China's credit markets under pressure

China's corporate sector has been hit with escalating credit problems. Here is the latest:

1. Shanghai Chaori Energy Science and Technology is about to miss a coupon payment on its bond (see story).

2. As a result, Suining Chuanzhong Economic Technology Development and 2 other companies scrapped their bond offerings - demand for new issue corporate bonds has dried up.

3. Secondary corporate bond trading has also slowed materially. This is fairly new for China since it has never really experienced large scale credit problems in its nascent bond markets.

4. There are indications that banks are cutting back lending as a result. In particular lines have been cut to natural resource wholesalers, traders, and importers (iron ore, steel, cement, etc.). These borrowers in turn are forced to sell inventory that is ofren used as collateral for these loans. Inventory sales depress prices of some of the raw materials, generating further losses for these businesses. This is compounded by the nation's slack industrial demand, with steel mills now running at 50-70% of capacity.

Iron ore April futures contract (source: barchart).

5. With banks cutting back on lending, demand for interbank funding fell materially, sharply lowering China's money market rates. Both 7-day repo and the 1-week SHIBOR are at lows not seen in quite some time. While lower money market rates are good for banks, at this point there is ample liquidity in the system with far less demand.

7-day repo rate (source: chinamoney)

1 week SHIBOR

These developments are quite negative for China's economy. Confidence in the nation's credit markets - both bank lending and corporate bonds - has taken a hit. It remains unclear however just how pervasive these problems could become - some think this is just the tip of the iceberg (see story).

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Reduction in fiscal stimulus creates tight monetary conditions in China

China's short-term rates have spiked again. In a replay of this summer's liquidity squeeze (see post), term money market rates (SHIBOR and repo rates) have risen across the board. The PBoC had to inject liquidity to stabilize the situation.

WSJ: - The People’s Bank of China said Friday it had been forced to inject more than 300 billion yuan (US$49.2 billion) into China’s money markets over a three-day period after the interest rates banks charge each other for short-term loans surged to 8.2%. The injection helped bring down rates to 5.6% by Monday morning.

Last week’s levels were the highest since June’s cash squeeze sent short-term rates soaring above 28%. Then, China’s lenders were caught in a credit squeeze caused by a combination of factors, ranging from lower capital inflows and seasonal tax payments to a mismatch between banks’ short-term funding and longer-term lending. The PBOC let the problem fester before stepping in, to teach banks a lesson.

Source: China Foreign Exchange Trade System & Nation Interbank Funding Center

The explanation this time around seems to be reduced government spending. The banks and the economy as a whole rely on seasonal fiscal stimulus, which is not nearly as potent this time around. Reforms focused on reducing "unnecessary" government spending are being put in place.

WSJ: - Those seasonal factors have come into play now as well. But “the recent rate spike is, to a large extent, a reflection of the government’s tighter stance on spending,” Citigroup economist Ding Shuang said.

The Chinese government usually draws down fiscal deposits — the amount of funds the government keeps in the financial system—more quickly in December, as it speeds up spending and fiscal disbursements before the end of the year, UBS economist Wang Tao said in a recent note.

That boost in government spending adds liquidity to the banking system, and the PBOC normally withdraws liquidity at the end of the year to offset the inflows. This time, though, the government’s tighter fiscal policy means year-end spending has been restrained, Ms. Wang said.

China’s Communist Party has launched a campaign this year to crack down on unnecessary government spending, from official banquets to investment projects. Even budgeted investment projects that are deemed unnecessary won’t get funding, Citigroup’s Mr. Ding said.

Withdrawal from years of stimulus is bound to have its side effects. And tight monetary conditions are likely to be just a part of the overall impact.

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More bad news on China's economy

The widely followed Markit PMI report of China's manufacturing for July was disappointing, coming in at an 11 months low.

Source: Econoday

Growth across developing economies has become a problem, and China is no exception.

