China blinks ?
China Liquidity Fears Ease As PBOC Injects 255 Billion CNY - Most Since Feb 2013
Despite all the reform policy imperatives to constrict credit and normalize and liberalize policy and rates, the PBOC just provided the largest liquidity injection to its banking system in a year - 255bn CNY. While this is not entirely unusual for a year-end, when Chinese banks have to confess their illiquidity sins and cover mismatches (and are always helped by the PBOC); this year, short-term money-market rates are triple that of last year and there is a very real chance of a very real default within the shadow banking system. Of course, the sell-side are desperately writing cover that this is all priced in and even if the PBOC "lets some Trusts go" then they will come to the rescue and any crisis will be "contained."However, no one knows who will be saved and therein lies the safety-first rub - now where have we heard "contained" before?
- *PBOC TO CONDUCT 75B YUAN OF 7-DAY REVERSE REPOS: TRADER
- *PBOC TO CONDUCT 180B YUAN OF 21-DAY REVERSE REPOS: TRADER
- *PBOC OFFERS 7-DAY REVERSE REPO AT 4.1% YIELD: TRADER
- *PBOC OFFERS 21-DAY REVERSE REPO AT 4.7% YIELD: TRADER
China Repo (lower) and Reverse Repo liquidity provision...(biggest liquidity provision in a year)
Crucially, the PBOC will have to withdraw this liquidity (obviously as the repo matures) if it is merely year-end window-dressing (as is obvious in the chart above with the large downward red bars in each Feb).
For now short-term repo rates are lower
1d: -85bps at 3.48%
7d: -135bps at 5.25%
14d: -34bps at 5.57%
But of course, the big banks always bid first and scoop up the supply - just as we saw yesterday - its the smaller banks that are the most in distress and 7-day repo went through a 8, 9, and 10% rates - these are triple those of the peak rates during last year's new-year liquidity crunch.
And as much as banks will contend - just as the China itself admitted tonight:
Credit default risks with Chinese companies are emerging because of rising borrowing costs and tight liquidity conditions, said the official China Securities Journal in a front page editorial. The government needs policy flexibility to prevent any systematic financial risks.
This problem - described as "contained" by one sell-side shop reminds us of the "it could never happen here" mentality in the 2008 US shadow banking system. Critically, when the PBOC suggests it may let some banks go (to prove its mettle and resolve to fight out of control credit creation); investors will sell first and think later about which are safe and which are not. A 'default' - which looks increasingly likely - may just be the test of just how 'planned' and 'controlled' the Chinese banking system can really be...
We have on little question... for now the only Wealth Management Trust product that is publicly on the verge of default is CEQ#1 and that is only a 3 billion CNY position - so why did the PBOC feel the need to provide more than 80 times that amount of liquidity to the banking system unless it was epically worried about contagion and the total size of the Trust market.
Of course, the knee-jerk reaction is positive (well it is 255 Billion CNY of magic money) but between the BoJ starting its two-day meeting and John Hilsenrath confirming that Taper is here to stay - JPY weakness (and USD strength) are dragging stocks higher with S&P futures +7.5 from Friday's close.
Fun-DURR-mentals?
Charts: Bloomberg
http://market-ticker.org/akcs-www?post=227759
It Comes From The East (And Soon)
On Friday, Chinese state media reported that China Credit Trust Co. warned investors that they may not be repaid when one of its wealth management products matures on January 31, the first day of the Year of the Horse.Why does all this matter? Because this "investment" was "offered" under terms that were essentially impossible to fulfill at the outset.
The Industrial and Commercial Bank of China sold the China Credit Trust product to its customers in inland Shanxi province. This bank, the world’s largest by assets, on Thursday suggested it will not compensate investors, stating in a phone interview with Reuters that “a situation completely does not exist in which ICBC will assume the main responsibility.”
They included a 10% annual return to investors, or three times bank deposit rates in China. This means that the company had to be paying more than that (since nobody lends intentionally at a loss.)
Obviously the firm that did the borrowing was desperate. The Forbes article details some of the probable reasons, but it doesn't matter why. What matters is that this is an instance of a facially-fraudulent scheme if looked at with any sort of diligence at all.
That's very much like our so-called "pension plans" that promise 8% returns in their portfolios, all of which are scams because there is no possibility of ever earning that return except by stealing it over very long periods of time. A person's work-life is about 45 years (20-65), and thus if we were to assume such a pension plan had a ~40 year time horizon the first dollar put in would have to have expanded by 21.7x over that 40 years. For that to be sustainable theeconomy would have to expand by 21.7x over the same 40 year period.
