Those of us who think it’s important to track developments in China’s economy and financial system had our work cut out for us this week.
Beijing’s efforts to curb capital flight created a truly epic squeeze in offshore money markets. HIBOR hit record highs in at least one tenor, the overnight depo rate soared, and CNH forward points surged above 250. Before giving back some of its gains on Friday, the offshore yuan put up its largest weekly advance ever.
Onshore rates have been rising as well as the PBoC moves to contain leverage and curb speculation. Have a look:
(Charts: Deutsche Bank)
As discussed previously, the central bank is effectively reducing the spread speculators can earn by arbitraging the cost of short-term wholesale funding and the yield on funded assets. Have a look at the profile of Chinese banks’ liabilities:
(Chart: Deutsche Bank)
Note the growing reliance on wholesale funding. Now consider the following from Deutsche Bank:
Funding in China’s banking system has weakened in recent years, becoming increasingly reliant on wholesale funding, i.e., borrowing from banks, NBFIs, the bond market and the PBOC, which tend to be less stable and bear higher funding costs than deposits.
To contain risks, PBOC has lengthened the duration of liquidity injection and increased direct lending to smaller banks. This has pushed up interbank rates and increased the funding costs for speculators in the bond and shadow banking markets. With a narrower spread (even negative ones in some cases), these speculators were forced to delever in both markets. This is why we witnessed a notable bond market correction in December 2016.
And while this may be a long-term positive in terms of containing systemic risk, it’s a short-term negative as it squeezes leverage out of the bond market.
The problem: as speculators delever, the market loses what previously was a perpetual bid. That could well trigger another rout which would only serve to perpetuate a rather harrowing circular dynamic.