The People's Bank of China told the country's largest banks Monday to rein in risky loans and improve their balance sheets, a warning that sent a jolt through already unsettled equity markets.
The Shanghai Composite lost 5.3% of its value and closed well below the 2,000 point barrier, the latest in a series of dismal performances. The struggling index is now down 13.5% from the start of the year.
The sell-off comes after short-term borrowing costs skyrocketed last week in China, leading to a credit crunch.
The rate at which Chinese banks lend to each other overnight hit a record high above 13% last week before moderating. Another key measure of cash in the banking system -- the 7-day "repo rate" -- peaked at 25%.
Rates continued to stabilize on Monday. But analysts questioned why the bank's leaders had not quickly intervened, and why the bank's intentions were not communicated to investors as rates continued to rise.
Official state media unraveled some of the mystery over the weekend, reporting that the China's shadow banking system was the central bank's target. "It's not that there's no money," the Xinhua commentary said. "It's that the money is not in the right places."
Some analysts worry that China's credit boom has saddled unworthy businesses with large loans, fueled the country's shadow banking system and put local governments on the hook for billions.
A credit squeeze by the central bank would discourage risky loans, and help China's economy complete a rebalancing that most experts say is required to secure long-term growth.
The central bank suggested Monday that its tough medicine is likely to continue.
"Commercial banks must pay close attention to the liquidity situation in the market and must strengthen their analysis and forecasts of factors affecting liquidity," the central bank said in a note posted Monday but dated June 17.
The notice also said that banks must "prudently manage liquidity risks that have resulted from rapid credit expansion" and "appropriately contain the pace of loans and bill financing."
As of now, the central bank said, "overall bank liquidity conditions are at a reasonable level."
Nomura economist Zhiwei Zhang said the guidance note suggests that the central bank's policy stance will remain tight.
"We believe this is another sign that the PBoC is not willing to loosen policies or inject liquidity to bring down interest rates," Zhang said.
Growth in China slipped to 7.8% last year. The government's target for this year is 7.5%. But the risk of a disappointment is rising and with it the prospects of a weaker-than-expected recovery in the global economy.
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