Friday, February 7, 2014

China's Liquidity Crisis Is Not Over: 1-Day Repo Jumps 127bps ..... China caught between reforming financial sector and hugh liquidity demands !

( Keep an eye on this one... )

Presenting China's Largest Shadow Bank

Tyler Durden's picture

Submitted by Nicholas Borst via The Peterson Institute blog,
Shadow banks in China come in a variety of forms and guises. The term is applied to everything from trust companies and wealth management products to pawnshops and underground lenders. What surprising is that China’s biggest shadow bank is actually a creation of the central government and receives billions in financing directly from the banks.  Even more interesting, this shadow bank recently pulled off a successful international IPO where it raised billions of dollars.
First, let’s deal with the terminology. The “shadow” in shadow banking doesn’t imply nefarious doings, although it frequently involves a bit of regulatory arbitrage. At the most basic level, shadow banking is borrowing funds and extending credit outside of normal banking structures.
So what is this mysterious shadow bank that has such tight government connections? It’s none other than Cinda Asset Management Company, a creation of the Ministry of Finance (MoF) and the beneficiary of a recent 2.5 billion U.S. dollar IPO in Hong Kong.  In terms of total assets, Cinda is more than 15 times as large as any of the country’s trust companies.
The normal business of a distressed asset management company (AMC) is not shadow banking. It involves purchasing troubled loans at a discount and trying to collect a higher amount from the debtors. Cinda was one of the four AMC’s created by the central government to bailout the banking sector in the 1990s. The initial round of bad debt purchasing was policy-directed, starting in the late 1990s and lasting through the mid-2000s. In the second half of the 2000s, the big four AMCs began to purchase NPLs from banks on commercial terms and in the process tried to transform themselves into market-oriented businesses.
Over the last three and a half years, Cinda’s business has diverged from this model. In addition to purchasing bad debts from banks and other financial institutions, it has accumulated a vast stock of distressed debt assets directly from non-financial corporations.

Net Balance of DA
These non-financial enterprises distressed assets (NFEs) include overdue receivables, receivables expected to be overdue, and receivables from corporates with liquidity issues. In effect, Cinda has become a huge source of financing for companies facing financial distress.
It comes as no surprise that real estate developers have been the primary recipient of this emergency funding. Squeezed by central government efforts to dampen the housing boom, real estate developers are frequently cut off from formal bank loans.  As is the case with the growth of shadow banking in other parts of the financial system, Cinda has found a way to circumvent these restrictions by offering credit to property developers through the NFE channel. The Cinda IPO prospectus states that 60 percent of distressed receivables are attributable to the real estate sector.
What makes the whole situation a bit dubious is that Cinda has financed these purchases through a massive borrowing spree at below market rates. Over the last 3.5 years, the size of CINDA’s borrowings increased 13x, while the interest on these borrowings has fallen dramatically (paid interest was less than three percent). Despite the claim from the IPO prospectus that the borrowing was primarily from “market-oriented sources,” it seems unlikely that any market-oriented actor would loan out funds at a rate significantly below inflation and less than half of the benchmark lending rate.
The cost of funding issue is important because while Cinda’s distressed asset business is profitable, its profitability is dependent on low borrowing costs. In 2012 total interest expense is equal to 50 percent of its net income. A large increase in borrowing costs could wipe out the company’s profitability.
Borrowing and Interest
Why would financial institutions make such cheap loans to Cinda? One possible explanation is that the company’s tight relationship with the MoF makes it a low credit risk. MoF’s support of Cinda has been immense.  MoF has allowed Cinda’s corporate tax payments to be used to pay down the bonds it issued to China Construction Bank. MoF also gave Cinda a 25 billion renminbi capital injection with a delayed payback period. The odds that MoF would let Cinda go belly up are exceedingly low.
The other reason that financial institutions might be willing to loan to Cinda on the cheap is that the company has come to play a very useful role for them.  Commercial banks face constant pressure from regulators to reduce their non-performing loan (NPL) ratio. The strikingly low reported NPL rates throughout the past several years stands in stark contrast to a slowdown in economic growth and fluctuating credit conditions. Shadow lenders like Cinda play a role behind the scenes in extending credit to companies short on cash who are in danger of defaulting on their bank loans. Having this type of lender of last resort helps banks avoid increases in their NPL ratios. It doesn’t, however, reduce the exposure of banks to these distressed companies as they are still on the hook through their loans to Cinda.
The IPO prospectus of Cinda has made clear that the company has rapidly transformed itself from a traditional distressed asset manager to a provider of emergency financing.  Though we lack similar disclosure, it is likely that the other three national asset management companies are proceeding along similar lines. China’s AMCs are an important part of the shadow banking system and an enabler of large-scale regulatory arbitrage.

China's Liquidity Crisis Is Not Over: 1-Day Repo Jumps 127bps

Tyler Durden's picture

Back from the lunar new year celebrations - having missed out on all the excitement in global turmoiling markets - the Chinese markets are re-open for business. However, despite the world of status-quo-apologists telling us that China's liquidity crisis was a storm in a teacup and would blow over once the 'normal' new year needs were met (and CEQ#1 was bailed out), it turns out that liquidity needs remain high... very high. Repo rates across the spectrum are higher with immediate overnight liquidity costs up 127bps to 4.27%. Get back to work Mr. PBOC as there's CNY 375 billion of year-end liquidity to be mopped up (tightened out of the system).