Let's look back 40 years, to 1974. GDP was 1.548 trillion. It would have to be 33.6 trillion today for that "estimate" to have worked, and we're fully 50% short of that aren't we ?
How about now? We're at $16.9 trillion today. GDP would have to be $366.7 trillion 40 years hence for that 8% return to "work."
The only other means for it to "work" is if you steal fully half of the return in your fund from someone else, assuming our so-called "expansion" matches the last 40 years. But it won't, because of this:
That is, what we've done over that last period, most-particularly from 1980 forward, is expand credit and therefore have people borrow more and more money to "produce" a lesser expansion in GDP. And that's exactly what we've gotten -- the blue line is over the red line. Further, continuing this charade requires ever-looser credit standards and ever-lower interest rates.
There are two problems with this: First, zero is an effective lower barrier on interest rates. But more to the point, as rates approach and reach zero there is no reason for someone who has capital to lend it at all, since they earn nothing from doing so.
How about now? We're at $16.9 trillion today. GDP would have to be $366.7 trillion 40 years hence for that 8% return to "work."
The only other means for it to "work" is if you steal fully half of the return in your fund from someone else, assuming our so-called "expansion" matches the last 40 years. But it won't, because of this:
That is, what we've done over that last period, most-particularly from 1980 forward, is expand credit and therefore have people borrow more and more money to "produce" a lesser expansion in GDP. And that's exactly what we've gotten -- the blue line is over the red line. Further, continuing this charade requires ever-looser credit standards and ever-lower interest rates.
There are two problems with this: First, zero is an effective lower barrier on interest rates. But more to the point, as rates approach and reach zero there is no reason for someone who has capital to lend it at all, since they earn nothing from doing so.
This in turn destroys the incentives to form capital, and that in turn chokes off GDP. As I have previously commented the impact from this sort of policy isnot felt instantly, which is why people like Ben Bernanke and Janet Yellen thought they could get away with it originally -- that it would be short-lived and therefore the impacts hidden in what would otherwise be a "recovery."
Unfortunately for them the recovery never came, because the credit bubble was (as are all credit bubbles) expressions of fraud. By suborning fraud one becomes a part of the fraud. Now the Fed is trying to slowly back away from that which they knew wouldn't work over an extended period (despite Bernanke's words) in the first place. How did they know this? Arithmetic never changes.
Frauds cannot exist forever. You choose either to expose and prosecute them, letting the consequences fall on the people who commit them, or you compound them and make them worse. Those are your options.
China has done the latter, but the important point here is that we have as well.
Yes, I expect China will try to cover this one up. And in the grand scheme of things the dollar amount of this scheme isn't all that large. But that's not the point either; all collapses of large-scale fraudulent edifices do not happen when the final "wall" is hit. They happen long before, when the critical person sticks up their hand and calls bull**** on what they are being told and sold.
Exactly who the critical person is and when the event happens is impossible to determine in advance. But that this event will happen, because from an arithmetic perspective it must, is simply not subject to debate.
Chinese Money Markets Spooked Despite Slight Beat (And Miss!) In GDP
UPDATE: China overnight repo rates just spiked to 6% - the worst since June...
Chinese overnight repo rates were already on the rise (several trades at 5.5%: 200bps above Friday's close) as contagion concerns over wealth management product default spreads and the Chinese Business Climate Index tumbled to its lowest since June 09. Equity futures were sliding also with JPY strength and the Shanghai Composite was testing down towards the 1-handle once again. Then, amid the glorious nashing of spreadsheets and in the face of missed manufacturing and services PMIs, Chinese GDP (according to the Chinese government) came in at a better-than-expected 7.7% YoY (7.6% exp.) and handily above the all-too-crucial-to-hit 7.5% target GDP growth - but in keeping with the Schrodinger plan missed QoQ expectations (+1.8% vs +2.0% exp.). Industrial production also miraculously met expectations of 9.7% perfectly; and (shocker) Retail Sales perfectly matched expectations of 13.6% YoY. The results of all this 'meeting expectations' - JPY weakness (back down to 104 instantaneously) and implicitly US equity futures regain some momentum and scramble back close to unchanged.
Chinese money markets are concerned...
