Covering the weakening Chinese economy

It was a tough day for global markets on Thursday after news broke that Chinese banks didn’t want to lend to each other and on concerns the Federal Reserve Board might wind down its stimulus plan, the New York Times wrote.

In a separate story, the paper covered the details of the Chinese credit crunch:

China’s financial system is in the throes of a cash squeeze, with interbank lending rates spiking on Thursday 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 last 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 has refused to step in and provide additional liquidity to the credit market. Analysts say the government is holding off for a reason: the government is trying to restructure the economy and punish speculators.

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 turning around and re-lending that money at high interest rates to private companies and property developers, usually those that have trouble borrowing.

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

The Wall Street Journal story led with the government’s risky gamble and the far-reaching consequences of their decisions:

The past week’s spike in Chinese interbank lending rates, failed bond auctions and even a mini default by one large bank show that Chinese leaders have decided to call time on one of the greatest credit expansions in history. If nothing else, this will subject the financial system to a useful stress test.

Shortages of liquidity are not unusual in China, particularly just before the end of a quarter when the banks shuffle assets around to meet capital adequacy requirements. Usually the central bank steps in with some loans and the pain goes away.

This time, however, the People’s Bank of China is sitting on the sidelines and the pain is only intensifying. A statement from the State Council on Thursday reassured strategic industries they will be protected from the coming credit crunch, but it also emphasized the need to contain financial risks and prepare for interest-rate liberalization.

That’s great news for China’s long-term economic prospects, but there will be widespread pain as banks scale back lending. The worry is that Beijing left it too late and a large number of unviable companies will need to be restructured. Growth would then slow substantially and the banking system could need recapitalization.

Hmmm, slowing growth and a banking system in need of capital….sounds scarily familiar. But because China is such a huge economy, the troubles there also took a toll on commodities, the Financial Times said:

But in China, the “flash” PMI fell to a nine-month low, offering fresh evidence that growth was slowing.

Furthermore, China’s money markets had another torrid session, with short-term repo rates reaching extreme levels as the People’s Bank of China refused to inject fresh liquidity.

“What is happening in China has now become a lot more important for risk markets despite something of a preoccupation with the Fed tapering QE,” said Divyang Shah, global strategist at IFR Markets.

China’s woes amplified tensions in industrial commodity markets. Copper fell more than 2 per cent to a 20-month low in London, while Brent crude settled at $102.15 a barrel, down $3.97.

But as the New York Times points out, the Chinese government has the ability to ease the crunch, if they choose to do so:

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. 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.”

Here’s hoping that the showdown doesn’t last forever. The longer markets remain volatile, the more confidence will erode, which could hamper the small global economic recovery.