MARKETS

The sentiment mobs holding global markets for ransom haven't been getting the action they've been demanding from China, writes MoneyShow's Jim Jubak, also of Jubak's Picks.

The People's Bank of China has taken a step back from the brink. But it's a small step.

Global investors are clearly still worried that actions by China's central bank will further slow China's economy. The Shanghai Stock Exchange closed down 5.9% yesterday, and Hong Kong's Hang Seng index dropped 2.22%. In Tokyo, the Nikkei-225 index fell 1.26%.

Last week, China's central bank let short-term interest rates climb and then climb some more. On Thursday, short-term money market rates climbed as high as 28%. The seven-day repo rate, a benchmark for the interbank market in which banks lend to each other for the very short-term, reached a record high of 12% on June 19, the highest level since 2006, and then shot up to 25% intraday on June 20.

That was enough to bring the People's Bank into the market. The seven-day repo rate fell to 7.32% yesterday after dropping 2.27 percentage points on Friday. The overnight repurchase rate fell 4.42 percentage points to 8.43% on Friday, and then dropped to 6.47% yesterday.

But the central bank hasn't injected enough liquidity into the markets to end the current cash squeeze at many banks, or to take rates down to normal levels. At 6.47%, the overnight rate is still more than double the average for 2013 of 3.09%.

And that's what has financial markets worried.

It looks like the People's Bank has decided to do just enough to avert a crisis in the banking sector. There were rumors in China on Friday and over the weekend of bank failures sparked by regular maintenance at one of the country's big banks that took ATM machines offline for an hour.

But it also looks like the central bank remains determined to use the current liquidity squeeze to crack down on the shadow banking sector. Total credit in China grew by a frightening 52% in the first five months of 2013 from the same period in 2012. Much of that—an estimated two-thirds of credit growth—is coming from the shadow banking system of loans from off-balance sheet bank vehicles, financial entities "associated" with local governments, trusts, and other wealth management vehicles.

That rate of lending is a problem, because when lending grows at that pace, the odds are that an increased percentage of loans will go bad. The central bank has minimal control over shadow lending, since the lenders in this parallel system aren't regulated by the central bank.

One solution, which these moves suggest the central bank has decided, is to shrink liquidity in general so that shadow lenders will have less access to cash. Of course, less liquidity means less economic growth. Economists are starting to suggest that growth in China could slow to as little as 6% in coming quarters, well below the 7.5% official growth rate.

China isn't facing a financial crisis, since ending the liquidity crunch is pretty much within the central bank's power. But 6% growth when the world is counting on 7% or 7.5%—and hoping for even higher—is a big deal for global economies and global stock markets.

Do remember, however, that any change in policy at the People's Bank will produce a huge snap back rally from what is now a bear market in China's stock markets.

When? Yesterday, the People's Bank said that liquidity in China's financial system was "reasonable." I think that's a sign that the current policy is likely to stay in effect, for this week anyway.

Full disclosure: I don't own shares of any of the companies mentioned in this post in my personal portfolio. When in 2010 I started the mutual fund I manage, Jubak Global Equity Fund, I liquidated all my individual stock holdings and put the money into the fund. For a full list of the stocks in the fund as of the end of March, see the fund's portfolio here.

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