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China funding squeeze at small banks is warning sign for market

[HONG KONG] Some of China's smaller banks are finding it increasingly difficult to borrow from one another, another sign that rising corporate defaults are starting to infect the financial system.

The cost of one-year interbank debt - a lifeline for small and medium lenders - was at 3.34 per cent on Monday, or about twice what it was in April. The yield is now 39 basis points higher than the rate offered by the People's Bank of China(PBOC) on its medium-term loans, the widest gap since July 2018.

China's smaller lenders rely on cash from other banks because they don't have direct access to liquidity offered by the central bank. A series of high-profile credit defaults have recently made China's larger lenders more cautious in handing out funds. Brokerages and insurers are also grappling with a volatile market for short-term borrowing.

It all means that even though the PBOC injected US$30 billion into the financial system on Monday - after adding short-term cash every day last week - those funds aren't trickling down to some of the most vulnerable parts of China's financial system.

Another concern is that the PBOC may soon pull back on the emergency stimulus measures it deployed to support the economy during the virus pandemic. Recent economic data seems to endorse such a move, with an official gauge of factory activity climbing faster than expected in November. PBOC vice-governor Liu Guoqiang said last month that tapering easing policies "is a matter of time and it is also necessary".

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China's borrowing costs will likely remain elevated, keeping government yields and the cost on interbank debt high in the near term, according to Larry Hu, head of China economics at Macquarie Bank in Hong Kong.

"More defaults could happen next year due to the ongoing policy tightening and the growth deceleration later," he said.

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