ANZ Bank has today released an interesting note (below) examining the second round impacts of China’s credit squeeze:
– If China’s central bank continues to tighten market liquidity without accommodating the rapidly deteriorating internal and external environments, we believe financial institutions will start to de-leverage which will last for 1-2 quarters. The real economy will suffer.
– The high inter-bank interest rate will pass-through to the bond markets and bank lending to corporates. It will also hurt local government’s financing ability. China’s local government debt outstanding remains above RMB10trn, which means that even 10bps rise of the funding cost will bring about RMB10bn in additional interest payments.
– We believe that medium-small banks will suffer the most from an inverted yield curve as they are price sensitive. The second round impact of the liquidity crunch will hurt small and medium-sized enterprises as it will result in a double whammy with high interest rate and strong RMB exchange rate.
In our view, if the central bank continues to maintain the relatively tight liquidity conditions without any signal of a policy easing to reflect the rapidly deteriorating internal and external environment, the de-leveraging process in the financial institutions will mean that credit extended to the real economy will fall in the next 1-2 quarters, which will further weaken the already sluggish economy…
If the liquidity tightness continues, we will likely see the following sequential developments in China’s bond and credit markets. We believe financial institutions will likely sell government bonds as they are the most liquid asset, followed by the sale of credit bonds such as corporate bonds and chengtou bonds if the overall liquidity environment stabilizes somewhat. This means that government bond yields will rise and the appetite for corporate and chengtou bonds will dry up. Indeed corporates, and particularly local governments, will face more difficulty in issuing bonds. If there is a freeze in the chengtou bond markets, some local governments will likely face difficulty in paying back their loans to the banking system, issued during the GFC period. This could lead to rising non-performing loans in the banking system. Meanwhile, commercial banks will find it difficult to sell low-rated bonds, but have to increase provisions to cover the mark-to-market losses and prepare for possible default.
While the above described sequential events that may not be realized, we believe policymakers will need to be aware of these spillover effects. In the past few weeks, at least 15 bond issuances have been cancelled, which is likely to dampen market confidence…
The tight inter-bank credit conditions will start to affect the real sectors of the economy in the coming months: First, we expect funding costs for the property developers and local government financing vehicles (LGFV) to rise further as they will find it difficult to roll over funds. Official data suggest that China’s local government debt outstanding remains above RMB10trn, which means that even 10bps rise of the funding cost will bring about RMB10bn in additional interest payments.
Second, small and medium-sized enterprises (SMEs) will likely suffer amid the liquidity crunch. Past experience suggests that the banks normally reduce the exposure to SMEs when the credit appetite eases. Given many of them are in the export sector, these sectors will experience double whammy effect from both rising credit costs and the strong RMB.
Third, the issuance of the WMPs will still be sizable in the foreseeable future as banks have to compete for funds amid the liquidity tightness. However, if the WMPs scale back as the commercial banks lower the leverage ratio, the medium and small banks’ lending capacity will also be constrained. As the medium and small banks mainly serve the SME sector, the SMEs will be further affected.
The challenge for the PBoC is to walk the tightrope between market discipline and over-tightening. If liquidity is too tightly rationed, banks may need to deleverage and will be unwilling to offer funds into inter-bank markets, exacerbating already sparse liquidity conditions. In this case, while the central bank emphasized that it will definitely prevent the systemic crisis from taking place via a series of instruments, this risk would remain if the PBoC cannot strike the correct balance between disciplining the banks and maintaining market stability.
Leith van Onselen is Chief Economist at the MB Fund and MB Super. He is also a co-founder of MacroBusiness.
Leith has previously worked at the Australian Treasury, Victorian Treasury and Goldman Sachs.
