Credit squeeze a test for China's leaders

Slower growth and the liquidity crunch offer one of the biggest challenges yet to the new policy makers in Beijing, writes Neil Gough.

China's financial system is in the throes of a cash crunch, with interbank lending rates spiking even as growth in the economy displays signs of slowing further.

The interest rates that Chinese banks pay to borrow money from each other surged to a record 13.44 per cent on Thursday according to official daily rates set by the National Interbank Funding Centre in Shanghai. That is up from 7.66 per cent on Wednesday and less than 4 per cent last month.

However, on Friday benchmark money-market rates retreated after the central bank was said to have made funds available to lenders. The one-day repurchase rate dropped sharply to 7 per cent.

Other comparable rates in China's interbank and money markets have spiked over the past two weeks, meaning banks and other financial institutions are becoming 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 interbank market is basically frozen - much like credit markets froze in the US right after Lehman failed," said Patrick Chovanec, managing director at Silvercrest Asset Management. "Rates are being quoted, but no transactions are taking place."

China's policymakers have an arsenal of options 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 some of the trillions of renminbi banks are required to keep on reserve with the central bank, the People's Bank of China.

"China's central bank, by allowing a spike in interbank rates to persist for longer than usual, is sending a message to the market that liquidity needs to tighten and credit growth slow at the margin," Andrew Batson and Joyce Poon, analysts at GaveKal-Dragonomics, wrote in a research note. "Indeed, the central bank has been using its open-market operations to drain liquidity from the interbank market since January, setting the stage for just this kind of showdown with banks."

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 funding for their investment in higher-yielding bonds or for off-balance-sheet activities or shadow banking.

"The PBOC and some other regulators could be taking the opportunity of the tight funding conditions to punish some small banks which had previously taken advantage of the stable interbank rates," Ting Lu, China economist at Bank of America Merrill Lynch, said in a research note. Lu said that although the surge in interbank lending rates could have the 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. This week a preliminary survey of factory purchasing managers in June suggested output in China had fallen to its lowest level in nine months as manufacturers cut production in response to slack demand at home and overseas.

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 since September and down from a final figure of 49.2 in May. Above 50 indicates growth, anything below signals contraction.

Stockmarkets across greater China fell sharply on the news.

"Manufacturing sectors are weighed down by deteriorating external demand, moderating domestic demand and rising destocking pressures," said Qu Hongbin, HSBC's chief economist for China. "Beijing prefers to use reforms rather than stimulus to sustain growth. While reforms can boost long-term growth prospects, they will have a limited impact in the short term."

Slower economic expansion and the liquidity crunch offer one of the biggest challenges yet to the new leadership in Beijing.

Prime Minister Li Keqiang, who took office in March, has said he plans overhauls that will promote sustainable growth, as opposed to relying on easy credit from state-controlled banks, which helped the country rebound strongly in the years since 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, or Cabinet, said in a statement this week according to Xinhua, the state-run news agency.

Louis Kuijs, an economist at Royal Bank of Scotland and former China economist at the World Bank, said in a research note that Beijing's response to HSBC's preliminary survey was unlikely to be drastic.

"Policy makers would want to see this weakness confirmed by the official PMI and hard activity data before making bold decisions," Mr Kuijs said. "Nonetheless, this kind of data will test the resolve of the government to maintain its current relatively firm macro policy stance."

The surge in interbank lending rates is a similar test for the PBOC, which is not independent. It reports to the State Council.