Source: Markit/HSBC

HSBC: - The lower reading of the July HSBC Flash China Manufacturing PMI suggests a continuous slowdown in manufacturing sectors thanks to weaker new orders and faster destocking. This adds more pressure on the labour market. As Beijing has recently stressed to secure the minimum level of growth required to ensure stable employment, the flash PMI reinforces the need to introduce additional fine-tuning measures to stabilise growth.

The "fine-tuning" that HSBC is referring to is some type of stimulus from Beijing. The PBoC however has trouble introducing additional liquidity. The central bank views such action as conducive to more shadow banking, which the authorities have been trying to curb (see post). Any significant "fine-tuning" is therefore unlikely - in fact money market rates are no longer declining (chart below). With exports remaining weak (see post) and no central bank easing, growth is expected to be anemic - at least by China standards.

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China's short-term rates stabilize but the yield curve remains inverted

The sharp jump in China's short-term rates has been nearly reversed. Repo rates are approaching their longer-term averages, with the PBoC coming to its senses and addressing the liquidity squeeze.

China's short-term repo rates (blue=o/n, red= 1w, green =2w)

However as the short-term rates came down, so have rates at longer maturities. The full interest rate swap curve has shifted lower but remains inverted (see post). The chart below compares today's curve with the one three weeks ago. The market continues to price in some further slowdown in China's economic growth.

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China's short-term rates spike to multi-year highs; SHIBOR and repo curves become inverted

China's interbank rates have unexpectedly spiked last week as the SHIBOR curve (China's LIBOR equivalent) became highly inverted. Given that there have been no indications of a change in policy by the PBoC (the central bank), there is only one thing that can cause such a move: a liquidity squeeze.

Source: Shanghai Interbank Offered Rate

China analysts point to a number of possibilities for this spike, including some action by the authorities to curb FX speculation or other trading activities. The best explanation however was that a panic ensued among China's banking institutions due to a rumor that several banks were about to fail. This rumor, though unverified, caused banks to cut lending to each other, creating a liquidity squeeze. The squeeze was exacerbated by China's markets being closed this Monday through Wednesday for the Dragon Boat Festival and liquidity already being tight coming into last week.

Reuters: - Early Friday, rates skyrocketed from already-high levels the previous day. Rumours that several mid-sized banks had defaulted on interbank loans added an element of fear to an acute liquidity shortage related to a coming national holiday and a slowdown in capital inflows. The rumours couldn't be verified.

The stock market tanked in response.

Shanghai composite

It is thought that the PBoC has stepped in on Friday afternoon to ease liquidity conditions. The spike in short-term rates was not limited to SHIBOR, as the repo rates (secured lending) have been on the rise in recent days as well (with the repo curve now also highly inverted).

Reuters: - The weighted-average one-day repo rate closed at 8.68 percent on Friday - the highest since October 2007 - from 6.15 percent on Thursday. It's extremely unusual for the one-day rate to move higher than the seven-day rate.

Dealers said the central bank had likely conducted short-term repos with selected banks, who were then able to transmit funds to the rest of the market.

Even the one-year government-issued bill rate spiked, indicating that the short-term liquidity concern has spilled over to some longer term instruments.

Source: Investing.com

This is a dangerous development, particularly when China is already struggling with a relatively weak (by historical standards) growth. While the nation's PMI numbers indicate an ongoing expansion on the whole, it is quite a slow one.

A spike in short term rates could dramatically dampen bank lending and slow growth even further. A prolonged spike could even put China into a recession. Many are hoping that the PBoC will deal with this issue aggressively by injecting more liquidity into the banking system in order to reduce the risk of a major credit contraction.

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The SHIBOR curve is now positively sloping

Another indicator pointing to some stabilization in China's economic growth (see discussion) is the SHIBOR curve. SHIBOR is China's measure of domestic interbank lending rates. The curve has gone from being inverted 18 months ago (inverted curves tend to indicate an impending economic slowdown) to a more traditional upward sloping shape. Note that the slope is still quite low, potentially indicating weak recovery.

