The day the wheels came off

“There has been a little distress selling on the Stock Exchange…” Such was the calm and unperturbed verdict delivered by JP Morgan’s senior partner Thomas Lamont after trading ceased on Thursday October 24, 1929.

The American historian Frederick Lewis Allen called this “one of the most remarkable understatements of all time”. It was, after all, the day that the Wall Street Crash began.

There was panic in China’s markets last Thursday too as interest rates spiked into double digits and rumours spread of major institutions defaulting on their interbank loans. Liquidity seemed to evaporate.

The fear soon hit the stockmarket. On Monday Shanghai’s stock index lost 5.3%, its worst single-day drop in almost four years. “Shares plunge amid cash crunch panic,” ran the headline in the South China Morning Post.

So was this also a case of “a little distress selling” or is it the start of something much more serious?

What exactly happened?

The first signs of trouble came a week earlier as China celebrated the Dragon Boat Festival. Mid-year is typically a time when demand for interbank liquidity rises as banks seek to call in loans to improve their cash position ahead of half-yearly reporting. Normally this doesn’t cause too much strain, as the central bank – the People’s Bank of China or PBoC – pumps additional cash into the system. But on this occasion no such assistance was forthcoming, which soon led short term rates to rise to uncomfortable levels.

Bankers remained sanguine, assuming that the PBoC would soon act. There was even some lobbying from financiers for a cut in the reserve requirement ratio – a move that would have freed up more money for lending.

But the central bank remained steadfastly silent.

As the pressure built, the interbank market finally cracked last Thursday. The overnight lending rate hit 30%, while the rate to borrow money for a week surged to 13.44%, more than three times the rate of a fortnight before.

In this febrile atmosphere, two rumours spread through the market. The first was that mid-size Everbright Bank had failed to repay an interbank loan. The second was even more staggering, claiming a loan default by Bank of China. The state-owned giant was stung into action by the speculation, issuing a denial and assuring that it had settled all of its payments on time.

But the mood further soured when netizens started to report on Sina Weibo – China’s Twitter-equivalent – that they hadn’t been able to withdraw money from the ATMs of another of the major banks, ICBC. Guangzhou Daily reporters confirmed that cash machines in the cities of Beijing, Shanghai, Guangzhou and Wuhan weren’t working.

ICBC, China’s largest bank by market value, said this was related to a systems upgrade. But that didn’t stop rumours circulating that a bank run might be underway…

What triggered the cash crunch?

The reasons why rates surged on Thursday (rather than a day before or after) remain largely unexplained, although some suggest the rumour about Everbright Bank was the catalyst. But 21CN Business Herald says the underlying cause is less mysterious. It cites data from Fitch Ratings as demonstrating that a liquidity crunch was looming and that everyone in the market should have been able to see it coming.

According to Fitch, Rmb13 trillion ($2.10 trillion) of wealth management products (WMPs) were outstanding by the first quarter of this year. These products are offered by banks and trust companies, typically offering higher rates than savings accounts (with good reason, since they invest in riskier assets). Fitch reckons “a large chunk” of these products were set to expire in June. If the trillions of renminbi worth of WMP money weren’t rolled over, the possibility was a surge in demand for cash to repay them.

It was this demand that explains why liquidity suddenly became so tight in the interbank market. Banks were calling in loans from each other in order to be able to meet redemptions of clients’ WMPs.

The pressure was particularly acute for medium-sized banks, where Fitch data suggests that the volume WMPs issued equates to 30% of their deposit base (up from 10% three years ago).

In this group, Fitch says, Everbright Bank is one of the most exposed and thus faced the worst liquidity position last week. It calculates that in order to meet client redemptions Everbright needed to call in 90% of its interbank positions, explaining why the rumours about the bank were the first to unnerve the market.

Why didn’t the central bank intervene?

The consensus is that the PBoC wanted to send out a signal that it won’t tolerate runaway loan growth. Bank credit has been rising by 23% annually. But what seems to worry the authorities most is that the biggest increases have been seen in shadow banking. For example, the Financial Times reports that ‘total social financing’ – a measure which includes estimates for shadow banking activity – grew an incredible 60% during the first quarter.

The fear is that much of this lending may go bad, as a lot of it is being directed at the property market or propping up the dubious debt incurred by many of the local government financing vehicles (LGFVs). As WiC has pointed out previously these LGFVs are a major concern, with finances severely strained by their excessive spending on infrastructure projects. Many aren’t expected to make a return adequate to service their debt, let alone repay it. (One example: LGFVs in Tangshan City, see page 7).

The shadow banking industry has grown at a phenomenal pace. For example, in February the assets of the trust firms that underpins much of the shadow lending exceeded those of China’s insurance industry for the first time. The China Economic Weekly reports that trust assets had grown to Rmb8.72 trillion, compared with a mere Rmb360 billion in 2007.

Capital in the shadow banking world – which also includes micro-credit firms, guarantee companies and curbside lenders – now exceeds Rmb23 trillion, according to estimates from Joe Zhang, an author of a book on the subject. Fitch also believes that shadow financing has uncomfortably close links to the formal banking system, suggesting a possibility for contagion. Due to the way the shadow banking system interacts with its more established peer, the agency suggests that the country’s banks are financially exposed to as many as three quarters of its transactions.

