What are the key culprits behind China's liquidity problem?

Regulation and lack of collateral are to blame.

According to Natixis, the dark cloud over the PBoC is that the massive injection of liquidity is feeding the further expansion of shadow banking, which spikes concerns on contagion risk and, ultimately, financial stability. In that regard, the PBoC has stepped up its efforts to safeguard financial stability by a number of tools.

The most relevant one is a quarterly Macro Prudential Assessment (MPA) introduced less than a year ago. It is a new, more sophisticated, type of window guidance, has shaped banks’ behavior quite drastically, especially on the funding side.

Here's more from Natixis:

Banks’ funding strategy for some time has aimed at substituting the reduction in the deposit base, due to capital outflows and a search for yield in the shadow banking, for other sources.

Among the non-collateralized ones (i.e. closer to deposits), wealth management products (WMPs) and, more recently, negotiable certificates of deposit (NCDs) have grown massively. At the same time, the interbank market has also expanded by introducing lower quality collateral (namely investment receivables).

Through its MPA, the PBoC has heavily influenced these choices. First, the choice of WMP has been penalized, which has led to a rapid reduction in WMP issuance by banks.

Instead, the issuance of NCDs has ballooned, as NCDs are not yet scrutinized by the regulator’s (i.e. not included in the MPA). The problem is that 48% of the stock of NCDs is maturing by end of Q2 2017. Beyond the refinancing risk, there is also the regulatory risk (as NCDs may indeed be brought under MPA soon).

Moving to the interbank market, the quality of collateral has been worsening, as the stock of standard collateral cannot keep pace with the growth of the interbank itself. More generally, its size has also been reduced pushed by a 33% limit imposed under the MPA framework.

Both the potential lack of high quality collateral for a good functioning of the money market coupled with the limits being imposed by MPA point to liquidity strains to continue, if not worsen, with increasing counterparty risk as the situation is very different across banks.

This is why we expect the PBoC to shift gears and, pump liquidity more forcefully again and/or soften its macro-prudential zeal (as exemplified by MPA). Chinese banks are not ready for tight monetary and regulation at the very same time. A softer tone on either or both sides is even more important as counterparty risk creeps up among China’s risk officers.