RENEE MONTAGNE, HOST:
Alarm bells went off in China's financial system yesterday. That's because interest rates for loans that banks make to each other - like the loans we've just been hearing about - shot up, drying up credit as China's banks searched for cash. The effects reached markets here, where the Dow dropped more than 2 percent yesterday.
All of this seems to be caused by the Chinese government trying to send its banks a message. To explain what happened and why, we turn to NPR's correspondent in Shanghai, Frank Langfitt. Good morning.
FRANK LANGFITT, BYLINE: Good morning, Renee.
MONTAGNE: So tell us exactly what happened this week?
LANGFITT: We'll we're talking about a thing called the Shanghai overnight interbank lending rate. And it doesn't usually get much attention. This year it's been about 4 percent most of the year. Well, yesterday, it shot up more 13 percent. This was a record, or a near record. It dropped down today back to around 8 percent or so. In real terms, what this means is the cost of borrowing overnight between these banks and for short-term loans got incredibly expensive, and lending started to freeze up.
MONTAGNE: And why did that have such an impact around the world?
LANGFITT: Well, you know, daily bank loans, they lubricate the financial system, and they allow banks to cover their payout and some of their short-term financial needs. China, the world's second largest economy, it got a lot of attention. And you know, as costs go up over time, there's the concern that there could even be loan defaults between banks here.
And in fact, the Bank of China, yesterday, actually went on Weibo - that's China's Twitter - to deny rumors there had been a default. So there was - kind of jitters all the way from here to Wall Street.
MONTAGNE: So tell us more about the Chinese government's hand in all of this.
LANGFITT: Well, what makes this really interesting, Renee, is actually, the government appears to have really been behind it; and what they're trying to do is deliberately punish state banks. They feel like there's too much lending going on here - it's growing too fast, and there's a lot of bad loans. Government wants to slow down the growth of credit. And so what they did is, they pulled money out of this bank-to-bank lending system earlier. With less money to go around, they want the banks to act more responsibly, use the money more wisely and frankly, make them pay more for it.
Here's a guy named Xu Bin, and he's an economist at the China Europe International Business School here in Shanghai. And here's how he put it.
XU BIN: Actually, the rest of the world, they should feel happy about this because China is on the right track to use more market forces to manage the economy.
LANGFITT: And so the point he's making is this is actually in China and the world's interests. And those market forces he's talking about are really crucial to the future of China. If you look at the old economic model here, it was kind of low-hanging fruit - cheap labor, cheap exports; that's pretty much over. The economy now has to get a lot more efficient to keep growth on track, and fixing the banking system is a big part of that.
MONTAGNE: Frank, though, they are dealing here with the heart of the financial system. How far is the Chinese government really willing to go, to make this point?
LANGFITT: That's the big question right now. I mean right now, there's kind of this standoff between the government and banks themselves. The banks don't want to lend. They're very concerned these rates are very, very high for them. They want the government to put more money into the system. The government wants to make a point and keep the pressure on and say hey, this time we're really serious; we're not messing around. And the question is, who will blink?
The central bank can solve the problem by just pumping money back into the system if they get really, really concerned. But economists are saying - you know, they shouldn't wait too long. And I was talking to an analyst today and he said - you know, people are taking this very seriously here.
MONTAGNE: Frank, thanks very much.
LANGFITT: Happy to do it, Renee.
MONTAGNE: That's NPR's Frank Langfitt, speaking to us from Shanghai. Transcript provided by NPR, Copyright NPR.