But as the name suggests, the shadow banking world is a murky place. For the central bank the lack of transparency is a worry.

Take wealth management products. When issued by the banks, they can resemble money market funds. But many are deliberately hard to fathom or hold questionable assets. As we described in WiC172, one product called Golden Elephant No 38 was underpinned by an empty housing estate in Taihe in Jiangxi province. But it offered a return of 7.2%, much higher than a bank deposit. The head of China’s securities regulator even compared products like these to a “Ponzi scheme”. For the central bank, the concern must be that too many of them end up resembling the toxic CDOs of America’s 2008 subprime crisis.

Zhang – who spent a year chairing a micro-credit firm before penning his book – told an audience at Hong Kong’s Foreign Correspondents Club that the trust firms remind him of Michael Milken’s Drexel Burnham Lambert. The stuff they have been repackaging and selling to their clients resembles the junk bonds of the 1980s.

But by allowing the interbank market to go into spasm last week, the PBoC was launching its first major attack on the worst of the shadow banking world. It also marked one of the first occasions in which a short-term move from the PBoC could genuinely be said to have moved the global markets – a trend that ought to become more pronounced in the decade ahead as it starts to rival the Fed in influence.

Have things calmed down since?

Yes. Having taken markets to the brink, the central bank sought to calm the situation on Tuesday, quelling fears of a credit crisis by announcing that it would adjust its “liquidity management” policy to stabilise the market. Bloomberg quoted the deputy director of the bank’s Shanghai branch as saying that money market rates would be kept at reasonable levels.

By Tuesday the interbank market’s overnight rate had dropped to 5.73% and the cost to borrow for a week came down to 7.64%. These were still higher than normal, but the reductions on previous days were a sign that liquidity was being released into the system and the short term panic was over.

The stock market – which had been down 5% that day – reversed its losses on the PBoC’s announcement.

However, the central bank wasn’t entirely finished, indicating that it will not tolerate a return to past bad habits. A statement released on Wednesday noted that “banks must prudently control the liquidity risks that arise from excessively rapid expansion of credit” and added that the PBoC would only come to the assistance of banks that act in line with “macro-prudential requirements”.

The FT parsed the statement down to “an order for banks to rein in credit growth and curb their appetite for risky practices”.

Who was behind the move?

There has been much speculation that it was the new prime minister, Li Keqiang who told the central bank to crimp liquidity last week. The warning shot was part of his reform agenda and had three purposes. First it was an indication that the banks needed to deleverage – and according to Century Weekly the message has definitely registered, with the major banks deciding not to make any fresh loans for the remainder of June.

Second, it was designed to squeeze local government financing vehicles, choking their access to easy money and flagging that the era of wasteful investment is over.

And in a related move, it also targeted industries suffering from overcapacity. In particular, the liquidity crunch was meant to remind banks to stop lending to firms in sectors deemed as over-supplied (for example, steel) or “backward” (i.e. inefficient and polluting). Hence analysts believe that another of Li’s goal is to encourage broader economic restructuring.

There is a sense that the new government is trying to advance on multiple fronts. The prelude to last week’s interbank shock was an attack on corrupt practices in the bond market. According to the Economic Observer a series of arrests (as well as a clampdown on Class C accounts, see WiC190) has seen the bond market’s daily trading volumes collapse.

Similarly a report last weekend in the Hong Kong-based journal Cheng Ming claimed that Wang Qishan’s anti-corruption work this year has already triggered the early retirement of at least 12 bank presidents and vice-presidents. Across the country over a thousand bankers have been investigated by the anti-graft team, the report said.

If true, it’s easy to see why a lot of bankers were already feeling rather nervous when the central bank dropped its bombshell last Thursday.

Then again, the timing of the panic has led to some interesting theories. A blogger on Caijing’s website drew comparisons with the late Qing Dynasty when the Emperor Guangxu launched a wave of reforms. He was defeated by vested interests at court, leading to the failure of what is known to history as the One Hundred Day Reform. Coincidentally enough, last Saturday was Li’s hundredth day as prime minister. The blogger thinks that vested interests – in state firms and at the major banks – deliberately ratcheted up the sense of crisis over the weekend as a means to blackmail Li into loosening credit policy once more and thereby backtrack on his reformist goals.

The theorist’s conclusion: Li stood his ground. Liquidity was eventually provided but not before the premier showed who was boss.

Slower growth ahead?

The danger in taking more dramatic action is the potential for collateral damage to the wider economy. Hence the New York Times called the PBoC’s act “a stern lesson”. But with the Shanghai stock index down 15% this month, investors will be more worried that the economy is weakening. Certainly the new administration looks ready to tolerate weaker GDP numbers. Qu Hongbin, HSBC’s chief economist for Greater China, terms the process “faster reform, slower growth” and HSBC has cut its GDP forecast for this year and next to 7.4% (down from 8.2% and 8.4% respectively).

Qu notes: “Three months into the job Beijing’s new leaders are clearly determined to use the reform process rather than stimulus to sustain growth.”

That said, Qu also believes that policymakers won’t want the growth rate to fall below 7%. Anything below that level will cause “labour market instability”, Qu forecasts.

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