China's 4Q Business Climate Index dropped to 119.5 from 121.5 (lowest since June 09); and the Entrepreneur Index also fell to 117.1 from 119.5 (also the lowest since June 09)
But GDP beat expectations on a YoY basis...
But misses on a QoQ basis - QoQ annualized growth only 7.4% down from 9.1%
The response - JPY weakness and US equit yftures picks up
For a sense of just how well "managed" (or how well "trained" the analysts are) the Chinese economy is - by that we mean goal-seeked -
- US Q4 GDP "guess" at 3.3% has a +/-0.4% error... (about a 13% standard error)
- China's Q4 GDP "guess" at 7.6% had a +/-0.1% error... (about a 1.3% standard error)
So does that mean China is 10-times better at Central Planning?
As Bloomberg's Michael McDonough ( @M_McDonough ) pointed out, here are the countries most dependent on Chinese demand for their exports...
Bank of America Is Actively Preparing For The Chinese January 31 Trust Default
- Australia
- Bank of America
- Bank of America
- Barclays
- Bond
- China
- default
- George Soros
- Gross Domestic Product
- Jim Chanos
- Market Manipulation
- Michael Pettis
- Monetary Policy
- Real estate
- Shadow Banking
Last week we were the first to raise the very real and imminent threat of a default for a Chinese wealth management product (WMP) default - specifically China Credit Trust's Credit Equals Gold #1 (CEQ1) - and its potential contagion concerns. It seems BofAML is now beginning to get concerned, noting that over 60% of market participants expects repo rates to rise if a trust product defaults and based on the analysis below, they think there is a high probability for CEQ1 to default on 31 January, i.e. no full redemption of principal and back-coupon on the day. Crucially, with the stratospheric leverage ratios now engaged in such products, BofAML warns trust companies must answer some serious questions: will they stand back behind every trust investment or will they have to default on some or potentially many of them?BofAML believes the question needs an answer because investors and Trusts can’t have their cake and eat it too. The potential first default, even if it’s not CEQ1 on 1/31, would be important based on the experience of what happened to the US and Europe; the market has tended to underestimate the initial event.
For those who have forgotten, below is a quick schematic of what a WMP looks like:
And as we previously noted,
...borrowers are facing rising pressures for loan repayments in an environment of overcapacity and unprofitable investments. Unable to generate cash to service their loans, they have to turn to the shadow-banking sector for credit and avoid default. The result is an explosive growth of the size of the shadow-banking sector (now conservatively estimated to account for 20-30 percent of GDP).Understandably, the PBOC does not look upon the shadow banking sector favorably. Since shadow-banking sector gets its short-term liquidity mainly through interbanking loans, the PBOC thought that it could put a painful squeeze on this sector through reducing liquidity. Apparently, the PBOC underestimated the effects of its measure. Largely because Chinese borrowers tend to cross-guarantee each other’s debt, squeezing even a relatively small number of borrowers could produce a cascade of default. The reaction in the credit market was thus almost instant and frightening.Borrowers facing imminent default are willing to borrow at any rate while banks with money are unwilling to loan it out no matter how attractive the terms are.Should this situation continue, China’s real economy would suffer a nasty shock. Chain default would produce a paralyzing effect on economic activities even though there is no run on the banks. Clearly, this is not a prospect the CCP’s top leadership relishes.
So the PBOC's efforts are merely exacerbating the situation for the worst companies... and as BofAML notes below, this is a major problem...
The 3bn CNY Beast Knocking
via BofAML's Bin Gao
via BofAML's Bin Gao
CNY stands for the currency, and also a beast
CNY represents China’s official currency. It also stands for Chinese New Year, the biggest holiday for the country and the occasion for family reunions and celebration. But less familiar for many, however, the Year (?) itself actually stood for a beast which comes out every 365 days and eats everything along the way from bugs to humans. The holiday tradition started as a way for people to fend off the beast by getting together and lighting up the firecrackers.
At the same time, custom dictated that people also to paid their due to avoid becoming the beast’s target. In particular, it has been a tradition to settle all debt before the New Year. From the perspective of such folk culture, the trust product Credit Equals Gold #1, referred as CEQ1 hereafter, by China Credit Trust planned poorly for having the maturing date on the New Year, leaving a 3bn CNY beast running wild.
High probability for the trust product to default
Though the term default is used quite frequently, there are actually confusions on what constitutes a default in this case when talking to investors and especially onshore investment professionals. To simplify the issue, we define a default as failing to pay the promised contractual amount on time.
