With "risk" in most of the developed world seemingly a long forgotten four-letter word, as seen by today's plunge in the VIX to a level not seen since 1993, traders hoping for some "risk event" have been confined to the recent turmoil in China, where overnight not only did trade data disappoint, with both imports and exports missing, but bond yields jumped to the highest level since 2015, dragging stocks lower even as the local commodity crash slammed iron ore and copper to new YTD lows.
While largely a "controlled" tightening, meant to contain China's out-of-control shadow banking system, the recent gyrations in Chinese capital markets are starting to have a profound impact on local funding, resulting in a collapse in new bond issuance, and according to FT calculations, in April the number of aborted issues rose to 154, up from 94 in March, 32 in February and 31 in January.
As DB added, "local bond markets are practically shut for corporates. In fact, YTD issuance is down 40%+ yoy and net issuance has been negative in three out of the first four months this year. A number of issuers are being forced to cancel bond issuances (over RMB100 billion YTD) and there were reports (Bloomberg) of even CDB halting issuance (though subsequently denied). Some AA corporates are now issuing at north of 7%."
These signs of mounting stress in China’s $9.3 trillion bond market come less than a month after the country’s banking regulator, Guo Shuqing, was quoted as supporting a campaign to sort out chaotic practices, and threatening to resign if the banking system became “a complete mess”.
Overnight, Deutsche Bank's China analyst Harsh Agarwal noticed the "gyrations" in the bond market, and compared the current selloff in onshore bonds to the similar episode one year ago, saying "this time, it's sharper and longer - AAA yield & spreads are almost 200bp and 100bp wider respectively in the past 6 months or so - because of China's focus away from growth to deleveraging. This is far from over in our view. Every day we see headlines on new regulations trying to control leverage in different parts of the system - WMPs, insurance companies, banks, etc. Having said this, we do believe in China's ability to make a U-turn quickly if the situation goes beyond control, and see these changes as a long term positive, hence we are not overly worried as of now."
Maybe not as of now, but Agarwal is surely getting more concerned with every incremental negative news out of China, even as the PBOC refuses to inject more liquidity, as it just did moments ago when for the third day in a row, the central bank skipped open market operations.
Meanwhile, confirming that Beijing is clearly concerned about developments behind the scene, potentially culminating in the worst possible case for China's banking system - a shadow bank run -China Banking Regulatory Commission said in guidelines on banks’ collateral management posted on its website.
Commercial banks should carry out pressure tests on collaterals at least once a year, China Banking Regulatory Commission (CBRC) posted new guidelines on banks’ collateral management, among which that banks should revalue collateral at least once a year; and that banks are being urged to prevent risks in the collateral business. Of course, since this is the country where due to "infinite rehypothecation" of collateral, thousands of tons of copper and aluminum were "found" to be missing at China's Qingdao Port, urging Chinese banks to engage in collateral "quality control" seems like a lost cause.
In fact, the banking regulator itself appears to be in on the joke, because as Bloomberg's Tom Orlik points out, the CBRC requires that collateral accepted by banks must actually exist, as explicitly stated in Chapter 3 on "Risk Mangement" in the just released Collateral Guidelines:
Article 15 The collateral received by a commercial bank shall meet the following basic conditions:
- the collateral is real;
- the relationship between the collateral is clear, the mortgage (pledged) has the right to dispose of the collateral;
- the collateral conforms to the laws and regulations or the national policy requirements;
- the collateral has a good ability to achieve liquidity.
That's not all.
In a subsequent notice posted in the Securities Times, the Chinese outlet reports that some Chinese rural banks have suspended their interbank businesses including negotiable certificates of deposit (or NCDs) "temporarily" while regulators conduct spot checks. It further adds that at the end of March total interbank liabilities of 25 banks listed in China’s stock market dropped by 1.54t yuan from end-2016, report says, citing Wind Info data, suggesting a sharp contraction in shadow funding.
While it was not immediately clear what the underlying catalyst for the unexpected move was, recall that at the end of March, Deutsche Bank reported that in the most recent troubling trend involving Chinese banks, numerous smaller banks had become acutely reliant on such shadow banking funding mechanism as Certificates of Deposit, which had become the primary source of short-term funding for many of China's banks mid-size and smaller banks.
As DB further explained, the banks most exposed to a shut down in this "shadow funding" pathway are medium-sized and small banks, for whome as of 1H16, wholesale funding made up 31% and 23%, a number that has risen substantially in the interim period.
As Deutsche reflected just over a month ago, "we view banks that are more reliant on CDs as more vulnerable to rising rates and tighter regulations."
Reflecting tighter liquidity, the interbank CD rate has rallied strongly, with the 6-month CD pricing at 4.6% on average. Some CDs issued by smaller rural commercial banks have been priced close to 5% recently. This would have pushed up the funding cost and notably for smaller banks. If banks invest in low-risk assets such as mortgages, discounted bills and treasury bonds, this would lead to a negative spread. Alternatively, banks can lengthen asset duration, increase the risk appetite, add leverage or slow down asset growth. Among these alternatives, we believe a slowdown in asset growth is the most likely.
And while it is tangential, here is a list of the banks most exposed to a sudden cardiac arrest involving CDs: INDB, SPDB and PAB are among the most exposed to interbank CDs.
We would not be surprised if these are among the banks that as of this evening have "suspended their interbank businesses."
Which again brings us to the most important question: "Are we close to a “tipping point” in China?" For those who missed the answer the first time, here is Deutsche Bank's conclusion as of mid-March. Note: since then the liquidity situation in China has gotten far more precarious. Here's Deutsche:
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.
In other words, whether or not China keels over and has a hard (or worse) landing, will depend on the PBOC; when (not if) the central bank gets involved, will depend on how soon China's banks and various CD-funded financial institutions run out of collateral (whether it exists or not) to sell, such as iron ore, copper, precious metals, bonds and even stocks. This will hardly come as a surprise. As we showed last month, the only reason the Chinese banking system hasn't imploded, is due to nearly CNY 10 trillion in central bank liquidity support for the local banks.
One thing, however, is certain: with western central banks refusing to let the market clear on its own, or deflate the $14 trillion liquidity bubble which has suppressed price formation for the past 8 years, the PBOC is merely doing what all of its "civilized" peers have been doing for years - kicking the can, and praying.
Until then, however, things may be about to get a whole lot worse for China's capital and commodity markets.