Bad medicine

Unchecked rate surge could threaten China's growth

Surging interbank rates pose a dilemma for China's central bank. Leave the squeeze in the money markets unchecked, and the effects could threaten China's growth. Come to the rescue, and important lessons will go unlearned.

The soaring cost to banks of borrowing from one another is partly a self-created drama. Smaller lenders have lent too freely and unwisely; many roll over loans rather than write off bad debts, reducing the cash they have coming in. May's collapse in currency inflows from the export sector may have been the last straw, causing the two-week bond repurchase rate to hit 12 per cent on June 7. By June 17, it had fallen to 6.8 per cent, but that's still double its one-year average.
 
So far the People's Bank of China has watched and waited, possibly in an attempt to prod the banks into being more responsible. But high rates pose a risk to the financial system and to the economy. An illiquid bank might find itself unable to meet its short-term commitments. At worst, it might even be unable to meet depositors' requirements for cash. Even if the central bank stepped in, and it almost certainly would, confidence in the whole banking system could take a hit.

Companies, too, could be caught in the web. Unlike in other countries, interbank rates don't directly affect the cost of loans, which are regulated. But the cost of funding is likely to influence the price of short-term lending like discounted bills, where clients exchange IOUs for cash. Such channels have become more important as cash flows thin. It took listed companies an average of 49 days to recover their receivables in the first quarter of 2013, compared with 28 days in 2007, according to a BNP Paribas study.

The central bank has various tools to end the liquidity squeeze. It could increase the size of its open market operations, or free up some of the 20 percent of total bank deposits it keeps locked in its vaults. The risk of moral hazard shouldn't be dismissed: if the central bank rides to the rescue, rates may well surge even more dramatically next time cash grows scarce. But when growth is at stake, that cost is probably acceptable.