“Some Folks Missed Payments”: There’s A Storm Brewing In China

Some folks missed some payments.

In the wake of the PBoC’s move to implement a second OMO hike in as many months…

…Bloomberg reported overnight that some “smaller financial institutions including rural commercial banks missed payments on interbank borrowing on Monday.”

That’s not a great sign and it prompted the PBoC to inject “hundreds of billions of yuan” into the system as CNY 1-year interest-rate swaps jumped as much as 13bps to 3.77% in earlier trading while the 7-day repo rate climbed to 3.09%, the highest since April 2015. The 14-day repo rate spiked 67bps, the most since late December, to 4.30%

Similarly, the O/N rate rose to the highest in almost two years at 2.74%. Bloomberg also notes that CNY forward swap points jumped, as two-week contracts saw 95.6 points, the highest since early last month. The cause: well, tight liquidity obviously, due in part to quarter-end regulatory checks, convertible bond sales locking up funds and certificates of deposit maturing. “Liquidity tightening is prompting investors to swap dollar into yuan in the short-end of the curve,” traders remarked.

Ok so look, all of that probably sounds like Greek … err.. Chinese… to you, and that’s fine because the bottom line here is simple: in late November, China embarked on a concerted push to tighten through repo rates versus policy rates. As we noted last week, “Beijing has essentially shelved policy rates in favor of repo rates when it comes to tightening.”

But then, in comments that accompanied this month’s OMO hike, they kind of tried to downplay the extent to which they’re transitioning to repo rates versus policy rates as a means of managing liquidity and financial conditions more generally.

Say whatever you want about that, but at the end of the day that’s a reflection of Beijing trying to walk a tightrope between keeping conditions loose enough to support growth (not to mention the global credit impulse which depends almost entirely on China) and tightening enough to discourage the rampant proliferation of leverage and speculative excess. What happens when these two competing agendas collide against a backdrop where the Fed is hiking, you ask? Well, there’s confusion and turmoil just like we saw in mid-December, when the Chinese bond market seized up after a few entrusted bond deals went bad at the same time the Fed hiked.

So basically, what you’re seeing this week is more confusion around this same narrative. Here’s Goldman to explain:

Interbank interest rates had been more clearly drifting higher in the past month, especially following the PBOC’s OMO rate increase last Thursday. In particular, the gap between R007 (general repo rate covering all counterparties including funds) and DR007 (specifically covering only banks) has widened again in recent days, suggesting tight liquidity conditions faced by non-bank financial institutions (NBFIs) (Exhibit 1).

Today’s fixing rate (set at 11:30am based on morning transactions) spiked, although funding conditions in the afternoon seem to have moderated somewhat. In our view, the rate surge reflects a combination of:

A tightening bias by the PBOC. The central bank has shifted policy stance since autumn last year, but the clearer interbank rate rise in recent days suggests that the hawkish bias has stepped up further.

Diminished clarity of the role of interbank rates in the PBOC’s policy framework. Since mid-2015, interbank rates had been kept largely steady, partly reflecting the PBOC’s efforts to build up a policy rate framework centering on interbank rates. The PBOC has also introduced SLF (standing lending facility; see our discussion here on PBOC’s toolkit), which is understood as a tool to keep volatility in interbank funding conditions low. However, in a signal that deviates from these previous efforts, the PBOC last Thursday tried to dissociate interbank rates from “policy rates”, which the PBOC said should mean benchmark bank lending and deposits rates. As we discussed then, the comment appeared to open up a bigger scope for the PBOC to allow interbank rates to move higher (with the possible intention to avoid conflict with its official “stable and neutral” policy stance or potential pushback from other policy authorities).

The SLF mechanism appears to have not functioned effectively in recent days. There have been occasional breaches of the general 7-day repo rate above the SLF rate (3.35% per PBOC’s official communication, although it was reportedly raised to 3.45% last week). This suggests that SLF has not effectively fulfilled its supposed function of imposing a ceiling to interbank rates. One possible reason is that SLF is accessible only by banks, and much of the spikes of the general 7-day repo rate have been a result of liquidity scramble by NBFIs (which have no SLF access), while banks’ interbank funding cost (as measured by DR007; Exhibit 1) has remained more moderate and still below the SLF rate (note that the 7-day repo fixing rate is partly based on funding cost of NBFIs as well). Nevertheless, the apparent lack of effectiveness of SLF in suppressing interbank rate volatility might have weakened the anchoring of the market’s rate expectations in the near term, and such uncertainty could have compounded the liquidity squeeze.

Continued high interbank repo borrowing by funds. The wide gap of R007-DR007 reflects continued stress imposed by NBFIs, likely particularly funds, on the funding market. Indeed, as of end-Feb, interbank repo borrowing by funds remained high at over 30% of the interbank repo borrowing (Exhibit 2) despite the increased pressure on the commercial viability of repo trades (borrowing via interbank repo to finance long-dated bond holdings).

5. Regulatory impact. The PBOC has tightened the prudential requirements (particularly on the growth of banks’ balance sheet) under its MPA examination, which is to be conducted at quarter-end. This has likely further contributed to, and amplified the impact of, a tightening in the interbank market.

