China's credit-market gauges are triggering alarm bells, as banks grow cautious in lending to each other while investors choose the safest government bonds.
The spread between the two-year sovereign yield and the similar-maturity interest-rate swap, a gauge of financial stress, touched 121 basis points on February 19, the widest in Bloomberg data going back to 2007. Two days later, the cost to lock in the three-month Shanghai interbank offered rate for one year achieved an eight-month high of 94 basis points over similar contracts according on repurchase agreements, which are acknowledge to be safer because they involve government securities as collateral.
Billionaire investors George Soros and Bill Gross have drawn parallels between the situation in China now and that in the U.S. before the 2008 financial crisis, when traders gauged lending appetite by monitoring the disparity between the London Interbank Borrowing Rate and the overnight indexed swap. Premier Li Keqiang’sefforts to curb leverage in the world’s second-biggest economy by driving up borrowing costs need to be controlled carefully to avoid wrecking confidence in the monetary system, according to Nomura Holdings Inc.
“What I do see are increasing parallels between China and the U.S. in the run-up to the global financial crisis,” said Patrick Perret-Green, a London-based strategist at Australia & New Zealand Banking Group Ltd. “Shibor-repo is similar to Libor-OIS. Shadow banking is subprime. Credit spreads are widening as they did in 2007. Money growth is softening as tightening bites.”
Widening Spreads
In July, 2007, U.S. banks began to hoard cash when defaults on subprime mortgages led two Bear Stearns hedge funds to seek bankruptcy protection, pushing up borrowing costs. The gap between the three-month Libor in dollars and the OIS rate soared to a record 364 basis points in October 2008.
Shadow banking in China, which includes trust companies and wealth-management products of lenders, is more closely linked to the real economy than in western countries, Finance Minister Lou Jiwei said in an interview in Sydney on February 22. Possible defaults in some WMPs don’t reflect a “big problem” and yuan weakness is within a normal range, he said.
While China’s bond risk has risen this year, it has fallen for four weeks. Credit-default swaps reached 105 basis points on January 24 in New York, the highest since Aug. 30, CMA prices show. They closed at 90.5 yesterday, up from 80 on December 31.
Currency Volatility
The yuan was down 0.03 percent at 6.1286 per dollar in Shanghai as of 11:40 a.m. in Shanghai today after falling 0.46 percent yesterday, the most since November 1, 2010. Nomura’s managing director of currency research said yesterday the central bank may double the size of the currency’s trading band versus the dollar within weeks.
“The drop in the cash bond yield was due to investors downgrading their forecasts of 2014 growth,” said Tim Condon, head of Asian research at ING Groep NV in Singapore. “Some of the credit-spread widening also could be a flight to safety by investors unnerved by the increased foreign-exchange volatility.”
The yield on two-year government bonds declined 26 basis points this month to 3.56 percent yesterday. The spread to the swap averaged a record 110 basis points this month and was at 95 basis points yesterday. In February 2013, it averaged 25.
“There is a big flight to quality,” said Wee-Khoon Chong, Singapore-based head of rates strategy Asia ex-Japan at Nomura. “In times of stress, you sell credits, sell longer-dated bonds into shorter ones and you are going to the government bond market. If the default situation gets out of control, yields are going to fall a lot.”
He forecast the central bank will cut reserve-requirement ratios for lenders to 19 percent this year from 20 percent as higher borrowing costs cool economic growth.
PBOC Tightening
Expansion in the world’s second-biggest economy slowed in the fourth quarter to 7.7 percent from 7.8 percent in the previous three months as the central bank drove up money-market rates to curb shadow-banking excesses.
The People’s Bank of China signaled on Feb. 8 that money-market volatility will persist and borrowing costs will rise, while saying it will enhance monitoring of local government financing vehicles, industries with overcapacity and property developers to prevent default risks from spreading.
It drained 100 billion yuan ($16.3 billion) from the financial system this week, following a withdrawal of 558 billion yuan in the previous two weeks. Money supply growth, measured by funds readily accessible for spending, fell to 1.2 percent in January, the lowest in data going back to 1996.
“A consistent rally in sovereign debt will be more likely if we start seeing more defaults in shadow banking or credit products, which will lead to flight-to-quality flows and also likely PBOC easing,” said Bin Gao, head of Asian rates at Bank of America Merrill Lynch in Hong Kong.
Trust Products
About 5.3 trillion yuan of trust products will come due this year, up from 3.5 trillion yuan in 2013, Haitong Securities Co. estimated last month. Assets in all trusts surged 46 percent in 2013 to a record 10.9 trillion yuan, the China Trustee Association said in a February 13 statement.
China averted its first trust default in at least a decade in January as investors in a 3 billion yuan high-yield product sold by China Credit Trust Co. to fund a coal miner that collapsed were bailed out days before it came due. A similar product created by Jilin Province Trust Co. is also missing payments, Shanghai Securities News reported.
Default Concern
In a sign of default concern, the premium for five-year AA rated corporate notes over the sovereign widened to 337 basis points on February 12, the most in two years. At least a third of China’s 200,000 steel-trading firms will collapse because of the credit crisis, the official Xinhua news agency said February 7, citing industry estimates.
The slowdown may fuel bank bad loans, which surged 28.5 billion yuan in the final quarter of 2013 to 592 billion yuan, the highest since September 2008, according to China Banking Regulatory Commission data. The economy will probably expand 7.5 percent this year, the slowest since 1990, according to the median estimate in a Bloomberg survey.
Credit-default swaps on Bank of China rose 32 basis points to 153 this year while those on Industrial & Commercial Bank of China Ltd. climbed the same amount to 165, CMA prices show.
Global Investors
Increased money-market turmoil and the outlook for slowing growth are serving as catalysts for a rally in government bonds as banks increase buying, according to Yii Hui Wong, a Singapore-based strategist at BNP Paribas SA. The rise in the short-end will spread to five-year notes, she forecast.
Demand for sovereign notes is also supported by global investors as China opens up its domestic capital markets and foreign funds look for a harbor from a sell-off in emerging markets sparked by the Federal Reserve’s reduction in stimulus.
“Offshore investors take a longer-term view, and they don’t feel that the government can’t handle the situation because it’s still a very controlled economy,” Wong said. “If the central government wants to do something, then it can. Government bonds at these levels are very attractive.”
