China’s benchmark rate Shanghai Interbank Offered Rate (Shibor) has jumped dramatically over the past few weeks, highlighting the liquidity squeeze in the world’s second largest economy. The three month Shibor rate stood at 5.329 percent on Tuesday, but it had spiked to 6.9 percent on Friday.

China-Shibor-Chart Shibor

In a research report Citigroup analyst Gary Lam said that Shibor one-month has surged from 1H13 running average of 3.9 percent to about 7 percent. Though reserves adjustments and seasonality added to to the short-term liquidity tightness, Citigroup expects Shibor to stay higher compared to 1H13. Slowing capital inflows and banks’ needs to meet investor obligations were also important factors. The liquidity squeeze may hinder a key funding source for growth as Chinese economy continues to slow.

Seven Day

Three Month

PBOC In Dilemma

It has placed even the People’s Bank of China in a tough situation. The Wall Street Journal says that the credit squeeze comes at a time when China is somehow trying to combat a credit binge that resulted due to a massive stimulus in 2009. Meanwhile, big Chinese banks are putting pressure on PBOC to release funds to ease the cash squeeze. Now the central bank has to decide whether to help lenders by infusing money into the economy, or stay on its plan to control a long-term expansion of credit.

Citigroup said that China’s exports have shown no signs of a rebound in May. China’s PMI for new export orders was 49.4 in May, well below the break even 50 level. Citi remains cautious over the country’s exports going forward as sliding container freight remains a cause of worry.

What China Can Do

Shibor is the rate Chinese banks use to lend to each other. The extent of cash squeeze is reflected by the fact that recently China Everbright Bank failed to repay 6 billion yuan in short-term loan on time to Industrial Bank. Though Industrial Bank called the reports untrue, market skepticism suggests otherwise.

So, how can China solve this problem? It can either infuse fresh cash into the economy or reduce the reserve requirement for banks. These two options can boost liquidity, says Matt Phillips of Quartz. However, the reserve requirements are in place to protect banks from losses on bad loans and China’s bad debts have reached alarming levels. According to CLSA, China’s total debt stands at 205 percent of its GDP. So, the two options available to boost liquidity will act as a bandaid. They’ll do almost nothing to reduce the systemic risks.

Well, it all is showing warning signs of what could become the next financial crisis.