With all the negative daily headlines it can be tough to filter out legitimate threats to portfolios. The event the following article talks about happened in June of this year. It received very little airtime in the press, but it’s one that we took very seriously and happened to the world’s second largest economy.
By NEIL GOUGH from Hong Kong & DAVID BARBOZA in Shanghai – The New York Times, June 20, 2013
HONG KONG – China’s financial system is in the throes of a cash squeeze as the government tries to restructure the economy and punish speculators, with interbank lending rates spiking on Thursday June 20th and bank-to-bank borrowing nearly stalled.
China’s interbank and money market rates have soared over the last two weeks, and banks and other financial institutions are afraid of lending to one another. Without that lending, an economy can quickly stultify. Those in need of short-term cash, or liquidity, must pay dearly or risk default.
China’s central bank, the People’s Bank of China, has refused to provide large amounts of additional cash to the credit market. Analysts say the government is holding off for a reason: it is trying to reshape the economy while reducing its future role. The bank is not independent, unlike many other central banks, and reports to the State Council.
A huge shadow banking operation has emerged in China in recent years, with smaller banks and trust companies borrowing from bigger state-run banks and relending that money at high interest rates to private companies and property developers, a practice that fuels speculation.
Pressuring speculators is a risky strategy for the Chinese government, which is also grappling with a slowing economy. Many borrowers may have a harder time paying back their loans, and analysts fear the losses could ripple through the banking system.
“The central bank wants to accelerate reform,” said Zhu Haibin, an economist at JPMorgan Chase. “They want to give the market a lesson: you need to manage your risk and not rely on the central bank.” Mr. Zhu and other economists say restructuring the economy, which has grown addicted to easy money, could be perilous for another reason. The decision could reduce lending and slow growth too quickly.
The worst case, absent intervention by policy makers, would be defaults at lenders with the most exposure and shakiest balance sheets. The damage could spread to other banks, setting off runs on deposits by ordinary Chinese. In the near term, markets will probably continue to be rattled, especially shares in financial institutions.
That was certainly the fear on Thursday around the globe. “China’s interbank market is basically frozen – much like credit markets froze in the United States right after Lehman failed,” said Patrick Chovanec, managing director and chief strategist at Silvercrest Asset Management. “Rates are being quoted, but no transactions are taking place.”
Stock markets across greater China fell Thursday on news of the liquidity situation and a disappointing survey on manufacturing. The Hang Seng Index in Hong Kong dropped 2.9 percent, and the Shanghai composite index fell 2.8 percent.
The interest rate that Chinese banks must pay to borrow money from one another surged overnight to a record high of 13.44 percent Thursday, according to official daily rates set by the National Interbank Funding Center in Shanghai. That was up from 7.66 percent on Wednesday and less than 4 percent last month.
The preliminary purchasing managers’ index, published by HSBC and compiled by Market, dropped to 48.3 points in the first three weeks of June, its lowest level since September and down from a final figure of 49.2 in May. A reading above 50 indicates growth, and anything below signals contraction.
The rise in interbank rates began two weeks ago, before China went on a three-day national holiday. Banks typically face higher demand for cash before public holidays, and the initial uptick in rates was not seen as abnormal.
But as the situation worsened, the central bank refrained from injecting new money into the system. Benchmark seven-day repurchase rates, another measure of borrowing costs, briefly soared as high as 25 percent on Thursday, up from 8.5 percent on Wednesday, before closing at 11.2 percent.
For financial markets this is scary stuff. The Chinese situation was similar to events that happened back in 2008 in the United States prior to the financial crisis. As a result we took action in June and increased cash positions to reduce portfolio risk.
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