Credit Tightens in China as Central Bank Takes a Hard Line

[t_co]

http://www.nytimes.com/2013/06/21/b...ng-contracts-to-lowest-level-in-9-months.html

HONG KONG — China's financial system is in the throes of a cash squeeze as the government tries to restructure the economy and punish speculators, with interbank lending rates spiking on Thursday and bank-to-bank borrowing nearly stalled.

China's interbank and money market rates have soared over the last two weeks, and banks and other financial institutions are afraid of lending to one another. Without that lending, an economy can quickly stultify. Those in need of short-term cash, or liquidity, must pay dearly or risk default.

China's central bank, the People's Bank of China, has refused to provide large amounts of additional cash to the credit market. Analysts say the government is holding off for a reason: it is trying to reshape the economy while reducing its future role. 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 relending 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 Chase. "They want to give the market a lesson: you need to manage your risk and not rely on the central bank."

Mr. Zhu and other economists say restructuring the economy, which has grown addicted to easy money, could be perilous for another reason. The decision could reduce lending and slow growth too quickly.

The worst case, absent intervention by policy makers, 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 by ordinary Chinese. 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."

Stock markets across greater China fell Thursday on news of the liquidity situation and a disappointing survey on manufacturing. The Hang Seng Index in Hong Kong dropped 2.9 percent, and the Shanghai composite index fell 2.8 percent.

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, has said he plans changes that will promote sustainable growth, as opposed to relying on the easy credit from state-controlled banks that helped the country rebound 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 said in a statement Wednesday after a meeting presided by Mr. Li, according to Xinhua, the state-run news agency.

The interest rate that Chinese banks must pay to borrow money from one another surged overnight to a record high of 13.44 percent Thursday, according to official daily rates set by the National Interbank Funding Center in Shanghai. That was up from 7.66 percent on Wednesday and less than 4 percent last month.

China's policy makers 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 hits a rough patch, the government usually steps 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 toward 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 on Thursday 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.

On Thursday, 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 in response to slackened demand both 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 level since September and down from a final figure of 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, in a statement accompanying the survey results. "While reforms can boost long-term growth, they will have a limited impact in the short term."

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

But as the situation 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 percent on Thursday, up from 8.5 percent on Wednesday, before closing at 11.2 percent.

Basically, for those non-finance people out there, the Chinese government engineered a Lehman event in miniature to tell their banks to "harden up".

Commentary here from one of my fav bloggers:

For many years, critics of China who identify with this mythical phoenix like creature called 'the markets' have been telling China that it needs to do something about its debt problem. Eventually Beijing, says 'Oh, OK' and deliberately stages – not allows to happen, but deliberately stages – a Lehman event across its banking system. This was not a response to a crisis: the PBOC could have pumped more money into the system this time just as it had done before. It's an act of will.

And 'the markets' promptly crap themselves, though I don't know if this is actually serious or that 'granny just saw a flasher' response that you seem to get a lot of. Actually, what the folk on the trading desks have been exposed to is something that people in China have known for a long time: this is how China solves its problems, with brutal and ruthless fixes. Ok, we have a problem. We also have absolute power. HULK SMASH. Think of this as being in the tradition of the One Child Policy.

This approach is sometimes characterised as Maoism, but it's really Dengism; the adaptation of all the tools in the Leninist box away from ideological mobilization and towards real world problems. Who cares whether the cat (the Party) is black or white so long as it's a ----ing huge apex predator?

One thing that can be said for Hu Jintao is that he didn't really go in for big bang solutions. He just let things go on, or metastasize, nagging from the sidelines about moderate overall prosperity and harmonious societies.

Xi and the new boys have more vigour, whether it's building 10,000 Stevenages overnight or conducting mass rectification campaigns. Hulk is smashing again. And on this occasion, those of us outside China are on the edge of his fist.

This is why China can "win" on the global economic stage - when time comes, the central government can coordinate all its political and military levers to enact policies with unprecedented efficiency and brutality, policies that scare market participants - even those in New York and London - into doing what the Chinese government wants.