China's Interbank Credit Squeeze - Second Round Impact?

Li-Gang Liu and Hao Zhou, ANZ Bank, Hong Kong.

This article appeared in the July 2013 issue of Current Economics with permission of the author.

Key Concepts: Interbank rate| Liquidity Tightness| Financial System|
Key Economies: China

The continuous and severe liquidity squeeze in China’s inter-bank markets has concerned many that the country is likely to experience a fast deleveraging process in its financial system. As a result, the real economy will continue to suffer.

The People’s Bank of China (PBoC) Governor Zhou acknowledged at the beginning of July that the market has basically understood the PBoC’s handling of liquidity. He said banks had great interest to extend loans in early-June but this was not in line with China’s monetary policy, and banks need to adjust. This is the first time that China’s central bank has admitted that the aim of the liquidity tightness is to slow the expansion of the commercial banks’ balance sheets, indicating that a deleveraging could be inevitable.

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 deleveraging 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. In this note, we investigate the second-round impact of China’s inter-bank credit squeeze and its implications for the overall economy and some sectors that are likely affected the most in the aftermath of the interbank turmoil.

We start from the financial markets first. Most Chinese banks now hold large amount of bonds as a part of their liquid asset holding. China’s bond outstanding reached RMB26trn at the end of 2012, equivalent to 25% of China’s banking assets. Nearly 90% of China’s bond transactions take place in the inter-bank market. In the past few years, China’s bond market transaction picked up steadily, rising by 17.5% from 2010 to 2012. More importantly, interbank bond repurchase surged by more than 60% from 2010 and 2012, suggesting that bonds are used as an important liquidity management instrument.

This means that a surge in China’s interbank rates will quickly transit in the bond markets. If under the pressure of a liquidity squeeze, those banks facing a cash crunch will have to reduce their bond holdings. Furthermore, because bond trading is also financed by short-tenor interbank repo (overnight and 7-day repos), a surge in repo rates will result in a negative carry, and thereby drive up bond yields as well. Indeed, we believe a fast rising government bond yield over the past few months is a reflection of the interbank credit squeeze, leading the yield curve to be inverted.

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 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.

It is reported that some Chinese commercial banks have suspended new loans extension amid the liquidity crunch. There does not seem to be a clear pass-through effect from the interbank borrowing rates to the loan rates, largely owing to China’s interest rate controls. However, past experience suggests that the actual lending rates tend to be higher while the interbank offered rates saw increased volatilities, and vice versa. This suggests that this round of liquidity tightness will not help increase loans to the real economy, and we will likely see higher lending rates for corporates, as overall credit conditions become tighter.

In our view, the lending activities and behaviour are different between big banks and the small and medium ones. For the big banks, as they have strong branch networks and hold large deposits, they may still want to offer loans to corporates, albeit at a higher price. For the small and medium banks, especially those adopting a FTP (fund transfer pricing) system, they may have to stop lending to avoid incurring losses. In most cases, the FTP is priced according to market interest rates, normally SHIBOR and bond yields. As the yield curve has been inverted, the commercial banks will not be able to make money in long-tenor loan extension. We believe most foreign banks will become more cautious in lending if the inverted yield curve does not disappear soon.

Commercial banks’ profit margin will be squeezed as a result, as overall funding costs are likely to be higher. For the big banks, the margin squeezing could be offset by higher lending rates. However, for the medium and small banks, the profits will likely decline significantly due to an inverted yield curve.

It is widely believed that this round of liquidity tightness was conducted by the PBoC with the aim to curb the inter-bank business which has flourished in the past few years. In fact, the interbank business has developed rapidly as these businesses require less capital and face relative looser regulations. As Chinese banks need to comply with strict loan-to-deposit ratios and are under capital tightness pressure, many banks turn to interbank business (no need to comply with loan-to-deposit ratio) to improve their profitability. At present, interbank business refers to interbank borrowing/lending, bonds, bankers’ acceptance draft (BAD), letters of credit (LC), etc. While banks are taking on interbank credit exposure in conducting interbank business, we believe that corporates and local governments (via chengtou bonds) are actually the end users of the funding.

The chart below shows that China’s medium and small banks have borrowed intensively from the inter-bank market in the past few quarters, suggesting that they will have to reduce such business in the coming quarters. As these businesses need to be financed by interbank borrowing and are very price sensitive, a liquidity crunch will sharply cut the scale of such business.

In our view, the deleveraging will take about 1-2 quarters, as the interbank businesses are normally conducted with one year tenor. Meanwhile, in order to finance existing business, some commercial banks will have to issue high-yielding wealth management products (WMPs) to diversify their funding structure.

The tight interbank credit conditions will start to affect the real sectors of the economy in the coming months: First, we expect funding costs for 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 outstanding local government debt remains above RMB10trn, which means that even a 10bps rise in 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 their exposure to SMEs when the credit appetite eases. Given that many of them are in the export sector, these industries will experience a double whammy effect from both rising credit costs and the strong RMB.

Third, the issuance of WMPs will still be sizable in the foreseeable future as banks have to compete for funds amid liquidity tightness. However, if the WMPs scale back as the commercial banks lower the leverage ratio, 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 in 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.

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