A Big Problem at the People's Bank

06/21/2013 5:00 am EST

Focus: GLOBAL

Jim Jubak

Founder and Editor, JubakPicks.com

China's central bank is taking surprisingly hawkish steps to stop "shadow lending," and the economy is feeling the bite, writes MoneyShow's Jim Jubak, also of Jubak's Picks.

And now we can worry about China and its central bank.

A day after the US Federal Reserve sent the US markets into a tailspin—the S&P 500 fell another 2.5% yesterday—it's the turn of the People's Bank to put ratchet up worry in the global financial markets.

The rate that's causing all the worry is the interbank lending rate, the rate that banks charge each other to make really short-term loans to each other in order to manage liquidity.

The seven-day repo rate, an interbank benchmark for funding costs, reached a record high of 12% on June 19, the highest level since 2006 according to Bloomberg—and then shot up to 25% intraday on June 20.

The high short-term rates are a reflection of a severe liquidity squeeze in China, caused in part by reduced cash flows into China in light of the attractions of a stronger US dollar and rising US interest rates.

In liquidity crisis like this, the country's central bank usually sends more money into the financial system so that banks have more to lend to each other. But so far, the People's Bank has refused to inject more than token amounts into the financial system. The central bank added 50 billion yuan ($8.2 billion) to the financial system on June 19, for example, to a single bank at a seven-day rate of 5.4%.

The central bank's reluctance to move more aggressively to add liquidity is part of an effort to rein in lending in China—not lending by the official banking system, but by a shadow banking system that includes letters of credit, leasing, loans from non-banks, and other informal sources.

Credit grew by 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. That rate of lending is a problem in that it adds so much money to the economy that it increases inflation. And because when lending grows at that kind of rate, the odds are that an increased percentage of loans will go bad.

By definition, 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, the one the People's Bank is pursuing right now apparently, is to shrink liquidity in general so that shadow lenders will have less access to cash.

That does have the effect of cutting official bank lending too—and that has the potential to reduce economic growth in China.

Right now, the People's Bank seems willing to take that risk. It's pretty clear that investors aren't willing to follow.

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. The fund did not own shares of any stock mentioned in this post as of the end of March. 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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