From JP Morgan comes this useful little Q&A on what the PBOC is up to:
Question 1: What is the PBOC trying to achieve with its tight interbank liquidity stance?
The central bank’s target remains to slow down credit growth, and its chosen policy tool is interbank liquidity. Between 2008 and 2013, China’s “Total Social Debt” rose from 145% to 203% of GDP, or an increase of RMB116tri. Also, M2 at 14.8% in 2013 remains higher than the 13% target of the central bank. Containing a further rise in leverage has therefore become a key priority for the central bank since last year, even if this comes at the expense of (some) growth.
Question 2: What are the risks of tighter liquidity?
Tighter liquidity and the spikes in the interbank rates it creates could lead to credit events. We have three particular concerns around the continued tight liquidity:
- Trust loans are privately placed (high-yield) loans, which are part of the shadow banking system.
- Non-transparent WMPs (wealth management products)…have an inherent term-mismatch, as they are sold to bank clients as a short-term product with tenors of 1M to 1Y, while the underlying assets are typically a longer-dated corporate bond or loans.
- Pass-through to higher lending rates. As higher interbank rates spill into higher lending rates, then corporates would suffer, especially those already hurt from overcapacity.
Question 3: Does the PBOC’s recent injection of liquidity and the launch of an “SLF” signal a shift in the central bank’s policy stance to easing?
No. First, the reverse repo injection was small, at just CNY375bn, and compares unfavorably to a CNY662bn injection before Chinese New Year last year. Second, the “SLF” (Standing Lending Facility) aims to provide short-term liquidity for small and medium-sized banks, and this is helpful. But the SLF will not address the overall liquidity in the banking system, as it will merely rebalance some of the uneven distribution of excess reserves between large banks and small banks.
Question 4: What would make the PBOC change its mind and switch from tightening to easing?
There are two realistic scenarios that could make PBOC reverse policy, in our view. Neither of these are our base case for the first quarter though.
1) A sudden jump in credit risk as non-performing loans rise in both the banking and shadow banking system.
2) A slowdown of the economy.Question 5: A trust product with an underlying near bankrupt company will mature this week on Friday 31 Jan. What will happen?
On Friday this week (31 Jan), the now-famous ICBCled managed “Credit Equals Gold No.1” trust product (issued by China Credit Trust and distributed by ICBC) will mature. According to local media, China Credit Trust (CCT) made an announcement this afternoon that investors of the troubled trust product will receive the principal of investment in full, but interest payment is not guaranteed. Market observers suspect that the losses will be covered by CCT, with assistance from ICBC (distributor of this troubled trust product) as well as the local government.
Question 6: Beyond January 31, what broader signals should we be tracking to understand China risk?
Standard economic data such as growth, BoP, etc. are not ideal indicators to track if the downside risk to growth comes from a liquidity crunch. Rather, we believe news on defaults or possible worrying developments in WMP and trust banking system will be leading indicators. We expect default risk to be increasingly discussed in the press, as a bankruptcy is inevitable at some stage.
Question 7: How relevant are credit market prices as an indicator for China risk?
In the past few weeks, China’s 5Y CDS rate has risen from 65 to 105bp.
…In the onshore bond market, corporate yields have jumped since last summer. But most of the rise can be explained by higher risk-free rates, and credit spreads have not widened much yet. Meanwhile, outright corporate bond yields still do not compare attractively to yields on “shadow” credit assets (banks can charge “shadow” credit assets by at least 150bp to 200bp higher than the yields of corporate bonds). Credit spreads (especially in AA-rated corporate bonds) have barely widened to fully reflect the potential credit risk,
Question 8: Are onshore CGBs a buy-opportunity now that yields have risen 120bp since July?
Two opposing forces make us neutral on onshore CGBs. The rising credit risk presents downside to growth, and will likely also discourage banks’ risk appetite and force them to return back to the government bond market. However, given higher funding costs for banks, heavy bond supply pressures and a cautious stance in liquidity from the central bank, we expect onshore government bonds may not rally far from current 4.50% (10Y).
Question 9: Should we stay in the long RMB trade?
Take profit on long RMB trade tactically. We recommend a tactical retreat from short USD/CNH trade and take profits, although we are still positive on RMB in the medium term.
In short, China is going to slow further, probably more than JP Morgan’s 7.4% 2014 forecast.
