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What the heck is happening in China?

Lately, the forex world has been abuzz with talk about a potential credit crunch in China, and it has been driving Chinese stocks crazy. Just this Monday, the Shanghai Composite plunged deep into bear market territory and registered a 5.3% drop. Now, it’s trading 13% below its start-of-the-year levels!

Naturally, the People’s Bank of China (PBoC) didn’t take this lying down. It stepped in and tried to stabilize the markets by announcing that it will provide support to institutions that help the economy. By providing funds to cash-strapped institutions that have been lending money in accordance with the government’s policy, it hopes to stabilize the money markets and give the economy a boost. Way to hit two birds with one stone!

What’s the credit crunch all about, anyway?

Well, in a nutshell, it’s got to do with the quick rise in China’s short-term borrowing costs. For instance, the SHIBOR, which is the rate at which Chinese banks lend money to one another, posted a record high last week as it rose to 13.4%. But that’s not all. The 7-day “repo rate,” which is another important of cash in circulation, recently topped out at a whopping 25%!

These days, credit has been hard to come by in China. Some of its state-owned banks have even been reported to charge each other over 25%. What’s interesting is that some believe that the PBoC is to blame for cutting off access to cheap money in its attempts to instill discipline on banks and make them less dependent on credit.

The PBoC’s big move has stoked fears that the money markets could dry up and force smaller lenders to go out of business. In turn, this has left investors highly concerned about the country’s banking industry and the overall economic environment. After all, if there’s not enough credit to go around, how will businesses grow?

Why is the potential Chinese credit crunch such a big deal?

For one thing, China is the world’s second largest economy so a credit problem in the country could be damaging for the global economy. In fact, some analysts have already been speculating that we could see a repeat of the 2008 financial crisis if this worsens.

A closer look at China’s banking sector reveals some similarities to the U.S. banking system in 2006. Back then, American banks were lending to borrowers who had little to no ability to repay their loans, eventually paving the way for a collapse of their financial system.

At present, analysts estimate that China’s non-financial debt is approximately 200% of its GDP. Most of this debt is in the “shadow banking system” of unsecured loans, which means that the risk of default is much higher. In case most of these borrowers default, the burden will fall on the Chinese government’s shoulders as it will have to step in to shore up the financial system.

How does this affect the forex market?

Finally, the million-dollar question! For one, the credit fears are keeping risk aversion in the markets. As soon as speculations of a credit crunch in China hit the airwaves, global markets saw a bloodbath on a fresh round of uncertainties. This was mirrored in forex price action where higher-yielders sold off and the safe-haven dollar strengthened.

Remember that several major institutions, such as the World Bank and IMF, already lowered their growth forecasts for China. A credit crunch would mean a slowdown in lending to individuals and businesses, and this would put a constraint on spending and investment. Despite this, the PBoC clarified earlier this week that it would not increase stimulus, which suggests that Chinese growth could remain weak.

Of course this doesn’t bode too well for the Australian economy, which is closely linked to China because of trade. With tight credit conditions weighing on business activity, lower demand for Australia’s raw materials exports could also weigh on the country’s economic growth and currency.