HONG KONG — China’s financial system is in the throes of a cash crunch, with interbank lending rates spiking Thursday, even as growth in the economy displays signs of slowing further.

The interest rates that Chinese banks must pay to borrow money from each other overnight surged to a record high of 13.44 percent Thursday, according to official daily rates set by the National Interbank Funding Center in Shanghai. That is up from 7.66 percent Wednesday and less than 4 percent last month.

Other comparable rates in China’s interbank and money markets have soared over the past two weeks, meaning banks and other financial institutions are growing afraid of lending to one another. Those in need of short-term cash, or liquidity, must pay dearly; failure to do so raises the possibility of defaults.

In a worst-case scenario, absent intervention by policy makers, defaults at lenders with the most exposure and shakiest balance sheets could lead those institutions to fail. The damage could spread to other banks, setting off runs on deposits by ordinary Chinese. In the near term, markets will probably continue to be rattled, especially shares in financial institutions.

“China’s interbank market is basically frozen — much like credit markets froze in the United States right after Lehman failed,” said Patrick Chovanec, managing director and chief strategist at Silvercrest Asset Management. “Rates are being quoted, but no transactions are taking place.”

China’s policy makers have an arsenal of options at their disposal to inject more money into the financial system, including conducting open market operations — trading in securities to control interest rates or liquidity — or, more drastically, freeing up some of the trillions of renminbi that banks are required to keep on reserve with the central bank, the People’s Bank of China. In the past, when China’s economy has hit a rough patch, the government usually stepped in, forcing state-run banks to pump liquidity into the market, even though there was a risk it could drive up asset prices and lead to overinvestment.

“China’s central bank, by allowing a spike in interbank rates to persist for longer than usual, is sending a message to the market that liquidity needs to tighten and credit growth slow at the margin,” Andrew Batson and Joyce Poon, analysts at GaveKal Dragonomics, wrote Thursday in a research note. “Indeed, the central bank has been using its open-market operations to drain liquidity from the interbank market since January, setting the stage for just this kind of showdown with banks.”

If the central bank’s inaction toward the deepening liquidity squeeze is a form of financial brinkmanship, some analysts see it as aimed at reining in smaller banks that had been tapping the interbank market as a source of low-cost funding for their investment in higher-yielding bonds, or to finance off-balance-sheet activities, or shadow banking.

“The P.B.O.C. and some other regulators could be taking the opportunity of the tight funding conditions to ‘punish’ some small banks which had previously taken advantage of the stable interbank rates,” Ting Lu, China economist at Bank of America Merrill Lynch, said Thursday in a research note.

Mr. Lu said that although the surge in interbank lending rates could have its desired effect on reckless lenders, “it will undoubtedly disrupt both the financial markets and the real economy if the liquidity squeeze lasts too long.”

China’s economy has been showing signs of a slowdown in recent months. On Thursday, a preliminary survey of factory purchasing managers in June suggested that output in China had fallen to its lowest level in nine months, as manufacturers cut production at a faster pace in response to slack demand both at home and overseas.

The preliminary purchasing managers’ index, published by HSBC and compiled by Markit, dropped to 48.3 points in first three weeks of June, its lowest level since September and down from a final figure of 49.2 in May. A reading above 50 indicates growth, and anything below signals contraction.

David Barboza contributed reporting from Shanghai.

Article source: http://www.nytimes.com/2013/06/21/business/global/china-manufacturing-contracts-to-lowest-level-in-9-months.html?partner=rss&emc=rss