Repo markets are on the rise again...

And remember all that liquidity will mature/roll off in a week or so...unless the PBOC folds on its reform mandates...

So that's CNY 375 billion about to be sucked out... no wonder the market's need for liquidity is high.

Charts: Bloomberg

China Needs to Tread Carefully on Reforms

China’s trust lending sector – part of the country’s shadow sprawling shadow banking system – has been in the news quite a lot recently. Pacific Moneyrecently outlined the salient details of the case that was the focus of much of the recent attention – a scare involving a trust product called Credit Equals Gold No. 1.
Some have argued that the failure to allow a default of this product was a kind of U-turn in the process of financial reform in China. The argument is that in order for a more market based system for capital allocation to develop, investors and borrowers have to be given some harsh medicine. A default would have been warning shot to all investors that they should be aware of the risk associated with high promised.
However, it is almost certainly too early for a dose of this kind of bitter medicine in China’s shadow banking system. A default of this trust product would probably have had very negative consequences not only for the trust industry, but for the wider economy as a whole.
A key factor explaining this phenomenon is a so-called maturity mismatch in the China’s wealth management product (WMP) business. Funds sourced from investors at short maturities (often three, six or nine months) are actually used to lend to companies and projects for durations of years. Investors who have bought these short-term products receive their cash back at the end of the investment term, but this leaves a “cash hole” on the side of the issuer, as the final borrower still has no obligation to repay the funds.
The solution is to issue another WMP to fill the hole  (an effective roll-over). This may take a couple of days – during which many issuers are forced to turn to China’s money markets to borrow the funds.
Had a default occurred and Credit Equals Gold No. 1 investors lost their funds, investors in all of China’s multitudinous WMPs would have received a very rude awakening. They would discover (many for the first time) that the products they were investing in could fail, and that the government would not be there to bail them out.
Some would continue to invest, but many would not. The ability of issuers to issue new WMPs to fill the holes would be destroyed. WMP issuers would thus be left with a big funding gap, forcing them and their end-borrowers into distress and an increasingly vicious spiral. The liability side (investors) of their balance sheets would be in crisis, and this would not take long to affect the asset side (the borrowers).
The economic fallout as various coal, real estate, and local government borrowers (to name a few key examples) lost this source of funding would be large. There is roughly USD$1.6 trillion invested in China’s trust industry, and this is not even the entire WMP picture. Many borrowers in this sector are forced to borrow here precisely because they are not able to secure cheaper financing from other lenders. Many would fail without these channels.
Equally, the formal banking system relies on WMP to earn fee income and move assets off the balance sheet. The fallout from a WMP rout would not be easily contained. The ensuing crisis would set reforms back as the government would have to move into full fire-fighting mode.
This hypothetical example serves as a reminder of why China’s reforms must come slowly. Any negative consequences that may result from each reform must be carefully anticipated and pre-empted. The authoritarian government in Beijing cannot afford a Lehman moment.

When China’s Trust Credit Does Not Equal Gold

A wealth management product sold by the Industrial and Commercial Bank of China, which was based in part on a trust loan extended to a Shanxi coal company, was recently “saved” from collapse with a bailout of the 3 billion RMB ($495 million) principal. The product, called Credit Equals Gold No. 1, was rescued by an unnamed third party that offered to buy the rights in the asset. The loan was extended to Shanxi Zhenfu Energy Group in 2010, two years before the owner of the company was arrested for illegally accepting deposits. Zhenfu Energy was later found to have leveraged up in high interest underground loans of 2.9 billion RMB.
What inferences can be drawn from this case? China Credit Trust is considered a more respectable trust, so if it lent to a corrupt institution like Zhenfu Energy without performing appropriate due diligence, imagine what a poorly regarded trust would do. Would anyone care to audit the balance sheet of Shanxi Trust Company, for example, and report on the riskiness of its lending record?  What is more, if the failure of one trust loan can reduce a trust’s capital by so much that the trust will refuse to guarantee the product (even if it can), the likelihood of multiple trust loan failures would almost surely result in failure of the implicit guarantee associated with the trust industry and end in extensive loan defaults.
A little publicized document called the “Trust Industry Risk Assessment Report,” released by Shanghai Jiaotong University, expands on these conclusions. After conducting stress tests on 60 trusts, the report found that solvency risk is relatively low, but that liquidity risk may present a real problem. The report also found that trust products are not priced for risk of the underlying asset. This, coupled with rapid expansion of the trust industry and with an implicit payment guarantee, has heightened the risks associated with trust products.
The report does not mention the types of loans that trust products are based upon, and this is also a rising concern. Some of the trust loan defaults have been based on loans to the coal industry, which  has declined in profitability. A full third of trust loans have been extended to the real estate or infrastructure construction industries, which have experienced price bubbles and low levels of occupancy. Growth in these sectors is expected to decline in 2014. With these reversals, the credit risk associated with trust loans will only rise.
All of these risks in fundamentals add to growing concern about China’s trust sector. This, coupled with a lack of regulation, and absence of risk control departments in most trust firms, sets the stage for a potential trust industry failure. Such an event may be triggered by an overall reversal in consumer sentiment—should households stop buying trust and wealth management products that contain these trust loans, the maturity mismatch inherent in the trust lending process (borrow short from households and lend long to firms) may truly present a problem. A liquidity crisis in the trust sector will expose some of the risks that have been covered up by steady income streams, and then these unregulated entities may face a final collapse.