The product, CEQ1, is straightforward. It is CNY3.03bn financing with senior tranches of CNY3bn and junior tranche of CNY30mn. In principle, the senior tranches are also equity investment, but the junior tranche holder pledged assets for repurchasing senior investment at a premium. The promised rate was indexed to PBoC’s deposit rate with a floor for three classes of senior tranches at 9.5%, 10% and 11%, paid annually (detailed structure is illustrated below).
In a sense, the product is in technical default already. The last coupon payment in December, with nearly all the money (CNY80mn) left in the trust account, came in at only 2.7%, falling far short of the promised yield. The bigger trouble is the CNY3bn principal payment, along with the delinquent coupon, on 31 January.
We see high probability of default on 31 January
Political or economic consideration: ultimately, given the government’s strong grip on financial institutions, default may be a political decision as much as an economic decision. From that perspective, CEQ1 would be a good candidate for default. The minimum investment in CEQ1 is CNY3mn, much more than the typical amount required for other trust investment and 75 times of per capita GDP in China. If defaults were to be used to send a warning signal to shadow banking investors, this group of rich investors may have been a good target because the government does not need to worry too much of them demonstrating in front of government offices.Timing: there is never a good timing for deleverage because of risks involved. But the current job market situation provides a solid buffer should defaults and subsequent credit contraction slow down the economy growth. The government planned 9mn jobs last year; instead it has created more than 12mn by November. So the system could withstand a potential shock.Financial capability: China Credit Trust has a bit over CNY10bn net assets, which some analysts cite as evidence of the trust company’s capability to fully redeem the product first and recover from the collateral asset later. However, the assets might not be liquid enough, so the net asset is not the best measure. Based on its 2012 annual report, the company has liquid asset of CNY3bn and short-term liability of CNY1.35bn, leaving liquid accessible fund of CNY1.65bn at most. ICBC for certain has much deeper pocket, but it has declared that it won’t be taking major responsibility.Career concern: To certain extent, the timing was unfavorable for another reason, the ongoing anti-corruption campaign. It is reported that there are around 700 investors involved. On CNY3bn senior tranche investment, it averages CNY4.3mn per investor. We do not know the exact identity but with CNY3mn entry point, we know no one is a small-scale investor. Legally unjustified, if either China Credit Trust or ICBC decided to pay 100% with their capital, the decision maker would have to ensure that he does not have any business deals with any of the 700. Because if he does, his career or even his freedom could be in jeopardy in the current environment of ongoing anti-corruption campaign and strict scrutiny of shady deals/personal favors.Questionable asset quality and uncertain contingent claim: There are cases in the past of near default, but most of them involved collateral of real estate assets, which have at least appreciated over the years. The appreciation of collateral assets makes it easier for the third party to step in by paying back investors and taking over the collateral assets. This particular product involves coal-mining assets whose value has been decreasing over the last couple of years. Moreover, there have been multiple claimants on these assets, as exemplified by the sale of Yangjiagu coal mine. Although the mine was 51% pledged through two levels of ownership structure, only 20% of the sales proceed accrued to trust investors (Exhibit 1 above). Such a low percentage would be a deterrence and concern to whoever contemplating a takeover of the collateral assets.Other cases less relevant: In the past, one way to deal with the issue was for banks to lend to shareholders of the existing collateral asset owners for them to payback investors, with explicit or implicit local government guarantees. Shangdong Hailong’s potential default on bond was avoided this way last year. However, in the current case, the owner has been arrested for illegal fund raising, making the past precedence less applicable.
Putting all the above reasons together, we think there is a high probability for CEQ1 to default on 31 January, i.e. no full redemption of principal and backcoupon on the day.
Immediate impact would be for China rates curve to flatten
The case has been widely covered in the media. However, many still believe one way or the other the involved parties will find a last minute solution to fully redeem the maturing debt. So if the trust is not paid, we believe it will be a big shock to the market.
China rates market reaction, however, might not be straightforward. On the one hand, default would likely lead to risk-averse behavior, arguing for lower rates. On the other hand, market players would likely hoard cash in such an event, leading to tighter liquidity condition and pushing money rates higher.
We think that both movements are likely to ensue initially, meaning higher repo/SHIBOR rates and lower CGB yield if default were to realize. We suggest positioning likewise by paying 1y IRS and long 5y CGB. On the swap curve itself, we think the immediate reflection will be a bear flattening move.
