This Central Bank Could Spark a Credit Crisis

Last week's challenging environment for stocks looks set to continue today, with the S&P 500 (SNPINDEX: ^GSPC  ) and the narrower, price-weighted Dow Jones Industrial Average (DJINDICES: ^DJI  ) plummeting 1.8% and 1.6%, respectively, at 10 a.m. EDT.

A central bank pulls back
Last week, a central bank that is steering a massive economy critical to global economic growth proved that there are limits to its monetary largesse, pulling back from the financial accommodation it has provided since the start of the financial crisis. Naturally, this had a dampening effect on global markets.

I'm not referring to the Federal Reserve here -- that story garnered the lion's share of media attention last week -- but rather to the People's Bank of China, the Chinese central bank.

Indeed, the Chinese banking system experienced a liquidity crunch last week. The seven-day repurchase agreement rate -- a benchmark for interbank borrowing costs -- spiked upward, reaching 28% last Tuesday. For reference, the overnight U.S. dollar London Interbank Offered Rate hit an all-time high of 6.875% on Sept. 30, 2008, at the height of the credit crisis.

Despite this, the PBoC offered no liquidity support; in fact, it didn't even address the matter publicly until today, when the bank released a statement (dated June 17) exhorting banks to "pay close attention to the liquidity situation in the market" and to "play an active role in using their advantages to support the central bank in stabilizing the market." The market began to stabilize after the PBoC ordered banks to lend to each other (a literal illustration of a "command" economy).

Under normal circumstances, this would have been the top story in every financial program and daily, but everyone was too busy watching the Fed. The PBoC has fueled a massive expansion of credit since the onset of the global financial crisis in order to maintain the clip of China's growth. This is a risk factor for China -- and, given its new prominence in the global economy, the rest of the world, as well. For U.S. investors, there is no need to panic. Know that this is a risk and know what you own; that's a good start under any circumstances.

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