During the Party Congress, even China’s somewhat watered down versus of the free markets was suspended so as not to disturb the glorification of Xi Jinping as the nation’s greatest leader since Mao. Returning to “business as usual”, some commentators have been disturbed by the continued rise in government bond yields with the 10-year hitting 3.93% earlier this week.
Bloomberg described it this morning as a “tumultuous few days”.
We also noted Huachuang Securities Co. comment that bond holders may be about to get hit by “daggers falling from the sky,” if the Party adopts more aggressive deleveraging policies. In a far less sensationalist way, the Wall Street Journal has attempted a post-mortem on the recent sell-off in the Chinese government bond market.
Catching sight of a chain reaction in China’s markets is rare.
Carrying out a postmortem of a recent selloff in China’s $9 trillion bond market shows how it is becoming harder for Beijing to untangle its increasingly intertwined financial system. In the aftermath of China’s twice-a-decade party congress last week, yields on benchmark 10-year Chinese government bonds spiked to 3.9%, their highest in three years. Government bond futures fell.
Reasons proffered for the sudden rout ranged from expectations of higher U.S. interest rates to general fearmongering.
Having acknowledged the growing complexity of China’s financial system, WSJ provides a valuable insight, noting the relative stability of corporate bond yields during the recent sell-off in the government sector...
An important anomaly to note about the bond rout: as government bonds sold off, yields on less-liquid, unsecured Chinese corporate bonds barely moved.
That is atypical in an environment of rising rates - usually, bond investors shed their less-liquid holdings and hold on to assets that are more easily tradable, like government debt.
Using this handy (kind of) diagram of flows in China’s financial system...
...WSJ tries to explain “how the selloff in China really worked”.
In essence what happened is that, as funding costs for Chinese banks have risen, they have been forced to compensate by placing more money in the shadow banking sector, with all the risks that entails (i.e. leverage and risky assets). Here’s the Journal’s version.
Let’s start with the travails of China’s small and midsize lenders that—like most banks—fund themselves by taking in customer deposits and by borrowing in wholesale markets.
In China, the latter has increasingly meant issuing short-term bonds known as NCDs, or negotiable certificates of deposit. The trouble for Chinese banks of late is that both these funding sources have become expensive: Borrowing costs have risen as Beijing pursues its deleveraging campaign, while bank-deposit growth has also been slowing.
To balance out these rising costs, banks have been placing more of their money with so-called nonbank financial institutions—the likes of trust companies, funds and securities companies—that offer high returns from investing in various markets, from bonds to stocks and commodities.
Deposits placed by banks with these nonbanks - the bulwarks of China’s infamous shadow banking system - had grown to more than $4 trillion as of September this year.
Okay, this is where things get more interesting.
Please bear in mind that (as we’ll explain later) a key pillar supporting the stability of China’s financial system is the maintenance of rising flows into the Chinese shadow banks.
This Bloomberg chart shows the rapid growth in China’s shadow banking system in recent years.
The WSJ explains that the reduction in flows into the shadow banks has led to redemptions and something had to be sold quickly...
But with less funds coming into banks now, less can go out. That has led to trouble for the nonbanks, which, after years of only ever-higher inflows, have started facing redemptions.
Banks’ claims on nonbanks have dropped 2% since peaking in June, according to Wind Info, equivalent to a $90 billion withdrawal of funds.
In addition to these redemptions, the cost for nonbanks of juicing returns on their investments by leveraging up has also risen because of the higher interest rates mentioned above.
That brings us to the bond market. Faced with redemptions, nonbanks have needed to sell something, and quickly. Offloading highly liquid government bonds has proven the easiest option.
Meanwhile, the nonbanks have held on to their higher-yielding corporate bonds, which at least have the benefit of helping them to maintain high returns.
We think that the Journal’s analysis is correct…but it doesn’t fully appreciate the bigger picture regarding shadow banks’ need to “maintain high returns”.
China’s shadow banks are, in part, engaged in Ponzi schemes, for example in the $4 trillion Wealth Management Products (WMP) sector. In May 2017, Forsea Insurance, one of China’s largest insurers, warned that there would be “mass defaults and social unrest” if it was prevented from selling new WMPs to meet payouts. See “Chinese Insurer Warns Of ‘Mass Defaults, Social Unrest’ Due To ‘Mass Redemption’ Run”.
A month earlier, Minsheng Bank, China’s largest private bank, was found to have committed a RMB 3.0bn fraud by selling non-existent WMPs. See “Investors Rage After 3 Billion Yuan Vanish From China's Largest Private Bank”.
The sell-off in Chinese government bonds implies that the deleverage in shadow banking we identified in September in beginning to bite.
We are in the last lap of the Chinese Ponzi as, piece by piece, the whole decrepit system is being exposed. In the end, it will boil down to how many trillions of RMB the PBoC needs to print to make the banks and their shadow banking relatives whole.