Izabella Kaminska at FT Alphaville has a post elaborating the liquidity crisis in China (free registration required). One probably underestimated point is that China recently ran a balance of payments deficit (Sep quarter 2012, see here or here). They needed the liquidity pushed in by QE to fuel the credit expansion which has been going on. The most recent round of QE starting in Sep 2012 was probably just what they needed in terms of timing.
The crackdown on export over-invoicing (show fake or over-valued exports to bring in foreign financing through the trade route) in conjunction with backing up of US bond yields could well have a larger impact on China and other emerging markets. Take for example the fact that Chinese imports are outpacing export growth. It is true that there is still a net current account surplus, but the surplus will narrow over time.
So what happens if actually exports are being over-stated thanks to the carry trade? What is the true state of the current account?
Let me illustrate how this can be done.
Company A in mainland China incorporates a subsidiary B in Hong Kong. B agrees to purchase (import) widgets from A (sale=exports). To finance this, B gets a loan from an offshore bank (who is keen to get CNY, actually CNH, exposure). A moves the widgets to a bonded warehouse and B sends the payment across. A uses the money in its business or invest in high yielding wealth management products (effectively a CDO). In this way China reports an export (widgets moved to bonded warehouse counts as export), while Hong Kong does not report an equivalent import (goods have not shipped). Obviously at some stage the transaction will have to unwind.
(chart source: ineteconomics.org)
The point is that with the increased risk on emerging markets, if inflows stop, this removes one source for financing for Chinese onshore businesses. Possibly the spike in overnight to seven day rates is related to this sudden stop of flows.