Zhu Jun, CEO of online game developer The9, posted on his Twitter-like Weibo account an article that laid out the idea that a financial crisis was at the doorstep; “This scary article woke me up. Get ready for a nightmare.”

China central bank holds line on shadow banking as rates spike

10:45am EDT

By Gabriel Wildau and Jason Subler

SHANGHAI/BEIJING (Reuters) – China’s central bank faced down the country’s cash-hungry banks on Friday, letting interest rates again spike to extraordinary levels as it increases the pressure on the banks to rein in rampant informal lending and speculative trading.

The banks have been using cheap official funds to finance the vast “shadow banking” market, which Beijing worries is siphoning credit from industry and creating asset-price bubbles.The People’s Bank of China (PBOC) has tried to put an end to this over the past three weeks, declining to inject significant funds into the money markets even as the interest rate for some banks to borrow short-term funds has soared to 25 percent or higher.

“They are trying to take a different approach to rein in shadow banking activity,” Charlene Chu, senior director at Fitch Ratings, told reporters on the sidelines of a conference in Sydney.

“This new approach, where you are trying to tighten the funding in the system available for that type of credit, is much more effective, but it is also taking the market by surprise.”

Cash remained expensive at least for the smaller banks, though the weighted average overnight bond repurchase rate — a measure of the cost of funds — fell to around 9 percent by midday from Thursday’s close of 11.62 percent.

Some worry the PBOC’s hardline approach could be a risky strategy, creating the potential for defaults and gridlock in the money markets of the world’s second-largest economy, as happened in the West after the collapse of Lehman Brothers in 2008.

Some calm returned on Friday after rumors of some major banks needing emergency funding were quelled. There was also market talk the central bank had guided the biggest state lenders to provide more short-term funds to smaller banks.

The central bank has so far issued no official statements on the episode. However, sources said on Friday that at a meeting earlier this week, the PBOC told banks it was not changing its prudent stance and they should not expect plentiful liquidity conditions forever.

“Some banks were blindly optimistic on the loose liquidity conditions…,” said a banking source who saw internal minutes of the meeting.

“The central bank gives clear information that they will keep policy stable without sudden changes in (policy) direction,” added another source, from a state-owned bank, who also saw the minutes.

RISKY BUSINESS

In a sign of the problems Beijing is trying to tackle, shadow-market lending has contributed to a sharp decline in the dividend the economy gets for each yuan of credit extended.

In 2008, only 22 yuan in corporate fundraising — mostly in the form of borrowing — was required to produce 100 yuan worth of economic output, according to a Reuters calculation based on central bank data. By the first quarter of this year, 52 yuan was required for the same amount of output.

“One consensus among many government officials and policy advisers is that tough decisions on economic reforms could no longer be delayed and that taking some short-term pain is necessary for healthy long-term growth,” Barclays economist Yiping Huang said in a research note on Friday.

China’s cabinet this week affirmed its commitment to reducing financial risks and ensuring that credit growth supported the real economy.

The central bank is loathe to take actions such as cutting banks’ required reserves to ease the cash crunch, as it is concerned that might only exacerbate problems such as the high property prices it is trying to tame.

A flurry of panicked comments on Chinese social media sites in the wake of the spike in rates and the rumors of emergency cash injections attests to the risk that any miscalculations by the central bank could potentially have unintended consequences.

Zhu Jun, CEO of online game developer and operator The9, posted on his Twitter-like Weibo account an article that laid out the idea that a financial crisis was at the doorstep, with a comment already reposted nearly 5,000 times: “This scary article woke me up. Get ready for a nightmare.”