“Is There A Problem We’re Not Seeing?” – China’s Banking System Reaches “Tipping Point”

Markets have short memories.

This time last year, China was still at the top of every trader’s list of things to be concerned about. And understandably so. You’ll recall that just before “liftoff” (i.e. the December, 2015 Fed hike), the PBoC’s “surprise” move to adopt a trade-weighted reference basket for the RMB spooked markets. Why? Simple: it conveyed Beijing’s desire to shift the market’s focus away from the bilateral exchange rate, a move that quite clearly paved the way for further depreciation.

That move helped catalyzed the deflationary market carnage that prevailed in January and February of last year.

Of course China’s problems run deep. Very deep. In addition to the tedious devaluation effort, the PBoC is also attempting to rein in speculation via a stealth tightening effort that finds expression in OMO hikes. The preference for OMO hikes as pseudo-policy rates is a reflection of China’s attempt to squeeze leverage out of the system without telegraphing an overtly tighter monetary policy. As we’re fond of saying, Beijing needs to deleverage and releverage at the same time, lest the effort to stabilize the financial system and get a handle on an unruly shadow banking complex should end up killing the domestic credit impulse that not only allows the NBS to pretend like GDP growth is 6.5%, but also ensures that the global credit impulse doesn’t dry up altogether.

As Goldman wrote last week, a new Macro Prudential Assessment framework which contains stricter oversight into banks’ off-balance-sheet activities, including the sale of wealth management products is part and parcel of the sweeping effort to rein in shadow banking. But that very same labyrinthine shadow banking complex serves as a credit creation and risk repackaging machine and is in many cases the only means by which borrowers who have lost access to traditional channels can obtain credit. Wealth management products (which are a maturity-mismatched nightmare) are a spoke on that wheel.

Getting a handle on all of this is quite difficult and requires months of research, but FT has a decent new piece out taking a stab at explaining the problem. For those who might have missed it or who are otherwise interested in reviewing the details behind the “cash crunch” FT mentions, you’re encouraged to read our comprehensive guides here and here.

Via FT

China’s financial system suffered a cash crunch this week as new regulations designed to curb shadow banking caused big lenders to hoard funds, highlighting the danger of unintended consequences from official moves to lower their debt.

Analysts have warned of rising risks from banks’ increased reliance on volatile short-term funding rather than customer deposits to fund loans and other investments. If money market interest rates spike in times of stress, institutions can be forced to dump assets in order to meet payments due to creditors. 

Tightening liquidity prompted the seven-day bond repurchase rate to hit a three-year high of 9.5 per cent on Tuesday, versus an average of below 3 per cent since the beginning of 2014.

Local media reported that several small rural lenders had defaulted on money market loans on Tuesday, prompting the central bank to offer them emergency funding. Central bank cash injections have since eased the problem, but the seven-day rate still hit 5.4 per cent on Thursday.

The People’s Bank of China trialled a new Macro Prudential Assessment system for evaluating bank safety last year. Authorities will fully implement the system this year, with the first quarterly assessment to begin at the end of this month. Authorities have also added new criteria that punish lenders for excessive shadow bank activity. Now they are concerned about a possible fire sale of bonds and loans if the PBoC applies the rules aggressively. 

“Actual liquidity is ample but the problem is expectations,” said Ming Ming, chief fixed-income analyst at Citic Securities in Beijing. “The market is nervous about the impact. Everyone is wondering, ‘could there be a problem we’re not seeing?’, or ‘will there be some punishment that forces an institution to dump assets? Then banks get cautious and stop offering loans.”

The new MPA framework will include off-balance-sheet credit – notably wealth management products backed by bonds and loans – in measurements of so-called “broad credit”. The change targets banks’ widespread use of off-balance-sheet structures to circumvent lending quotas. Banks where broad credit has grown too fast will face punishments including higher capital requirements.

Ok. So what does this look like? How does this work? And finally, who’s at risk?

Well, we’re glad you asked. Here’s some color from Deutsche Bank for those who want to take the plunge down the Chinese shadow banking rabbit hole:

Are we close to a “tipping point”?

For now, probably not, especially in a year of leadership transition. In our view, the risk of an uncontrollable liquidity event is low, as the PBOC will do whatever it takes to inject liquidity if needed. In the domestic liquidity market, the PBOC exerts strong influence in both the volume and pricing of liquidity. With 90%+ of financial institutions directly or indirectly controlled by the government, PBOC will likely continue to give liquidity support. In 2H15, the central bank established an interest rate corridor to contain interbank rates within a narrow range and pledged to inject unlimited liquidity to support banks with funding needs.

However, continuing liquidity injections do not come without a cost. A bigger asset bubble, persistent capital outflow pressure and a lower yield curve over the longer term are side effects that China will have to bear. At the same time, the execution risk of PBOC itself is rising.

Implications on system credit growth

We expect system credit growth to moderate from 16.4% yoy in 2016 (16.1% in Feb’17) to approximately 14-15% yoy in 2017 (Figure 23). As a result, the credit impulse is likely to trend lower from the current high level (Figure 24). The slower credit growth is mainly attributable to several factors: 1) a tighter liquidity stance to push up the funding cost of smaller banks and to force them to slow down asset growth; 2) further curbs on shadow banking; 3) a higher bond yield to defer bond issuance; and 4) slower mortgage loan growth.

Implications on individual banks

Reflecting the differences in balance sheet structures, we expect banks with lower credit-to-deposit and stronger deposit franchise to be less vulnerable to financial deleveraging (Figure 25). In a nutshell,

• The big four banks should benefit from higher rates, as they are the net interbank lenders and enjoy a solid deposit franchise. And the big four have limited exposure to shadow banking, so they are relatively immune to the recent tightening.
• In contrast, joint-stock banks are likely to suffer from higher funding cost, being more reliant on wholesale funding (than on deposits). Moreover, with heavy exposure to shadow banking, joint-stock banks are likely to face higher capital and earnings risks amid tighter regulations.

We conducted a test on three groups of banks: big-four, listed joint-stock banks and 179 city/rural commercial banks. The test concludes that joint stock banks and city commercial banks are more vulnerable to a market rate hike due to their higher financial leverage and heavier reliance on non-core funding (Figure 26). In particular, a 50bps market rate hike would knock off 8% and 4% earnings for JSBs and smaller banks, respectively. In contrast, this magnitude of market rate hike would bring a 1.4% earning boost to the big four banks given their net lending position in the interbank market. Figure 27 shows the market rate hike impacts on individual banks, with INDB, SPDB, MSB and CITIC Bank the most severely hit (>9% PBT impact).

Finally, here’s a diagram of liquidity flows that takes the idea of “one person’s asset being another person’s liability” to a whole new f*cking level…