Chinese banks pose new threat to global stability

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Europe's financial sector woes have been pushed from the headlines by Chinese banks, which suddenly find themselves wrestling with a liquidity crisis.

Earlier this week Chinese interbank lending rates – the rates that the banks charge to borrow from one another – reportedly shot as high as 28 per cent after financial institutions started hoarding their cash. Because they staunched the supply of credit, anyone who wanted to borrow had to pay a hefty price.

The financial crisis in 2008 began in a similar fashion, and the situation quickly spiralled out of control, ultimately sending Lehman Brothers into bankruptcy.

Luckily the situation isn't so dire this time around, and for good reason: the government actually hoped this would happen. For months there have been concerns about the volume of debt that is sloshing through the Chinese economy, so the People's Bank of China limited the amount of cash they injected into the banking system.

China's shadow banking sector – comprised of institutions that lend to people like property developers – has grown astronomically, and the credit bubble has fuelled speculation that the financial sector could come crashing down if the economy cools and loan defaults spread like wildfire.

After the government turned off the cash taps, the banks cut back on how much they lend. The problem is that China's financial sector – and economy in general – is such a black box that suddenly people started freaking out and borrowing rates skyrocketed.

By the end of Thursday, interbank borrowing rates jumped to 11.6 per cent and one individual loan was inked at 28 per cent – an astronomical rate that spooked investors.

Making things worse, this confusion spread at precisely the same time the global markets came off their morphine drip better known as the Federal Reserve's bond buying program, adding to negative investor sentiment.

The good news is that the Chinese government got the message: act now, before the situation gets out of hand. On Friday morning the People's Bank of China started pushing more cash into the system, and it asked banks not to hoard their reserves. Interbank borrowing rates quickly fell, relieving some of the system stress.

However, this does little to solve the long-term problem. China has an unbelievable amount of debt circling through its financial system, and at some point the government will need to curtail how much is being lent out – the same way the Fed has to, at some point, end its bond buying.

How successfully China does this could very well determine whether its financial sector stays strong.

(Tim Kiladze is a Globe and Mail Reporter.)

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