Coordinated policies from the central bank and the banking regulatory agency are needed to prevent risks triggering a crisis

China's shadow banking system, including its distinct interbank business, poses a big potential risk to its financial system, which, along with the real estate bubbles and the colossal local government debts, means the country's financial situation is very complicated.

If no timely measures are taken to regulate the country's sprawling shadow banking system and lower the high leverage ratio of commercial banks, the accumulated risks will further increase the likelihood of a financial crisis in the future.

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However, the authorities also have to consider that if forcible actions are taken to address the risks, defaults in the shadow banking system could trigger widespread repercussions.

For effective regulation of the shadow banking system, the central bank and the banking regulatory agency, should coordinate their policies, but so far there has been no appreciable cooperation between them. The People's Bank of China and the China Banking Regulatory Commission have each adopted their own measures to prompt commercial banks to regulate their shadow banking business over the past year. However, the overlapping force of these measures has also caused concerns that they will result in the disorderly collapse of the sprawling shadow banking sector.

At the same time, the government is also confronted with a difficult choice between maintaining relatively high interest rates and stopping the large-scale influx of profiteering short-term capital.

The central bank can maintain a relatively high interest rate in the liquidity market as a way of pressing commercial banks to lower their leverage ratios. However, its continuous interventions into the yuan's exchange rate against the US dollar have facilitated cross-border arbitrage. The inflow of a large volume of overseas funds aimed at profiting from the higher domestic interest rates will, to a certain degree, offset the central bank's efforts to maintain a higher interest rate. That will affect the central bank's independent decision-making on the yuan's exchange rate against the dollar. As a matter of fact, compared with previous years, the elasticity of the yuan's exchange rate against the dollar decreased last year and the monetary authorities' previous phobia about the yuan's appreciation seems to have flipped and become a phobia about the yuan's depreciation. In this context, any efforts by the central bank to maintain a stable exchange rate for the yuan will affect its independent monetary policymaking. For example, while deciding the yuan's benchmark interest rate, the central bank also has to take into consideration the influence the changed rate will have on cross-border capital flows besides considering domestic inflation.