Tough new credit rules in China, imposed by a government determined to take the air out of a dangerous financial bubble and craft a better-balanced economy, threaten to slow domestic growth and throw a spanner into the global recovery.
The new policy has already triggered a credit crunch in China, sparked a stampede out of Chinese stocks, and rattled markets around the world. On Monday, the Shanghai stock index suffered its worst one-day loss in nearly four years and Chinese financials took their worst drubbing since the darkest days of the global financial crisis in 2008.
The news out of China, coming at the same time the U.S. Federal Reserve is signalling its readiness to cut back after four years of aggressive stimulus, fuelled market fears that tighter monetary conditions in the world's two biggest economies would derail still-sluggish global growth, driving down global stocks Monday, though North American markets regained some ground.
Beijing's effort to clamp down on reckless lending, particularly from the shadow banking system that provides a large chunk of the credit needs of smaller businesses, "shows the bind that they're in … how difficult it is for them to seriously rein in both over-all credit growth and particularly shadow lending," said Patrick Chovanec, chief strategist at Silvercrest Asset Management in New York and a former associate professor at Tsinghua University in Beijing.
"And it shows how much trouble it causes when they make even fairly modest moves in that direction."
Chinese banks faced serious cash shortages last week as the costs of borrowing from each other shot up, and the central bank, the People's Bank of China, conspicuously failed to step in to ease the crunch. The Bank of China, one of the country's biggest financial players, was forced to deny reports it had defaulted on interbank loans.
"The intention of the central bank is now crystal clear to investors," said Na Liu, founder of CNC Asset Management Ltd., of Toronto, who advises Scotia Capital on China. Through "a partially self-engineered interbank market crisis," he said in a research note, the bank is sending a warning to commercial lenders that it will not tolerate "unchecked credit expansion, particularly through the shadow banking system," as well as seeking to root out those banks most at risk of default.
Although tight financial conditions had improved by the end of last week, the message was indeed clear: Rein in credit or face the consequences.
Mr. Liu believes the next step will be a move by the government to force banks to bolster their balance sheets.
If Beijing sticks to its guns, it will be a bold signal that a new generation of political leaders is prepared to tolerate a period of financial disruption and slower economic expansion in its efforts to take the air out of a credit bubble, wean the country off its heavy dependence on industrial exports for growth, and build a more sustainable, if slower, economy based on a sounder financial footing and increased domestic consumption.
"If there is financial instability in China, the risks are primarily in China. Obviously, however, that impacts the real economy," Mr. Chovanec said.
Already, analysts have been downgrading forecasts for Chinese economic growth this year, and several now doubt the government will reach its target of 7.5 per cent. That, in turn, has negative implications for countries counting on at least stable Chinese demand to keep their own economies chugging along. That list includes resource producers such as Canada, Australia and Brazil and exporters of industrial machinery and equipment, led by Germany and Japan.