Interestingly, an informal survey conducted on WeChat among finance professionals suggests the same kind of repo rate reaction (Chart 1). We think this survey is important because we believe these investment professionals will likely behave accordingly because the default event is not priced in and hard to hedge a priori.
Trust company can’t have their cake and eat it too
Of course, we can’t rule out that the involved parties do find a solution to avoid default. However, with a case as clear cut to us as this one favoring default, we believe such outcome would send a strong signal to investors that the best investment is to buy the worst credit.
Thus, we believe the near term market reaction with no default would be for the AA credit to shine brightly since this segment has been under pressure for quite some time. Trust investment would be met with enthusiasm and trust assets would likely expand further.
However, we see a fundamental problem in the industry; the leverage ratio has gone to a level which requires investors and trust companies to answer some serious questions: will trust company stand back behind every trust investment or will trust company have to default on some or potentially many of them? We believe the question needs an answer because the trust companies can’t have their cake and eat it too.
For the industry, the AUM/equity ratio has nearly doubled from 23 to 43 in less than three years during the period of 4Q2010 to 3Q2013 (Chart 2). Some in the industry has argued that one should only count the collective trusts since other trusts are originated by non-trust players like banks. Thus, trust companies have no responsibility for paying investors other than collective trusts.
We see two problems.
Even if we accept the trust companies’ argument, it is still questionable whether trust companies would be able to pay even a reasonable amount of default. The growth of leverage on collective trusts was much more aggressive. Collective trust AUM/equity ratio was 2.7 in 1Q2010 and 4.7 in 4Q2010 (Chart 2). It rose to 10 by 3Q2013, more than doubled in less than three years and more than tripled in less than four years. Along the way, the average provision has dropped from 84bp to 34bp when measured against collective AUM.As the case of CEQ1 illustrates, as long as full redemption is on the table, no involved party could walk away totally clean. CEQ1 is a case of collective trust, but the ICBC still faces the pressure to pay. If the bank is being pressured to pay in the case of collective trust default, trust companies will likely be pressured to pay as well should some non-collective trusts get into trouble. If trust companies are on the line for the total AUM, their financial condition is even shakier, with average provision covering barely 7bp of total AUM as of 3Q2013.
On longer term market trend
Based on the analysis in the above section, we see a possibility for trust companies to have to let some trust products default with such high leverage and so few provisions. This is especially likely the case given that there will be more and more trust redemption this year and next year as a result of the fast expansion of this industry over the last couple of years and short duration of such products.
The heaviest redemption in collective trusts this year will arrive in the 2Q (Chart 3). Given that the financial system is stretched thin and there were more cases of near defaults on smaller amount of redemption last year (three cases in December alone), we believe some form of default is almost inevitable in the near term.
The potential first default, even if it’s not CEQ1 on 31 JANUARY, would be important based on the experience of what happened to the US and Europe; the market has tended to underestimate the initial event. Over the last year, China appeared to be mirroring what happened in the US during 2007, the spike of money rate (much higher repo/SHIBOR), the steepening of money curve (14d money much more expensive than overnight and 7d), and small accidents here and there (junior tranches of a few wealth management products offered by Haitong Securities losing more than 60%, a few small trusts and now CEQ1’s redemption difficulty).
Theoretically, China’s risk is best expressed using a China related instrument, but we also think the more liquid expression of China goes through the south pacific. The following points list our longer views on China and Australia rates.
- We have liked using Australia rates lower as a way to express our China concern and we continue recommending doing so as a theme.
- We recommend long CGB and underweight credit product. The risk for such positioning in the near term is no CEQ1 default. But we believe any pain suffered due to overt market manipulation to avoid default will be short lived since it has become much harder to keep the debt-heavy system in balance and the credit spread is bound to widen.
- After a brief flattening on CEQ1 default, we see swap curve steepening as being more likely on more default threatening growth leading to easy monetary policy and more issuance going to the bond market.
- We look for higher CCS rates due to the fact that the currency forward will more likely start expressing the risk.
As Michael Pettis, Jim Chanos, Zero Hedge (numerous times), George Soros, Barclays, and now BofAML have explained... Simply put -
"There is an unresolved self-contradiction in China’s current policies: restarting the furnaces also reignites exponential debt growth, which cannot be sustained for much longer than a couple of years."
The "eerie resemblances" - as Soros previously noted - to the US in 2008 have profound consequences for China and the world - nowhere is that more dangerously exposed (just as in the US) than in the Chinese shadow banking sector.
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