Chinese banks feel the pain as PBOC chokes shadow banking

Hikes interest rates to extraordinary levels.

The People’s Central Bank of China late last week let interest rates rise to previously unheard of levels that increased the pressure on banks to curb rampant informal lending and speculative trading rapidly becoming a serious economic threat.

Banks have been using cheap official funds to finance the vast shadow banking market that PBOC said is siphoning credit from industry and creating asset-price bubbles.

Interbank rates hit an all-time high on June 20, due in part to PBOC’s new strategy to rein in the growth of shadow finance in China by squeezing the supply of funds.

PBOC has tried to end the financial pipeline to shadow banking over the past three weeks by not injecting significant funds into the money markets even as the interest rate for some banks to borrow short-term funds soared to 25% or higher.

Analysts said this new approach of trying to tighten funding in the system available for that type of credit, is much more effective, but is also taking the market by surprise.

Some worry PBOC's hardline approach could be a risky strategy, creating the potential for defaults in China’s money markets as happened in the West after the collapse of Lehman Brothers in 2008.

Sources said PBOC had told banks it was not changing its prudent stance and they should not expect plentiful liquidity conditions forever.