The Chinese government could not have issued a clearer wake-up call to the domestic bond market on the first trading day of the Year of the Rooster. Its decision to increase repo and standard lending facility (SLF) rates by 10 basis points to 0.35% squeezed liquidity out of an already nervous market, catching many participants off-guard.
For many it has signalled the final nail in the coffin for the country’s three-year bond bull-run. Xu Hanfei, chief fixed income analyst at China Merchant Securities, tells WallStreetcn.com that, “it marks a complete reversal of the central bank’s monetary policy. Before the holiday, we were only speculating whether the central bank would adjust long-term rates not short-term ones. It now appears both will be adjusted.”
The history of China’s financial markets suggests that any unwinding will not be a smooth process. Typical of the apocalyptic comments was Guotai Junan principal bond analyst’s Qin Han. “Debt disaster 2.0 is in progress,” he told the same Chinese financial website.
One of the biggest challenges in China is the elevated leverage within the financial market, particularly a shadow banking system where assets are believed to have topped Rmb58 trillion ($5.24 trillion) in June, or 82% of the country’s GDP.
Late last year, President Xi Jinping said the country’s 6.5% GDP target could be reduced if it created too many risks. Financial analysts generally believe these include the growing debt loads that have been hidden away from the balance sheet of Chinese banks and other corporates. This was echoed by the Central Economic Work Committee, which concluded its annual conference in December with a commitment to “prevent and control financial risks” caused by China’s credit mountain.
Since then the term “deleveraging” has become a buzzword in the financial sector, leading to a surge in corporate and government bond yields. In many respects yields are still playing catch up with US markets, which turned last summer on expectations that the Federal Reserve will hike interest rates again in the near future.
Benchmark 10-year US Treasury yields climbed from 1.35% in July to 2.47% on Wednesday, representing an increase of 112 basis points over seven months. By contrast, China’s 10-year government bond yields had risen from 2.66% in late October to 3.45% on Wednesday, a 79bp widening in three-and-a-half months. There is still a long way to go before 10-year yields hit the 4.85% peak of November 2013. And on February 8, Xinhua warned citizens not to go bargain hunting in the bond market over the short-term.
The People’s Bank of China (PBoC) finally injected Rmb100 billion into the system via reverse repo six days after its first announcement, but since Rmb190 billion was maturing on the same day, it still accounted for a net reduction. A research report by HSBC points out that the central bank’s liquidity tightening moves make it much harder for fixed income fund managers to accurately forecast the average funding cost over the life of a leveraged bond trade. HSBC says this was probably one of the central bank’s chief aims, given how asset managers had increased their fixed income leverage in 2016, becoming “aggressive buyers ” and “snapping up 80% of net policy bank issuance and 160% of net corporate bond issuance”.
Where corporates are concerned, rising yields raise their cost of capital, a process which is likely to accelerate if less investment flows into fixed income markets, pushing yields wider still.
One escape route for corporates that need cash is the offshore bond market where liquidity is plentiful partly because of capital outflows from China.
The rising US dollar and falling renminbi, which underlies these capital ouflows, resulted in foreign exchange reserves falling below the symbolic $3 trillion threshold to $2.998 trillion at the end of January (see page 10). But government attempts to stem the flow have not yet impacted demand in the dollar-denominated Asian bond market where Chinese banks and institutions are the main buyers.
Yet venturing offshore exposes Chinese firms to foreign exchange risk – with the renminbi reckoned to be heading in only one direction: down. Foreign banks have been noticeably more bearish than their domestic counterparts about the currency’s prospects in 2017, forecasting a decline of roughly 5% to 7% compared with 3% to 4% by domestic houses.
However, fund managers believe the Chinese are likely to bet the situation will have reversed by the time bonds need to be repaid in five to 10-years time, although there will be increased coupon costs until then.
A second escape route for borrowers has been entrusted lending (corporate to corporate lending), which started to pick up strongly particularly during the second half of the year when direct bond market financing dropped off. Financial data provider CEIC’s figures show that the value of entrusted lending jumped 20% during 2016 to Rmb13.2 trillion. The Wall Street Journal points out that is roughly double the size of Wells Fargo’s loan book.
The newspaper says embattled companies in traditional industries are more likely to use entrusted lending to boost net income. For instance, with its core smelting operations struggling due to a glut of aluminium, Chalco has been growing its loan book. The state giant took in about Rmb31 million in interest income from entrusted lending in the first half of 2016, which equated to close to half of its net profit during the period. The WSJ also says banks are charging 5% fees to act as middlemen, but are leaving all the credit checks to the companies themselves.
This signals another potential flashpoint emerging from the murky depths of China’s shadow banking sector (we pointed to yet another one in WiC353, namely regional financial asset exchanges or RFAEs). The country’s corporate debt now amounts to Rmb18 trillion, or 168% of GDP.
In a recent research report, HSBC draws parallels between the current situation in China and Japan’s at the end of the 1980s when the Japanese government attempted to deleverage the financial system by pricking a property and equities bubble Between May 1989 and August 1990, Tokyo raised interest rates five times from 2.5% to 6%..
The comparison between the two countries is not a reassuring one for fixed income investors as the move contributed to decades-long deflation and stagnation, which Japan is still struggling to escape from.
HSBC concludes that China is less able to withstand a similar shock to its financial system because GDP per capita is lower (about $10,000 to Japan’s $25,000 in the late 1980s) and net foreign income is low.
But it also argues that China has learned from Japan’s mistakes. “We believe the Chinese authorities are aware of the risk and expect Beijing to introduce a very moderate liquidity tightening cycle over a long time,” the bank states.
So far, the Chinese government has used liquidity tightening rather than follow the US Federal Reserve lead of raising rates, which would have a far greater impact on a company’s cost of capital. But HSBC also points out just how important stability is to the Chinese government, adding impetus to arguments that it will try to deflate the credit bubble more slowly.
This argument is endorsed by global rating agency Moody’s. It highlights that defaults amounting to Rmb40.1 billion (including private placements) accounted for just 0.06% of bond market outstandings at the end 2016. The rating agency concurs with HSBC that stability will remain the watchword. “We believe the government is unlikely to allow large defaults that could undermine the integrity of the onshore bond market,” it concludes.
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