We know: what-the-f*ck-ever, right? But it really does make sense when you think about it in terms of trying to manage things with what amount to stealth hikes (OMO rates) versus policy rates. It’s all the same narrative: tighten to rein in speculation and leverage while preserving the idea that policy remains accommodative enough to support growth. OMO (stealth) versus policy rates (overt). See?

Why bend over backwards to try and hide the fact that they’re trying to curtail speculation and squeeze leverage out of the system? Well because you do not want to make the rest of the world question whether the Politburo is going to suddenly choke off this…

(Citi)

China is responsible for the entire goddamn global credit impulse. You start aggressively (and overtly) tightening and that goes out the f*cking window.

Ok, so here’s Goldman (again) with more on the Chinese “balancing act” described above:

Spike in 7-day repo fixing rate indicates tightening bias in China. China’s 7-day repo fixing interest rate rose to 5.5% yesterday, the highest level since late 2014. Contributing factors include the prospective quarter-end macro-prudential assessment examination for the banking sector and continued tightening bias from the PBoC. Although interbank rates may remain fairly volatile in the coming days, we do not expect such elevated rates to be sustained.

2. China growth has stabilised and offshore credit spreads have rallied. We turned negative on the China property HY sector in late October last year on the expectation that policymakers would continue to adopt risk control measures to contain the rise in property prices, and reduce the risk of asset bubbles forming. That view was in line with our China economics team’s expectation for a tightening of fiscal policy, which would weigh temporarily on 2017Q1 domestic demand and GDP growth. However, after the expected weakness in Q4, fiscal outlays rebounded robustly in January, and our China Current Activity Indicator has picked up meaningfully in recent months to around a 7% pace. February housing price data indicate that average house price growth appeared resilient despite the tightening measures introduced in 2016. As concerns regarding slower growth and tighter risk controls subsided, they contributed to the tightening of China offshore credit spreads, with the spread on the Asia Broad Bond Index (ABBI) China IG index and on the ABBI China HY index tightening by 15bp and 96bp so far this year, respectively.

3. But risk controls are still in place. Despite the rebound in activity levels this year, a number of policy actions suggest that controls to contain financial sector risks are still very much in place. The most notable is the rise in 7-day repo rates since October 2016, and this less easy monetary stance has led to higher government bond yields (Exhibit 1) and a substantial decrease in domestic corporate bond issuance over the past four months (Exhibit 2). The spike in the 7-day repo fixing earlier this week at 5.5%, the highest level since late 2014, is another signal that the hawkish bias has stepped up further. Other measures introduced include a new Macro Prudential Assessment regulatory framework for the banking sector, which our China banks team believes could help to slow down credit growth. Therefore, the need to reduce financial sector leverage, in particular in the bond market, is very much a focus . A recent default in China’s domestic bond market, the first in 2017, is a reminder that credit concerns remain.

4. A balancing act between growth and reform. With the leadership transition occurring later this year, the emphasis to maintain stability will remain; but containing financial sector leverage and asset price bubbles are also important goals, as the recent tightening bias shows. An example of that is the new Macro Prudential Assessment framework which contains stricter oversight into banks’ off-balance-sheet activities, including the sale of wealth management products. Looking ahead, we expect to see a continuation of this balancing act between maintain growth and controlling risks. Our China economics team expect to see the 7-day repo rate at around 3% for the rest of 2017, with near-term risks to the upside, compared with earlier expectations of a reduction towards the end of the year. Should we see a sharper slowdown in growth due to the tightening bias, we would likely see additional fiscal support.

This balancing act means that deleveraging and faster recognition of credit issues are not likely, and we expect the pace of corporate defaults to follow a similar path to what we have seen in recent years — a slow grind higher for default rates. Still, we prefer to be defensive on China credit, with a preference for shorter-dated IG over HY, as the yield on China HY is at or near post-global financial crisis lows, and we do not think that is sufficient to compensate for the credit risks.

Got all that? Good (but seriously, just read the bolded and underlined passages and fit them with the simultaneous deleveraging and releveraging narrative).

Note how Goldman mentions “a slow grind higher for default rates.” This seems like an opportune time to remind you of what we said in late January. To wit:

Beijing is big on keeping up appearances. Anything to project a positive image to the rest of the world.

As many a Chinese reporter learned in the aftermath of 2015’s epic summer equity market meltdown, anyone who even suggests that things might be falling apart is subject to arrest, imprisonment, or worse at the hands of the Politburo.

Fortunately I’m not reporting from China and as such I’m free to point out that no matter how hard you try to suppress default rates by restructuring loans and/or shifting sour assets to off-balance-sheet vehicles, the charade can only last so long.

With that, I bring you a chart of Chinese onshore defaults with a bit of color from Goldman.

Via Goldman

Since the first China domestic bond default in July 2014, the pattern of defaults has followed a stop-start path, with defaults oscillating between periods of zero defaults and periods of rising stresses. To us, this stop-start pattern reflects policymakers’ ability to switch into forbearance mode when rising defaults threaten to result in financial instability.

And finally, allow us to demonstrate, with one “simple” graphic, why squeezing out leverage and curbing speculative excess (i.e. why tightening conditions by any means necessary) is important…