Just how bad is Chinese counter-party risk? Really, really bad can be the only possible answer.
After just a few weeks of credit stress, Chinese authorities have folded like a deck of cards on China Huarong Asset Management:
- The PBOC is considering a $15bn bailout.
- The PBOC unit will effectively become a new bad bank to manage the dud assets of the former badder bank.
That authorities have buckled so quickly tells us that they really had no idea what kind of scam Huarong was running, nor how expansive was its counter-party risk.
I don’t see any talk here of “bail-ins” so this may be a total capitulation for bondholders. Certainly, the junk bond markets liked the news:
Still, there are signs that credit tightening is ongoing elsewhere. Capital Economics with the note:
Commercial banks left the Loan Prime Rate (LPR) on hold today. Given that official efforts to rein in credit are being achieved by other means, we do not expect any changes to policy rates in the coming months.
The one-year LPR was unchanged at 3.85% (both the Bloomberg consensus and our forecast were 3.85%), while the five-year LPR remained at 4.65%. The LPR is the reference rate against which all new loans, and outstanding floating-rate ones, are priced. Today’s inaction was expected since the PBOC didn’t adjust the rate on its medium-term lending facility (MLF) this month as it did ahead of the past three LPR moves. This would have been the most straightforward way for the PBOC to influence the LPR, which is set as a spread above the MLF rate.
With the economy doing well, policymakers are now focused on tackling financial risks. But political constraints mean that these efforts are unlikely to include policy rate hikes. Instead, policymakers have tightened quantitative controls – in March the PBOC told banks to cap 2021 lending at last year’s levels – and are paring back state support for bond issuers. This has already brought new borrowing back down close to pre-COVID levels. The upshot is that, even in the absence of rate hikes, tighter credit conditions will become an increasing headwind to economic activity over the coming quarters.
The economy is going to slow from the H2 onwards:
My view is it will also sink CNY as yields fall. Stocks may well be next, via Goldman:
Correction puts leverage in focus
The combination of a 12% correction from recent peaks in A shares, concerns about liquidity/policy tightening, and recent events including a high-profile forced liquidation in Chinese ADRs has prompted investor questions about leverage in Chinese stocks, a factor that amplified selling in the last two ‘Major’ A-share corrections in 2015 and 2018.
Leverage risk looks well contained
Official margin financing balance remains subdued in a historical context (Rmb1.5tn,5.8% of free float market cap), and stock pledged loans have been significantly reduced vs. the peaks in 2018, suggesting leverage-oriented systemic risks are better contained now than at previous stressed points. We estimate that the average cost basis for CSI300 could be at around 5000 (now at 5099), implying that the index would need to correct 43% to trigger margin-call unwind for average positions.
But new flash points have emerged
Strong consumer loan growth since the COVID outbreak points to “hidden leverage” among young, tech-savvy investors. More importantly, onshore mutual funds’ AUM and their positioning concentration has risen substantially since 2018, with the top-50 A-share favorites contributing 21pp of the 24% index gains since 2020, representing 45% of equity mutual funds’ AUM, 52% of Northbound holdings, and 16% of market ADT in the past 6 months. Further significant market weakness and redemption pressures could test the authorities’ downside risk tolerance especially in the lead-up to the Chinese Communist Party’s centenary celebration on July 1.
My base case is for further falls for Chinese equities as growth and industrial profits slow ahead.
Given the range of risks presented by the Chinese market, in particular regulatory and sovereign, I wouldn’t touch the market with a barge pole even in the good times, something that more foolhardy investors have learned the hard way. Even legends like Hamish Douglass, Kerr Neilsen and Ray Dalio have cooked themselves in China.
And right now you can add cyclical policy risk to the normal range of problems.