China’s financial system is in the throes of a cash crunch, with interbank lending rates spiking Thursday and bank-to-bank borrowing nearly stalled, even as growth in the economy displays signs of slowing further.
China’s interbank and money market rates have soared over the past two weeks, which has made banks and other financial institutions 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.
In a worst-case scenario, absent intervention by policy makers, defaults at lenders with the most exposure and shakiest balance sheets could lead those institutions to fail. 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.
“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.”
The interest rate that Chinese banks must pay to borrow money from one another overnight surged 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 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 conducting 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, the People’s Bank of China. In the past, when China’s economy has 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 and lead to overinvestment.
“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 Thursday 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 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 funding for their investment in higher-yielding bonds, or to finance off-balance-sheet activities, or shadow banking.
“The P.B.O.C. 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 Thursday in a research note.
Mr. Lu said 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.”
Signs of a slowdown
China’s economy has been showing signs of a slowdown in recent months. 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 at a faster pace in response to slack 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.
Stock markets across greater China fell Thursday on news of the liquidity situation and manufacturing survey and were the worst performers in Asia. The Hang Seng Index in Hong Kong dropped 2.9 percent, while the Shanghai composite index fell 2.8 percent.
“Manufacturing sectors are weighed down by deteriorating external demand, moderating domestic demand and rising destocking pressures," Qu Hongbin, HSBC’s chief economist for China, said in a statement accompanying the survey results. "Beijing prefers to use reforms rather than stimulus to sustain growth," he added. "While reforms can boost long-term growth prospects, they will have a limited impact in the short term.”
The combination of slower economic expansion and the liquidity crunch in the financial sector 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 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 Wednesday after a meeting presided over by Mr. Li, according to Xinhua, the state-run news agency.
“The central bank wants to accelerate reform,” said Zhu Haibin, an economist at J.P. Morgan. “They want to give the market a lesson: you need to manage your risk and not rely on the central bank.”
Yu Song, an economist at Goldman Sachs, said in a report Thursday that the government’s decision to tighten liquidity to deal with financial risks could slow growth in the near term. But, he added, “the flip side to this new approach is that the reform measures should reduce systemic risks and possibly raise the level of potential growth.”
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 P.M.I. 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 People’s Bank of China, which, unlike many other central banks, is not independent and reports to the State Council.
The rise in interbank rates began to take off two weeks ago, before China went on a three-day national holiday to observe an ancient dragon boat festival. Banks typically face higher demand for cash before public holidays, and the initial uptick in rates was not considered abnormal at the time.
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 percent on Thursday, up from 8.5 percent on Wednesday, before closing at 11.2 percent.
Some analysts interpret the central bank’s move to allow the cash crunch as part of a campaign to crack down on shadow banking, which they say can sometimes rely on the interbank market as a source of funding.
According to this theory, the central bank is attempting to rein in the issuance of so-called wealth management products in China. These are short-term debt investment products that are marketed by banks as paying stable returns akin to normal bank deposits, but at higher interest rates. The total amount of such products outstanding in China as of March was about 13 trillion renminbi, or $2.1 trillion, according to estimates by Charlene Chu, a senior director at Fitch Ratings in Beijing.
Banks are able to increase their fee income from the sale of these products, but because they do not appear on banks’ balance sheets, there can be little transparency regarding what loans, bonds or other assets have been packaged together under a given product. Moreover, although the products themselves are typically for a short term of, say, three months, the underlying loans they support are often of longer durations — two years, for example.
“To some extent, this is fundamentally a Ponzi scheme," Xiao Gang, then the chairman of the Bank of China, wrote in an opinion column in China Daily last October, referring to the mismatch between the maturity of wealth management products and the loans they pay for. "The music may stop when investors lose confidence and reduce their buying or withdraw" from the products, he wrote. Mr. Xiao now serves as the chairman of the China Securities Regulatory Commission.