China's Central Bank Shuts the Spigot

TAIPEI (TheStreet) -- First, China's monetary authority took a rare whack at its commercial banks by withholding money for interbank lending.

Then, its official news agency rubbed in the salt, calling the lack of first aid an "essential move to discipline unchecked lenders."

Then, Chinese stocks went to the ICU.

The long-term prognosis: This move points to the seriousness of Chinese officials to reform their economy by breaking asset bubbles and to put the world's second-largest economy on a more normal track.

But wait -- this is China, land of double-talk and unpredictability. The symptom might just go away on its own.

Over the past two weeks, the pain has been real. The withholding of relief that commercial banks have grown used to over the decades knocked back the share prices of big lenders including the Bank of China ( BACHY) and the Industrial and Commercial Bank of China ( IDCBY), though in the end China's notoriously high savings rate should leave them plenty of funds to carry on normal business.

Property and infrastructure developers keen on loans may be stunned momentarily, as well, though probably market-wise enough to avoid going on the drip.

Among those scrambling would be China HGS Real Estate ( HGSH), which faced dangerously low minimum bid prices last year and saw share prices fall sharply in June. Hong Kong-listed Franshion Properties, a builder of energy-efficient homes in mainland China, watched shares plunge in June, though they've bounced back.

Chinese stock markets have slid since the government made it known last week that it would not ease the latest liquidity crunch, which sent interbank interest rates past 6%, up more than two percentage points over May. Hong Kong's H Share index of mainland Chinese firms hit its lowest level last week since October 2011, while the Shanghai Composite Index went to its worst since the global crisis in late 2008.

Falling Chinese shares generally do little service to Wall Street.

"The decision of the People's Bank not to intervene was a surprise to market participants," says Mark Williams, chief Asia economist with Capital Economics in London.

"Short-lived spikes in interbank rates are not unusual in China due to shifts in the supply and demand for liquidity and the fact that policymakers don't directly target interbank rates as a policy tool," Williams says. "But the People's Bank has always stepped in in the past to smooth things out."

Beijing, tired of being an econo-medic, appears ready for whatever fallout comes as long as its decision helps advance a broader goal of a cooler, more balanced economy.

Communist officials said in March after forming a new government that they wanted a more balanced economy after more than a decade of dangerously fast growth. For social stability, they also want to control housing prices that are driven more often than not by speculators.

A "cautious attitude toward fueling another round of easy money is necessary to squeeze the bubbles and send the economic vessel onto a safer route," the state-run Xinhua News Agency said in a June 26 commentary.

"Analysts have lowered their forecasts of China's GDP growth for 2013," the commentary continues. "But the central (monetary) authority has shown rare tolerance for slower growth rate in exchange for more sustainable and balanced development. It has the courage, as well as the ammunition to keep the situation within control."

Balanced-growth reformists in Beijing got their way largely because the government had approved a 4 trillion yuan ($652 million) post-global financial crisis stimulus package that included bank lending. And look who got stimulated.

Banks, developers and local governments "used the package as a chance to start a credit binge," Xinhua said, sending money to financial derivatives instead of the "real economy."

Debt from Chinese enterprises totaled 122% of the country's $8.28 trillion GDP in 2012, the news agency added, citing a State Information Center researcher.

By the book of today's economic reforms, lending is supposed to go to legit projects with paybacks, the storybook cash advance to open a store, earn some money from sales and then pay the loan back.

Quoting the oddly outspoken Xinhua again, "It is time to deflate bubbles and restore normal practice. The road map is clear."

But in China, such grand statements usually precede reality by years, decades or worse.

The central bank might take more inaction when lenders need it, meaning the case last month was the start of a trend. Or the injury inflicted on lenders could prove a one-off move, only to scare banks into a healthier lifestyle.

In that case, interbank liquidity would rise, rates would fall and money would flow once again into investments -- and probably derivatives. To extend the medical metaphor, that means back to smoking and drinking.

"Once that reminder has been sent out, so policymakers move on," says James Berkeley, managing director of London-based management advisory service Ellice Consulting. "My multinational clients and investors' overwhelming response was that this had been a planned move at the outset. As for the future, without hard evidence, it is too early to tell what further action may be taken."

At the time of publication the author had no position in any of the stocks mentioned.

Ralph Jennings is on LinkedIn.

This article was written by an independent contributor, separate from TheStreet's regular news coverage.

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