The same holds true for longer term rates. The SHIBOR-based interest rate swap curve (similar to the LIBOR based interest rate swap curve in the US) is now also positively sloping (though only slightly).

Source: Chinamoney

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PBoC managing China's rising interest rates

Interest rates in China have been on the rise. The 7-day repo swap rates have been increasing across all tenors. These swaps exchange the 7-day repo rate (reset weekly) for a fixed rate over a longer period (such as 2 years) - thus providing a window into the market's long-term expectations of repo rates. The increase is an indication of tightening liquidity conditions in the interbank market.

2-year fixed for floating  (7-day repo) swap rate (Bloomberg)

China's central bank has been trying to add more liquidity to the money markets in order to stabilize rates (without adjusting the bank reserve ratio).

WSJ: - The People's Bank of China injected 220 billion yuan ($34.7 billion) into the money market Tuesday via reverse repurchase agreements offered in its regular open-market operation, continuing efforts to ease monetary conditions and bolster a slowing economy.

So far these liquidity injections have not worked, as demand for short-term money remains high and rates continue to rise.

Reuters: - China's key money rates ticked higher on Tuesday, with the central bank's largest fund injection since early July failing to ease conditions amid elevated month-end cash demand and corporate tax payments. The People's Bank of China injected 220 billion yuan into the banking system via reverse repos on Tuesday, against a net 87 billion yuan scheduled to be drained this week due to maturing bills, repos, and reverse repos.

That guarantees a net injection of at least 133 billion yuan for the week not including additional reverse repos likely to be auctioned on Thursday. Such an injection would be the largest since the week of July 2-6.

"The market demand is quite large. Monday's demand was really heavy. The central bank's action today basically just satisfied current demand, but didn't in any way exceed it in a way that would bring rates down," said a trader at a city commercial bank in Shanghai.

The PBoC has been cautious about flooding the market with liquidity due to risks it could reignite inflationary pressures. Yet left unchecked, rising interest rates could threaten growth, given that the GDP is already growing at the lowest rate since 2009. This will require a delicate balance for the central bank going forward.

China GDP YoY (Bloomberg)

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Goldman's bullish call on China may be premature

So far markets' reaction to the latest increase in China's manufacturing PMI has been quite muted (h/t Avi Cohen). Here are four market indicators as well as two other factors demonstrating that it's way too early to call for a bottom in China's economic activity.

1. SHIBOR 1-year swap rate declined last night and is hovering near the recent lows. As discussed before, this swap rate is a measure of short term rate expectoration going out to 1 year. Just as in teh US, expectations of material improvements in economic growth would have resulted in the swap rate increase.

1-year SHIBOR rate swap

2. The Renminbi (CNY) continues to weaken. Clearly Bejing has the ability to control it but the government is allowing the currency to float within some range. This weakness may be an indication of some capital outflows.

CNY (per 1 dollar)

3. China's equity market hit another recent low, showing lack of confidence in corporate profit growth.

Shanghai Stock Exchange Composite Index

4. Imported iron ore prices (discussed earlier) are experiencing a sharp decline as well and are now nearing the three-year support level. A good indicator of demand decline for industrial commodities in China would be a breach of this support level the next few days.

China import Iron Ore 62% Fe spot (CFR Tianjin port)
USD/metric tonne (Bloomberg, Steel Business Briefing)

A couple of other indicators also support the slowdown thesis, negating the jump in the manufacturing PMI. One is the ISI Company Survey Index of China Sales, which is now at 2009 levels and is not showing signs of bottoming out.

Source: ISI Group

Another is today's Caterpillar (CAT) call which hinted that the firm is continuing to see soft machinery demand in China. CAT announced that they have no intentions of bung back stock at least in part due to lack of confidence in China's growth. The stock sold off in response.

CAT shares intraday

These indicators clearly tell us that yesterday's Goldman bullish call on China, based on the July flash PMI reading, may be premature.

