Michael Pettis at
China Financial Markets commented on the liquidity crunch and spike in SHIBOR a few days ago via email.
His comments came in before China intervened to quite the markets as noted in
China Acts to Calm Markets; Stock Market Rebounds From 6% Plunge After Central Bank Pledges More Liquidity; Wet Nurse Action.
Nonetheless his comments are still relevant and much worth a review. What follows is a guest post from Micahel Pettis.
Pettis Guest Post Special Points - Short-term rates in the interbank lending market rose steadily over the past two weeks and then suddenly soared Thursday amid rumors of the market's having frozen up and one or more large banks having missed payments.
- For the past ten years China's soaring credit has been accommodated by rapid money expansion as the PBoC was forced to monetize large net inflows on the current and capital account. This year, however, while credit continued to expand at historically unprecedented rates, net foreign exchange inflows seem to have dried up, especially after the authorities clamped down some time in May on the over-invoicing of exports that had been used to bring "carry trade" money illegally into the country.
- The tension created by accelerating credit expansion (much of it supporting activities that were not generating sufficient cashflow to repay the associated debt) and decelerating money creation has created liquidity strains for much of the past year. Last weeks' events were likely to have been simply an exacerbation of those strains.
- I believe talk in the market of China's experiencing its own "Lehman moment" are very much exaggerated. There is liquidity in the system and the PBoC still has the tools needed to alleviate a short-term liquidity crunch before it leads to a banking crisis. Government credibility is high, and given the wide-spread assumption that the government stands behind the banks, I do not expect anything approaching a bank run.
- There are however two important lessons to be drawn. First, we are likely to see similar stress in the banks many times again (and have seen it before) as a financial sector wholly addicted to cheap and plentiful credit struggles to accommodate Beijing's determination to control credit growth.
- Second, the way the crisis was handled should make it clear that volatility in the financial sector is suppressed by administrative measures. This, however, may increase the risk of a future gapping in confidence and volatility.
- During the coming week I believe that a significant amount of Wealth Management Prodiucts (WMP) will mature, and because of asset/liability mismatched this WMP must be rolled over. Beijing, correctly in my opinion, continues to be eager to clamp down on risks within the shadow-banking sector. This is likely to create further stress in WMP placement, which, if mismanaged, could create a run on WMP.
- If there is indeed a reduction in the amount of funding available for WMP, the money will have to flow into some other sector. Given the large size of the WMP market, these flows might be significant, although it is not yet clear to me where they will go.
Probably the main lesson of last week is that systems in which volatility is suppressed often seem less volatile, but this is only true when shocks are small. Large shocks tend to result in increases in volatility that far exceed expectations.
I have always argued that China's lack of transparency wouldn't matter too much during the bull phase of the market. It is when market sentiment turns negative that we see the real cost of a lack of transparency. When investors and businesses are nervous, they are likely to over-interpret bad news and to fill in knowledge gaps with the most alarming of the various plausible scenarios.
Lack of transparency, in other words, is a kind of positive feedback mechanism that exacerbates volatility. It can increase buying appetite on the upside (limited information gives us greater scope to assume best-case scenarios) and it hurts prices on the way down (uncertainty rises dramatically and worst-case scenarios become plausible).
This means not only that non-transparent markets are likely to be more volatile, but also that this volatility can be suppressed when adverse shocks are small and exacerbated when adverse shocks are large. Markets lacking transparency, in other words, are more likely to experience lower volatility during normal times and more likely to "gap" when conditions change. Market participants may not have access to negative information until the negative information has accumulated and there is no longer any way to prevent it from becoming widely known, in which case the decline in the market can be sudden and even out of proportion to the value of the negative information.
This is why I think we need to watch carefully what happens this week. It is not clear to me how widely Chinese depositors knew about or understood the events of last week. Although they were discussed in the specialized financial press, the accounts tended to be very "factual".
By this I mean that the articles provided the raw data – money market interest rates surged during the week and peaked on Thursday – but there was little attempt to explain why this happened, or to discuss the seemingly credible rumors of bank defaults, or to analyze the terrific stress in the payments system. To the extent that the press covered the events, they were more likely to focus on the fall in the stock market than on the liquidity squeeze among the banks.
If the foreign and Hong Kong press makes a big deal about trying to understand what happened last week, concerns may filter back into the mainland and may affect behavior. The impact on the behavior of market participants might be very limited, as it usually is when transparency is limited, but the risk is that when it does affect behavior we are more likely to see significant "gapping" in market behavior.
The most important effect is likely to be on demand for wealth management products. I believe that there is RMB 1-2 trillion of WMP coming due before the end of June, and most if not all of this will have to be rolled over. Already it seems that WMP rates are rising. Several friends received SMS offers on their mobiles (this happens a lot in China) for short-term WMP deposits at 6%, which is 100-200 bps higher than we have seen in the past and higher than the 5% cited in the People's Daily article. Until recently, the average rate on WMP seems to have been around 4.3%.
