China financial squeeze grips as central bank wields the big stick

A slowing economy and tightening of credit challenges the new leadership in Beijing.

A slowing economy and tightening of credit challenges the new leadership in Beijing. Neil Gough and David Barboza report.

China’s financial system is in the throes of a cash squeeze, with interbank lending rates spiking this week and bank-to-bank borrowing nearly stalled, as the government tries to restructure the economy and punish speculators.

With China’s interbank and money market rates soaring over the past two weeks, banks and other financial institutions are afraid of lending to one another. Those in need of short-term cash, or liquidity, must pay dearly; failure to do so raises the possibility of defaults.

China’s central bank, the People’s Bank of China, has refused to provide additional liquidity to the credit market. The bank is not independent, unlike many other central banks, and reports to the State Council.

A huge shadow banking operation has emerged in China in recent years, with smaller banks and trust companies borrowing from bigger state-run banks and then re-lending that money at high interest rates to private companies and property developers, a practice that fuels speculation.

Pressuring speculators is a risky strategy for the Chinese government, which is also grappling with a slowing economy. Many borrowers may have a harder time paying back their loans, and analysts fear the losses could ripple through the banking system.

‘‘The central bank wants to accelerate reform,’’ said Zhu Haibin, an economist at JPMorgan. ‘‘They want to give the market a lesson: you need to manage your risk and not rely on the central bank.’’

Zhu and other economists say restructuring a slowing economy that has grown addicted to low interest rates and easy money could be perilous; the decision could tighten lending and slow growth too quickly.

The worst case, absent intervention by policymakers, would be defaults at lenders with the most exposure and shakiest balance sheets. The damage could spread to other banks, setting off runs on deposits. In the near term, markets will probably continue to be rattled, especially shares in financial institutions.

That was certainly the fear on Thursday around the globe.

‘‘China’s interbank market is basically frozen – much like credit markets froze in the United States right after Lehman failed,’’ said Patrick Chovanec, managing director and chief strategist at Silvercrest Asset Management. ‘‘Rates are being quoted, but no transactions are taking place.’’

Sharemarkets across China fell on Thursday on news of the liquidity situation and a disappointing survey on manufacturing. The Hang Seng Index in Hong Kong dropped 2.9 per cent, and the Shanghai Composite Index fell 2.8 per cent.

The combination of slower economic expansion and the liquidity squeeze offers one of the biggest challenges yet to the newly installed leadership in Beijing.

Prime Minister Li Keqiang, who took office in March, plans changes that will promote sustainable growth, as opposed to relying on the easy credit from state-controlled banks that helped the country rebound from the 2008 financial crisis.

‘‘While the economy faces up to many difficulties and challenges, we must promote financial reform in an orderly way to better serve economic restructuring,’’ China’s State Council said in a statement on Wednesday after a meeting presided over by Li.

The interest rate that Chinese banks must pay to borrow money from one another surged to a record high of 13.44 per cent on Thursday, according to official daily rates set by the National Interbank Funding Centre in Shanghai. That was up from 7.66 per cent on Wednesday and less than 4 per cent last month. But on Friday China’s benchmark money-market rates retreated after the central bank was said to have made funds available to lenders. The one-day repurchase rate dropped 3.8 percentage points to 7 per cent.

China’s policymakers have an arsenal of options at their disposal to inject more money into the financial system, including open market operations – trading in securities to control interest rates or liquidity – or, more drastically, freeing up some of the trillions of renminbi that banks are required to keep on reserve with the central bank.

In the past when China’s economy hit a rough patch, the government usually stepped in, forcing state-run banks to pump liquidity into the market, even though there was a risk it could drive up asset prices.

If the central bank’s inaction towards the deepening liquidity squeeze is a form of financial brinkmanship, some analysts see it as aimed at reining in smaller banks that had been tapping the interbank market as a source of low-cost funds for their investment in higher-yielding bonds, or for off-balance-sheet activities.

Ting Lu, China economist at Bank of America Merrill Lynch, said in a research note that although the surge in interbank lending rates could have its desired effect on reckless lenders ‘‘it will undoubtedly disrupt both the financial markets and the real economy if the liquidity squeeze lasts too long’’.

China’s economy has been showing signs of a slowdown in recent months. Economists at HSBC joined counterparts at several other banks on Wednesday in cutting growth forecasts for the Chinese economy this year.

A preliminary survey of factory purchasing managers in June suggested that output in China had fallen to its lowest level in nine months, as manufacturers cut production at a faster pace in response to slackened demand.

The preliminary Purchasing Managers’ Index, published by HSBC and compiled by Markit, dropped to 48.3 points in the first three weeks of June, its lowest level since last September and down from 49.2 in May. A reading above 50 indicates growth, and anything below signals contraction.

‘‘Beijing prefers to use reforms rather than stimulus to sustain growth,’’ said Qu Hongbin, HSBC’s chief economist for China.

The rise in interbank rates began two weeks ago, before China went on a three-day national holiday. Banks face higher demand for cash before public holidays, and the initial uptick in rates was not considered abnormal.

But as the situation has worsened, the central bank refrained from injecting new money into the system. Benchmark seven-day repurchase rates, another measure of borrowing costs, briefly soared as high as 25 per cent on Thursday, up from 8.5 per cent on Wednesday, before closing at 11.2 per cent.

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