U.S. Markets closed

China Stands Firm On Risky Lending As Markets Tumble

China's credit crunch, which many had hoped would be short-lived, continued to take its toll Monday on borrowers in the world's No. 2 economy. And the fallout sent stocks and bonds tumbling around the world. The Shanghai composite took the biggest hit, sinking 5.3%. Benchmarks also slid in Hong Kong (off 2.2%), Singapore (off 1.6%) and Australia (off 1.5%).

Yields surged too. The 10-year Treasury rate rose 5 basis points to 2.56% after hitting 2.63% intraday. Ten-year yields jumped 9 ticks in Germany (the EU's safe haven), 22 in Belgium, 28 in Australia, 34 in Singapore and 35 in Portugal. Some of those surges cooled off by day's end.

Chinese interbank rates — the barometer of China's cash shortage — fell Monday for a second straight session — though they remained high. That's due to targeted liquidity injections as the People's Bank of China seeks to "appropriately fine-tune" its policies, as it said in a statement.

But the PBoC made a statement that certainly wasn't meant to reassure a rattled market: Banks must "be prudent in managing the liquidity risks that may arise from an overly fast expansion of loans and other assets.

China Banks Misbehaving?

Behind the disciplinarian action lies a big issue. "(China's leaders) know there's a potential bad-debt problem," said Todd Lee, senior director of global economics at research firm IHS Global Insight. Banks have been making high-risk loans to speculative ventures, especially to property developers. Many such loans come from small banks, which can ill afford a rash of defaults.

Even worse, a so-called shadow banking system has emerged, where banks make loans off their balance sheets, sometimes using fictitious names for borrowers. This is a bid to avoid monitoring by the central bank, which would certainly object to the loans' amounts and risk. Is this legal? "It's a gray area," Lee said.

Authorities' willingness to crack down carries two strong messages, analysts said. First, they're confident that their actions won't lead to an all-out crisis. Second, that banks' push into high-risk areas warrants the PBoC's painful moves.

This may curb short-term economic growth. Goldman Sachs cut Q2 and full-year GDP targets in a Sunday note, noting China's tighter financial conditions.

Morgan Stanley and other investment banks were shaving China growth estimates even before the past few days' turmoil.

Orders From The Top

New Premier Li Keqiang has already cooled expectations for more aggressive fiscal or monetary moves. "(T)he room to rely on stimulus policies or government direct investment is not big ... we must rely on market mechanisms," he said in a May 13 speech.

Might this lead to an unanticipated catastrophe

"We believe a blow-up in systemic risk will not occur as the People's Bank of China is clearly closely monitoring what is happening and still has plenty of ammunition to ease the pressure," Nomura analyst Lucy Feng said in a Monday note. "What is obvious is that the PBoC is no longer tolerating banks taking advantage of the interbank market to boost yields or funding.

The PBoC is flexing its muscles at the worst time from the banks' perspective, said IHS Global Insight's Lee. This is a high-demand season for cash in China. And the Federal Reserve is being more explicit about its quantitative easing exit plans.