Bad Omens In China: Banks Default, Debt Auctions Fail
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On Friday, China’s Ministry of Finance sold only 9.53 billion yuan of government bills, far less than the 15 billion yuan offered. It was the first failed Finance Ministry auction since July 2011. To add insult to injury, Beijing had to pay 3.76% on the 273-day bills, higher than the 3.14% yield on similar obligations already in the market.
That’s the second failed Chinese auction this month. The state-owned Agricultural Development Bank of China sold only 11.51 billion yuan of six-month bills in a 20-billion-yuan offering on the 6th.
There’s evidently a funding squeeze in China. Overnight rates in the interbank market skyrocketed to about 15% earlier this month. On Friday, it was north of 7%, compared to 2.7% in late April. This condition is not sustainable, but is it also significant and long-lasting?
Many will say that there’s little reason to worry. Money has been tight because banks are hoarding cash to meet quarter-end capital requirements,because businesses need to pay taxes soon, because individuals withdrew cash for the just-completed three-day holiday, because last month the State Administration of Foreign Exchange tightened enforcement of “hot money” inflows.
None of these reasons sounds alarming. Moreover, analysts point out that Friday’s auction failed because the People’s Bank of China, the central bank, did not pump sufficient cash into the system and, in a bid to ease liquidity, that institution on Thursday suspended open market operations by not issuing three-month bills. Moreover, last week the PBOC allowed 92 billion yuan of existing obligations to expire, thereby releasing money into the economy. The moves were not enough to save Friday’s auction, but there’s plenty of cash where that came from. The People’s Bank has more than enough firepower to prevent embarrassing auction failures in the future.
Nonetheless, there is cause for concern. The fundamental reason why money is tight is that Beijing is now starting to let the economy adjust. Then PremierWen Jiabao did not allow adjustments when the global downturn hit China in 2008. His successor, the newly installed Li Keqiang, is starting this critical task. “Their choice is not whether to tighten or not, but when to tighten,” saysZhang Zhiwei of Nomura. “The earlier they act, the lower the cost. If they waited longer, there would be more bad loans to deal with.”
The oft-quoted Zhang makes it sound as if China is starting early. The new premier, to his credit, is starting in the first days of his tenure as premier, but Beijing should have begun tightening long before he was formally installed in March.
The primary constraint Premier Li faces is China’s massive debt. Total credit looks like it reached an incredible 198% of GDP by the end of last year. By 2015, that number will hit 245%, according to Francis Cheung of leading brokerage CLSA Securities. Fitch Ratings has just sounded an extraordinary warning on China’s credit creation.
Li Keqiang has few options, and none of them are good. True, he can avoid a day of reckoning by just continuing the lax monetary policy. That course, however, aggravates the underlying debt problem by keeping money cheap and thereby permitting even more bad investment decisions. China has long passed the point of diminishing returns when it comes to debt. In 2007, Wen Jiabao created 83 cents of gross domestic product for every dollar of credit he authorized. Today, Premier Li gets just 17 cents of output for every dollar.
So Li should not expand the money supply, and he cannot tighten credit either, at least without risking a calamity. If even the central government is having problems raising cash, as evidenced by Friday’s auction, just think about the debt-raising difficulties of highly leveraged enterprises, strapped local governments, and shaky banks.
Shaky banks? The China Banking Regulatory Commission has tried to rein in the issuers of the absurdly dangerous wealth management products, which have been accumulating short-term liabilities while holding long-term assets, and the notorious “shadow bankers.”
The CBRC’s crackdown is already sending shivers through China’s creaky financial system. For instance, China Everbright Bank defaulted on a 6-billion-yuan interbank loan on the 6th of this month. Reuters reports rumors that several banks have recently failed to meet interbank obligations.
The defaults mean it is unlikely Beijing will be pushing up rates soon. As HSBC economist Frederic Neumann told Reuters in the middle of last week, “The constraint here is that we have such high levels of leverage that it is hard to raise interest rates without doing tremendous economic damage.”
China’s economy, in the words of Forbes contributor Kenneth Rapoza, “is firing blanks” at a time that money is pouring out of Asia and heading for either the U.S. or nations that are considered proxies for the U.S. Funds left China following Fed Chairman Bernanke’s comments last month suggesting the “tapering” of his quantitative easing program. A record $1.5 billion was withdrawn from Chinese shares and bonds in the week ending June 5, and the outflow looks like it has continued since then.
No one likes what they are seeing in China, where the numbers get worse as each month passes. Investment banks and the multilateral institutions are lowering forecasts, currency bets point to a 2.2% fall in the renminbi against the dollar over the course of a year, and China’s stock market index hit a six-month low at the end of last week. The official Xinhua News Agency referred to comments from a Chinese analyst to the effect that liquidity shortages created “panic” in the equity markets this month.
China’s economy has always relied on money coming from the outside to keep it going, and now the inflow is becoming an outflow. As trends begin to run against China, Premier Li has few tools at his disposal and little margin for error.