China Faces Fallout of Self-Made Cash Crisis

Updated June 21, 2013, 7:41 p.m. ET

China Faces Fallout of Self-Made Cash Crisis

Central Bank’s Attack on Informal Lenders Criticized as Too Aggressive; Borrowing Costs Ease Somewhat but Remain High

By BOB DAVIS in Beijing and SHEN HONG in Shanghai

China’s central bank is wrestling with a liquidity crunch of its own creation.

A cash shortage that has sent short-term interest rates as high as 25% earlier this week and alarmed the world’s markets, eased a bit Friday. Traders said the People’s Bank of China, may have asked big state banks to refrain from hoarding cash and release more funds to ease the liquidity squeeze. But the top priority for the central bank, acting on instructions from China’s political leadership, continues to be taming runaway informal lending.

China’s campaign to tame runaway credit may be too aggressive, critics say, creating as many problems as those it is trying to solve and raising the risk that the world’s second-largest economy will face continuing turmoil and slow growth.

If its action further reduces growth in China, the effects will ripple around the world to commodity suppliers in Asia, Latin America and Africa, to manufacturers and high-tech firms in Europe and the US.

The PBOC, which rarely explains its actions, hasn’t responded to repeated requests to comment

Its squeeze on China’s liquidity comes at moment of market volatility caused, at least in part, by the Bank of Japan‘s 8301.JA -3.68% aggressive monetary easing and the U.S. Federal Reserve’s talk of beginning to take its foot off the monetary accelerator.

Speculation the Chinese central bank may be taking steps to ease the cash crunch helped lower benchmark borrowing costs in China’s interbank market, where banks led to each other. The seven-day repurchase agreement rate was 9.29% on a weighted-average basis at midday Friday, down from 11.62% at Thursday’s close.

Still, the rate remains far above its typical 2%-3% range, and analysts say authorities may need to take forceful action to restore funding conditions. The interbank rate could still jump this coming week as lenders rush to raise money to meet urgent quarter-end funding needs.

With interbank interest rates remaining at elevated levels, banks’ funding costs are elevated too. “If the banks pass on these charges in higher lending rates, it is effectively monetary tightening,” said Haibin Zhu, a China economist at J.P. Morgan. “That would put further pressure” on an already slowing economy.

China’s GDP grew 7.7% in the first quarter from a year earlier, one of its worst performances since the global financial crisis, and was widely expected to slow further even before the central bank started pushing interbank rates higher in early June by withholding liquidity. It was a calculated move: Leaders knew growth could slow further as higher interest rates are bound to reduce lending, at least in the short run.

The PBOC hasn’t said why it is squeezing the market, how long it will continue the policy or how it measures success or failure. That isn’t unusual in the opaque Chinese system. Chinese officials were largely silent, too, when credit surged in the third quarter of last year, which temporarily boosted growth a bit.

The PBOC, unlike central banks in developed countries, isn’t independent. It reports to both the government’s top body, the State Council, and the Communist Party’s top body, the Politburo Standing Committee. On Wednesday, the State Council pledged it would “firmly guard” against “systemic risks” and make sure credit gets channeled into productive uses. In practice, say China analysts, that means that PBOC will continue to shut off funds as a way to reduce the surge of lending by what are known as shadow banks—an assortment of trust companies, leasing firms, pawnshops and other informal lenders—that sometimes fund projects that can’t cut it commercially and rely on political bailouts to get paid back.

Domestic credit—also called total social financing and encompassing both bank loans and other credit, including loans by trust companies—in China has spiraled to 207% of gross domestic product in 2012 from 145% of GDP in 2008, according to Nomura, a rate of increase that economists warn is similar to credit bubbles in Asia, Europe and the U.S. that eventually burst, sending the economies into deep recessions. In China, much of the credit growth came from shadow banking institutions. While few predict an imminent crisis in China, which has formidable financial reserves and is largely closed to the global financial system, Chinese officials and outside economists have increasingly worried that China would eventually face a reckoning.

“The Chinese are perhaps hoping that by tackling the problems proactively, they have a better chance of a soft landing,” said Harvard economist Kenneth Rogoff, who has studied centuries of financial crises. “They also may believe they can reverse course if credit contracts too quickly.”

Clamping down on the interbank market can also reduce the ability of banks to engage in financial arbitrage, said Mr. Zhu, a former researcher at the Bank for International Settlements in Basel, Switzerland, an organization of central bankers. That is because banks can borrow from the interbank market and use the money to lend to trust companies—considered nearly risk-free borrowrers—at higher rates, rather than hunt out underserved borrowers, who might have a higher chance of defaulting. In China, trust companies are vehicles that borrow from investors and lend out to various projects.

The central bank’s timing may be driven by political goals by China’s new leaders to boost lending to small firms and sectors that, unlike big state-owned companies have a hard time getting bank credit.

Creating a cash crunch in June also makes it more likely for any fallout to have passed well before a major Communist Party conference in October. By that time, the new leaders are bound to want the economy to be on an upswing. “From a political environment, tightening then wouldn’t be the best timing,” said Nomura analyst Zhiwei Zhang.

But the PBOC’s actions may assume the Chinese government has a degree of control over the economy that it no longer does.

The PBOC can control the amount of credit it provides to the market, but has very little ability to control how that money is then loaned out. In the past, the central bank and more senior officials looked at the large state-owned banks as essentially arms of the government. But their ability to micromanage has eased as the banks have become more powerful economically and politically and China’s economy has become larger and more complex.

“This wrestling [over liquidity] has heightened systemic risk in the financial system, creating policy uncertainty and further induced market volatility,” wrote Credit Suisse analysts Dong Tao and Weishen Deng. “The market has a legitimate reason to ask whether the central bank has the will and ability to calm the interbank market.”

Even if the central bank does turn on the credit tap again and markets are calmed, it isn’t clear whether it will achieve the State Council’s goal of getting banks to lend to favored industries. Bankers may become more conservative and focus their loans to their usual clients: big state-owned companies, often in industries marked by overcapacity, like real estate, steel, concrete and among other.

“After this episode, lenders will be more hesitant to lend,” said JP Morgan’s Mr. Zhu. “It’s beyond the policy ability of the PBOC to guide lending to the appropriate targets.”