With China’s credit-to-GDP ratio over 200%, it appears, as Barclays notes, that the PBoC is acting in line with the government’s efforts to deleverage, rebalance and position the economy towards a path for sustainable growth. Though they expect that the PBoC is likely to stabilize the interbank market in the near term (perhaps by more of the same ‘isolated’ cash injections), short-term rates are likely to remain elevated, at least for a while, possibly leading to the failing of some smaller financial institutions. With the small- and medium-sized banks having grown considerably quicker than the larger banks, having been more aggressive on interbank business (i.e. alternative channels to get around lending constraints), the following banks are at most risk of major disturbance of the funding markets remain stressed leaving the potential for retail bank runs or greater fragmentation in the commercial bank market.
A tipping point
The current liquidity squeeze has roots in a gradual tightening of liquidity in the banking system earlier in the year, but the tipping point was the abrupt drop in FX inflows in May (and likely in June) precipitated by the global unwind of the carry trade and the crackdown on unauthorised FX inflows by Chinese authorities. As the level of excess reserves dropped, banks started to hoard cash, in our view.
Unlike the recent past, the PBoC has not injected funds into the system through reverse repos. On the contrary, by issuing small amounts of bills this week, the bank has signalled its tolerance for the deleveraging process that ensued. Based on our projections, we do not think the liquidity situation will improve in the coming weeks barring strong FX inflows, which we think are very unlikely in the current environment.
The distress in China’s fixed income markets is palpable.
In the absence of prompt policy action, we expect the sell-off in rates to spread to bonds and other fixed income markets. The market will clear over time, but not before a significant level of deleveraging, in our view.
The rout in the fixed income market started at the end of May and accelerated after the three-day Dragon Boat Day holiday (10-12 June), as liquidity conditions did not ease. We think a confluence of several factors has created the tension in the funding market, which has now spilled over into bonds and equities, in our view. The following sequence of events played a role, in our view:
- Tight liquidity has been building gradually this year. Banks’ reported excess reserves stood at 2% of deposits at the end of March, according to the PBoC, and we estimate that ratio dropped to 1.4% at the end of May. High deposit growth – a CNY4.2trn jump in March alone – which generated reserve demand of CNY1.47trn during January-May and OMOs that drained CNY478bn of liquidity in that period, were higher than the offsetting FX inflows of CNY1.57trn.
- FX inflows dropped sharply in May and are likely to have stayed low or turned negative in June, pushing the excess reserve balance into tight territory. The turnaround was very sudden and driven by global market volatility, in our view. Note that liquidity appeared flush, judging by low repo rates, as late as the second half of May.
- The hawkish policy response surprised the market. The PBoC has not responded to surging repo rates by injecting liquidity. Even though it let CNY252bn of repos expire in the first two weeks of June, this was not sufficient to break the trend. Moreover, the PBoC auctioned a token amount (CNY2bn) of 3m bills on 18 and 20 June, signalling tolerance for higher rates. In an unfortunate timing, the squeeze in the funding market came at the time when banks have been in the process of unwinding riskier wealth management products (WMPs) due to regulations introduced in March and require bridge financing for the assets behind those WMPs. Additionally, the rotation out of WMPs into deposits generates demand for reserves, which PBoC is not accommodating.
- Facing with the quarter-end liquidity needs, banks are probably hoarding cash now, transmitting the stress into bond, FX and equity markets.
The growth rates of small and medium-sized banks were faster than the large banks (the “big 4” banks). Moreover, they have higher interbank assets as a percentage of total assets than the big banks.
We believe this was mainly because:
1) the small and medium-sized banks were more aggressive on interbank business, which was used as an alternative lending channel to get around the lending quota, and LDR and capital constraints; and
2) they are more dependent on interbank funding to support their business growth.
In particular, we believe some mid-sized banks, such as Minsheng Bank and Industrial Bank, are using credit risk product-based (such as, discounted bills and Trust Beneficiary Rights [TBRs]) reverse repos and repos to arbitrage regulatory requirements. Such assets, which we believe have a much higher default risk than bonds-based reverse repos/repos, grew rapidly at these banks over the past two years.
Minsheng’s reverse repo under discounted bills increased 376% y/y in 2012 and Industrial Bank’s reverse repo under discounted bills and TBR increased 61% y/y in 2012.
In our view, the regulators are more likely to tighten these products in future.