So what can we conclude from the events of last week? The good news is that the new administration seems far more determined than the previous to rein in credit growth and restructure the economy. Clearly the PBoC's refusal to provide liquidity to bail out the interbank market reflects Beijing's tougher stance on speculative excesses. The bad news is that the credit system is so distorted and over-leveraged that any attempt to rein in credit growth creates enormous stress in the system.
By the way I seriously discount much the overexcited talk in the market about how the PBoC engineered the freeze the markets in order to punish the banks and to force discipline onto the financial system. Clearly there is some truth to this argument, and the PBoC certainly did refrain from bailing out the liquidity needs of the banks for the past two weeks as rates rose, but we shouldn't let lack of information lead us into conspiracy theories.
I suspect the PBoC never expected this to happen the way it did and they were caught as flatfooted and confused as everyone else. Remember that the PBoC has almost no experience of any kind of financial market condition except that of soaring money creation and credit expansion. Until last year they have never had to deal with a stable or even contracting money supply, and consequently they have had little experience in dealing with these kinds of conditions. This was new for everyone.
In fact there is an important lesson here for the PBoC, and investors more generally. Chinese financial markets often seem less volatile than one would expect for a poor, developing country, largely because of administrative measures that intentionally or unintentionally suppress normal volatility. These kinds of systems, however, are not less volatile. They seem less volatile because small shocks have minimal impact. Larger shocks, however, tend to cause a much greater than expected surge in volatility. Perhaps last week was a case in point.
Going forward we will probably see more of this in China. Volatility will be suppressed for periods of times only to erupt in greater than expected volatility from time to time. This is not only a China problem, of course. One can easily argue that the Fed's actions under Alan Greenspan seemed to induce a "great moderation", but only temporarily, and when the great moderation became less moderate, the economy was always likely to be more disorderly than expected. The euro, similarly, sharply reduced volatility in peripheral Europe for many years until it suddenly exacerbated it. Of course no student of Hyman Minsky would be surprised by any of this.
Beyond the lesson of unexpected surges in volatility, this coming week is likely to be important. One of my colleagues tells me that according to Fitch there is RMB 1.5 trillion of WMP coming due in the next ten days. I want to confirm this number but haven't yet had the time to do so, although this information is from a credible source, so I assume it is correct. This matters because there may be real trouble rolling over some of these WMP and we know that there is likely to be a huge maturity mismatch in the funding of WMP. The demand for short-term funding might be quite high this coming week and it will be interesting to see how the PBoC reacts.
Stay tuned. This is not a "Lehman moment" and we are not likely to see a sudden crisis, but it certainly indicates just how strained the money markets have become. Some questions:
1. If there is indeed enough money in the system, as the PBoC says there is, and the problem was just that the big banks were hoarding money, where did that hoarded money show up? Was it in higher excess reserves at the PBoC, or higher central bank bill purchases, or somewhere else? We will need to wait for the next PBoC data release in July to see whether excess reserves went up in June, although we will only get month end numbers, which won't tell us much about what happened last week.
2. Why hasn't this received more attention in the mainland press? Are they trying to prevent Chinese depositors from knowing how risky things are? If the foreign press makes this into a big deal, eventually ordinary Chinese are going to find out. How will they react? Will they close out WMP positions?
3. If demand for WMP drops, where will the money that until now went into WMP show up? I can only think of the following: more outflows from China, higher deposits in the banks, stock markets, real estate markets, cash hoarding.
This coming week is quarter end, and we are likely to continue seeing tough liquidity conditions in the markets. I will be watching interbank interest rates closely, of course, as well as trying to get a sense of what the perceptions might be among ordinary households. I will also be watching WMP closely. I think we can safely discount warnings that China's financial system is about to collapse. For many years it was impossibly difficult to convince many people that China's growth model was leading inevitably to a serious debt problem, and it is sort of ironic that it has become equally hard to convince people nowadays that we are not going to see a financial collapse.
Because of limited investment alternatives, a more-or-less closed capital account (unless you are rich or powerful), and resilient government credibility, we are unlikely to see bank runs among the large banks or a financial collapse (which is ultimately just a kind of bank run). The huge maturity mismatches in the banking system are effectively "hedged" by the inability of bank depositors to leave the system. But one way or another we do have to write down the huge hidden losses in the country's balance sheet, and this will mean not a collapse but rather many years of Japanese-style slow growth as the system grinds its way though its excesses.
Pettis Guest Post End China Bulls Beware The last sentence above is worth repeating "
One way or another we do have to write down the huge hidden losses in the country's balance sheet, and this will mean not a collapse but rather many years of Japanese-style slow growth as the system grinds its way though its excesses."
Those still bullish on base commodities because of demand for China, and those who think China will pass the US in GDP this decade are about to find out how wrong they are.
Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
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