Do China's Risk Signals Point to a Meltdown?

Risk signals point to problems in China's banking market, which may have implications for world financial markets.
China's central bank recently injected money into the banking system to ward off a credit freeze. Photographer: Tomohiro Ohsumi/Bloomberg

Equity futures are under pressure this morning as concerns about a shadow-banking credit crunch in China increase. A Chinese credit-market risk gauge is hitting new highs amid growing concerns that leverage and credit risk have reached unsustainable levels.

Observers are comparing this to thewidening in the Ted spread -- a measure of risk in certain eurodollar securities compared with Treasuries -- in 2007, which turned out to be a key precursor to the financial crisis. The comparison to the U.S. financial crisis wasfirst observed last June, if not earlier.Goldman Sachs Group Inc. has noted that China's "bond market has grown from virtually nonexistent into one of the world's largest." As of the end of 2013, local government debt had "swollen to 17.9 trillion yuan ($2.95 trillion), underscoring risks to the financial system."

Compared with the steps taken by policy makers in the U.S. during the financial crisis, Chinese central bankers seem tentative. Last month, the People's Bank of China made a one-day injection of 255 billion yuan -- about $42 billion dollars -- into the interbank market. Earlier this month, it issued new rules and guidelinesfor banks.

If we learned anything from the U.S. debt crisis and the freezing of credit between financial institutions, it takes a much bigger hammer to break through frozen credit. China's shadow-bank network, like the one that emerged in the U.S., is difficult to reach through traditional central bank policy. So far, the limited steps to inject liquidity into the system should bring comfort to opponents of quantitative easing, who ideologically dislike any central bank interventions.

No worries here, goes the thinking, markets will sort it out eventually.

How significant are China's banking troubles? That really depends upon whether they have a near-full-scale melt down, like we did, or if their central bankers act preemptively to avoid one.

The peculiar thing is concerns that a new slowdown was at hand in the U.S. led to a mere 5.9 percent pullback in the broad indices earlier this year, followed by a rally to new highs. How the U.S. equity markets respond to events in China may well foreshadow what the next few quarters of market returns look like.

Furthermore, the traditional flight to quality anytime there is global trouble probably means more buyers of U.S. Treasuries. Watch today to see if rates slip lower, a sign of concern about risk.

Strap yourself in: This might be a very interesting day in financial markets.

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(Barry Ritholtz writes about finance, the economy and the business world for Bloomberg View. Follow him on Twitter at @Ritholtz.)

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.