposit rates and would signal support for lending, though it is unlikely that banks could really price loans cheaper, given interbank tightness.