The news this month that China's banks were no
longer lending to each other hit financial markets like a shockwave,
similar to that generated by the collapse of Lehman Brothers bank in
"The market froze ... No transactions were taking place," said Patrick Chovanec, a former business professor at Beijing's renowned Tsinghua University, who has moved to a position as chief economist at Silvercrest Asset Management.
"It's serious," he told dpa after the interbank market came to a standstill last week.
Bank of China, the state-owned heavyweight, found itself compelled to deny rumours that it was insolvent. There had been talk that payments were being delayed by 30 minutes for lack of funds.
"What does defaulting mean? Not answering the phone when creditors are calling? No, but they were not paying out either. It's a question of semantics. They did not default, because they were buying time," Chovanec said.
The prospect of a banking run in a population the size of China's - especially given the huge deposits private savers have set aside - filled observers in Beijing with horror, even though market watchers had seen signs of a storm brewing at the beginning of the month.
Money market rates have risen steadily, indicating banks are increasingly wary of short term lending to each other. Last week, those rates hit almost 14 per cent, although they fell from those highs on Friday.
Expectations in the market are that rates will hover at around 8.5 per cent for the month ahead. For economists, rates anywhere above 6 per cent count as a credit crunch.
"That puts them right up at the edge of freezing up again," Chovanec says. "If there is some kind of shock, the market will freeze."
The crisis hit just as China's real economy - the world's second-largest - is faltering. Business sentiment is in negative territory, with the latest purchasing mangers' indices pointing to contraction after years of growth.
All of this is bad news for a world economy that has grown accustomed to depending upon China for growth.
"Should this trend continue, there is a danger that the squeeze could be felt in loans to business and thus in the real economy," analysts at Germany's Landesbank Hessen-Thueringen said.
China's government is also unable to return to the easy money policy it deployed after the 2008 financial crisis broke, since that is the precise source of the current difficulties.
"The background is that China over the last five years was fueling growth with stimulus ... This generated a lending boom," Chovanec says.
But not all the investments are performing to expectations, he adds.
"If a lot of lending is going into investment and not generating returns, then the loans need to be rolled over, and that means they don't pay off the capital," he says.
The easy credit has become a drug. "You need more and more credit expansion to generate growth ... You get less GDP (gross domestric product) growth with more lending, and this creates stresses for the banking sector," Chovanec says.
He also expressed concerns about funds flowing to the shadow banking system, which are made up of asset management companies, some of whose investment strategies are suspect. Payments due to this sector are behind the current liquidity shortage and the high interest rates.
Wang Tao, chief China economist of Swiss bank UBS, told the Xinhua news agency that the Public Bank of China (PBOC) had made clear over the past fortnight that it would rein in credit expansion. The central bank last year already intervened to ease bottlenecks.
However, its calls for financial discipline have largely gone unheeded.
"Banks may have to scale down their credit growth plans and manage their own liquidity more prudently," Wang said.
Total social financing, a gauge of China's credit expansion, surged 52 per cent during the first five months, compared with the same period last year. Much of that liquidity entered the financial system, rather than the real economy.
"The central bank and other regulators must tread very carefully in the coming months in managing the process to try to minimize the risk of an unexpected break in the liquidity chain or unwanted credit crunch," Wang warned.
Chovanec points out that recent mild tightening by the PBOC led to a frightening surge in rates and warns that worse may be to come.
"It's a very dangerous place to be," he says.
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