How China’s credit crunch could hit global markets

In 2008, one of the key warning signs that we were heading for trouble was what was happening to the Libor rate.

Keeping things simple, Libor the London interbank offered rate is the interest rate that banks demand from each other to borrow money in the very short-term.

In 2008, Libor began to spike as banks stopped trusting one another. They wouldn't lend money to each other, because they were all worried that their fellow banks were bust.

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It was a clear warning of the trouble to come.

Why am I raising it now? Because in the last couple of days, Shibor the Chinese equivalent of Libor has rocketed

China's deliberate credit crunch

Now, comparing this to 2008 makes it all sound scarier than it necessarily is. These sorts of credit crunches are not unusual in China. This is not a sign that things are on the verge of imminent collapse again.

However, what is unusual, is that the Chinese authorities have stood by and let it happen. They intervened this morning to loosen money conditions a little, but what's surprising is that the spike happened at all.

So what's going on?

Let's cast our minds back to the US subprime mortgage business. The fundamental problem was that banks mainly because of skewed incentives all the way down the chain of command loaned money to people who had no hope of ever paying it back. When the scale of this bad lending became clear, everyone panicked, lending for any purposes dried up, and the central banks eventually had to step in.

In other words, lending was done for all the wrong reasons. The return on the end loan didn't matter. Lending was done for political reasons (to boost home-ownership) and for reasons of greed (brokers got bonuses based on the amount of mortgage business written, not the quality of the loans).

China has a similar problem. To avoid collapse in the wake of 2008, China pumped lots of money into the system to spend on infrastructure. But the quality of lending was politically driven. So lots of money has gone into projects that will never, ever be able to pay it back.

Yet despite the best efforts of China's leaders to rein things in, rampant credit growth has continued this year. And to make matters worse, there's also the expansion of the shadow' banking system, which is much more concerning for the government much more concerned because it's not under its direct control.

So perhaps this is best seen as a warning shot across the bow: stop the reckless lending, or else.

As Peng Wensheng of China International China Corp tells the FT, China's "central bank wants to send a message to banks to be more cautious in their risk control and to improve their own liquidity management. It is saying that you cannot expand credit as you like, and then simply rely on the central bank to back you up."

In other words, with somewhat ironic timing, China is yanking away the central bank put', just as Ben Bernanke does the same in the US. It wants banks to think more carefully about putting money into productive projects, rather than investing in any old rubbish, safe in the knowledge they'll be bailed out.

China is serious about getting a grip on growth

But the main thing to understand is that China is serious about getting a grip on its ropey financial system.

Now China may well manage to clean out its financial system without having a 2008-style messy collapse. It certainly won't be the first time that China has had to clean up a bad-debt riddled banking sector. As a research note from Nomura point out, the government last did it "in early 2000, when the non-performing loan ratio was 30%."

And in the long run, a more efficient banking sector in China would be a good thing. But in the short term, it cannot be good for Chinese growth. As Nomura adds, the deleveraging process will be "painful". It could hammer property developers and manufacturers among many other sectors.

In turn, falling Chinese demand won't be good news for a fragile global economy. In this week's issue of MoneyWeek, out today, CLSA analyst Russell Napier highlights how this could lead the world into a deflationary shock. The end game could well be an opportunity to buy equities far cheaper than they are today and we may see a lot more money-printing too. But in the meantime, Russell has some clear ideas on where to hunker down. If you're not already a subscriber, subscribe to MoneyWeek magazine.

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