Cash crunch in China as rising interest rates crimp lending

Hong Kong - China's financial system is in the throes of a cash squeeze, with interbank lending rates spiking Thursday and bank-to-bank borrowing nearly stalled, as the government tries to restructure the economy and punish speculators.

With China's interbank and money market rates soaring over the past two weeks, banks and other financial institutions are afraid of lending to one another. Those in need of short-term cash, or liquidity, must pay dearly; failure to do so raises the possibility of defaults.

China's central bank has refused to step in and provide additional liquidity to the credit market. Analysts say the government is holding off for a reason: The government is trying to restructure the economy and punish speculators.

A huge shadow banking operation has emerged in China in recent years, with smaller banks and trust companies borrowing from bigger state-run banks and then turning around and re-lending that money at high interest rates to private companies and property developers, usually those that have trouble borrowing.

It is a risky strategy for the Chinese government, which is also grappling with a slowing economy. Many of those companies might have a harder time paying back their loans and many analysts fear the losses could ripple through the banking system.

But analysts say the central bank is willing to hold off on pumping money into the economy-a move that would likely lower short-term interest rates-in the hopes of reducing the role of the state in the economy.

"The central bank wants to accelerate reform," said Zhu Haibin, an economist at JPMorgan. "They want to give the market a lesson: You need to manage your risk and not rely on the central bank."

Zhu and other economists say restructuring a slowing economy that has grown addicted to low interest rates and easy money could be perilous; the decision could tighten lending and slow growth too quickly.

In a worst-case scenario, absent intervention by policymakers, defaults at lenders with the most exposure and shakiest balance sheets could lead those institutions to fail.

"China's central bank, by allowing a spike in interbank rates to persist for longer than usual, is sending a message to the market that liquidity needs to tighten and credit growth slow at the margin," Andrew Batson and Joyce Poon, analysts at GaveKal Dragonomics, wrote Thursday in a research note.

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