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China's domestic rate expectations trending down

China's rate expectations continue to decline. The chart below shows China's 2-year domestic rate (SHIBOR) swap level - the market expectation of where average short-term rates will be for the next two years.

China 2-year rate swap (SHIBOR) 

With inflation seemingly under control and the stock market near recent lows, the authorities will have little choice but to further bring down short-term rates.

Source: ISI Group

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To see China's slowdown in "real time", just watch their interest rates

PBoC, China's central bank, is having trouble stimulating lending. The trouble now seems to be more demand driven, as the economic slowdown sets in.

Bloomberg: - Combined net lending by Industrial and Commercial Bank of China, China Construction Bank Corp., Bank of China and Agricultural Bank of China Ltd. was almost zero in the two weeks through May 13, Shanghai Securities News reported today, citing an unidentified person familiar with the matter.

The slowdown (particularly the lack of demand for loans) is driving interest rates lower. The one-year SHIBOR swap rate is registering the sharpest decline since 2008. Again, swap rates show the market "consensus" of short term-rates in the future - a rate at which someone is willing to "lock in" short term rates for a year or longer (in this case locking in the 3-month SHIBOR rate for a year).

1-year SHIBOR swap rate

When we discussed China's inverted yield curve a couple of months back, many dismissed it as supply/demand aberration. But as has been the case in the US, an inverted curve continues to be the best predictor of economic downturns.

SHIBOR swap curve move

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AUD below parity points to China-Australia link

China's one-year SHIBOR swap, an instrument that works just like the LIBOR based USD rate swap, provides a window into near term market expectations of rates in that country. And these expectations have adjusted down sharply in the past few days, revisiting the December lows.

1-year SHIBOR swap rate

After a string of weak economic numbers from China, PBoC cut the bank reserve ratio. It is fully expected that the interest rate will be cut as well (as the SHIBOR swap rate shows), but that requires authorization from the central government and takes time. For now PBoC will keep cutting the reserve ratio - possibly quite aggressively.

But there is something familiar about this SHIBOR swap rate chart above. It happens to look similar to the chart below of AUD/USD exchange rate - which just broke parity. And that's not a coincidence.

AUD/USD FX rate

The currency markets are concerned about a material decline in investment growth in China. The resource focused Australia is particularly vulnerable to China's fixed asset investment trends.

The Australian: - The lowest investment growth in China in a decade, reported on Friday, along with other data issued last week showing the weakest industrial production, retail sales and trade growth for more than a year have forcefully brought the Chinese slowdown to the market's attention.

China Fixed Assets Investment (Excluding Rural Households) Cumulative YoY

Some have been refusing to believe that fixed investment growth in China will stall, although this has been expected by a number of economists (see this post on forecast from CS and one from Capital Economics). It was hard to imagine that the good times may end - particularly in Australia, whose economy benefited tremendously from this growth. But now Australians can wake up to read the following the the paper:

The Australian: - " ...China's share of global demand for such commodities as iron, cement and copper is completely disproportionate to its size and almost wholly a function of its very high growth in investment. As investment growth drops sharply, as it must, global demand for non-food commodities will plummet."

This prediction from Peking University's Michael Pettis would so transform the economic outlook for Australia, were it to come to pass, that it bears some reflection.

So what's the solution? China will obviously continue to try stimulating the economy (including lowering rates), but it's not clear just how much effect that would have on investment growth. Instead Australians are suggesting that China open up to foreign investments to allow Australian firms to potentially facilitate more commodity imports into China.

The Australian (different article from the one above): - As fears grow about the sharpness of the slowdown in the Chinese economy, Foreign Minister Bob Carr is pushing for the lifting of restrictions on Australian companies investing in China as he meets with senior leaders, including Premier-elect Li Keqiang, in Beijing this week.

Good effort on the part of Bob Carr, but is unlikely to yield significant results.

To be sure, relative to the rest of the world Australia's economy is still booming. And as AUD weakens, it may in fact provide further stimulus to the nation's near-term growth. The long-term outlook however has now become far less certain.

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