HONG KONG, June 27 (Reuters) - The liquidity crunch in China's financial system last week spooked global markets and led to a downgrade in the outlook of Hong Kong banks that has raised alarm bells about contagion.
The widespread panic from the dizzying spike in onshore interbank rates offers a valuable lesson in risk management for the gatekeepers of Hong Kong's growing yuan markets as the territory's banks have deep ties to state-run mainland banks.
China's central bank has balked at injecting funds into the money markets as it cracked down on funds flowing into the country's vast informal loans market known as "shadow banking".
While offshore markets saw only moderate volatility from the credit squeeze and plunging stock prices, the spillover effects are hard to ignore even for the most ardent cheerleaders of China's yuan internationalisation project.
"As the cross border channels strengthen between the onshore and the offshore markets, it is not going to be easy for Hong Kong's regulators to avert a contagion effect and they need to be prepared to stem any impact," said Becky Liu, a strategist at Standard Chartered Bank.
The shortage of funds in China has spilled over into Hong Kong, pushing up the cost of funds in the growing offshore yuan market amid speculation that subsidiaries of Chinese banks were remitting money to the mainland.
The clearing bank for yuan-related transactions in Hong Kong and Taiwan had to raise yuan interest rates this week to attract more yuan deposits. Some Chinese banks reportedly jacked up deposit rates for short-dated yuan funds, and the Chinese government narrowly sold out a jumbo bond sale on Wednesday.
Indeed, Fitch Ratings said this week that sustained stress in the Chinese interbank market would raise counterparty risks for Hong Kong banks' exposure to mainland banks arising mainly from interbank placements and from guarantees on trade finance.
Fear of a banking crisis are surfacing as the world's second-largest economy is already showing signs of slowdown.
Confidence in Hong Kong's banking system is also critical at a time when the yuan becomes more popularly used in business and trade, making new inroads into markets outside Asia.