Markets living on the edge
Recent events and upcoming challenges around money market rates, exchange rates and shocks in the bond market are putting the banking sector on the defensive heading into 2017
In 2017, China’s financial institutions look set to face multiple threats: higher money market rates, a further slide in the yuan-dollar exchange rate, and intermittent shocks from high-profile defaults in the nascent bond market.
Confidence in the Chinese banking system has been embattled as capital outflows accelerated in the second half of 2016, along with a steeper depreciation of the yuan against the US dollar.
For the time being, the People’s Bank of China has made every effort to ensure the yuan stands it ground against the US dollar at below 7, reinforced by the prohibitively high cost of short-selling the Chinese currency in the offshore market. The Hong Kong equivalent of the SHIBOR (Shanghai Inter-bank Offered Rate) has been multiple that of the onshore rate throughout December.
Sentiments in the onshore banking system have also calmed somewhat in the final week of 2016 as bond prices rebounded and yields reversed, but both are nowhere near their levels seen before this past September and are not expected to bounce back either in the coming year.
To give credit to the market regulators, both the Chinese central bank and securities watchdog gave their fair share of market support when situation seemed to spin out of control in mid-December.
The People’s Bank of China pumped in extra liquidity to stave cash crunches, while the China Securities Regulatory Commission facilitated negotiation with more than 20 counterparts over settlements following the dramatic default of Sealand Securities on its bond transactions. Chinese government bond futures regained much lost ground following the use of the “X-Repo” system, at the urging of the central bank.
Still, there are good justifications for Beijing to impose a tighter monetary stance in the coming year, including rising inflation expectations, speculation in the real estate sector, and the bad behaviour of bond traders that culminated in a rout earlier in December.
For the more immediate future, though, the PBOC will likely remain accommodative, at least before the Chinese New Year in late January, when the populous country takes a week and half off from work, exerting pressure on the money market and putting liquidity on edge.
Demand for cash typically surges prior to the beginning of the festive period.
Arthur Lau, the Hong Kong-based head of Asia ex-Japan fixed income at PineBridge Investments told Bloomberg: “You have Chinese New Year quite early, and because of that one-month window, most of the banks will try to lock the money in a three-month cycle. The current situation in the bond market is partly because of year-end and because of Chinese New Year.”
The following charts reveal some of the core indicators of liquidity in the Chinese monetary system, illustrating the point that a healthy degree of stability has been restored in the past week across the money markets both in terms of interest rates and exchange rates but that areas of challenge lie ahead.
Short-term repo rates in the interbank market ended the week on a lighter note as compared to last week as the risk of imminent market stress eased. The ultra short-term overnight SHIBOR borrowing rates fell to 2.23% on Friday for the 9:30am fixing and traded at around 2.10% throughout the day, down from the previous week’s 2.35% and 2.40%, respectively.
In sharp contrast to the interbank market’s relatively good mood, borrowing costs in the Shanghai Stock Exchange have turned extremely volatile in the past weeks. The one-day repo rate collateralized by Chinese government bonds saw wild intraday swings in recent trading sessions, reaching an intraday high of 33% on December 27, the biggest spike since September.
Market reports suggest non-bank financial institutions found themselves with a shortage of funding suppliers after banks took on a more cautious stance against lending money to them in the wake of the Sealand Securities bond dealing scandal.
The scramble for liquidity by certain non deposit-taking financial institutions such as brokerages, asset managers, and insurance companies is helping to propel a substantial upward shift in the mid-to-longer end of the SHIBOR curve. Fixings rates for one-month to one-year are now hovering around 3.3%, up between 40-50 basis points from three months ago.
Money dealers in banks are expressing their anticipation of tighter monetary conditions in 2017 by demanding higher longer-term repo rates in the interbank market, shown below for the three-week and three-month tenures. The pair have jumped substantially to trade periodically above 5% since late November, following nearly two years of calmness at around 3%.
While there is little doubt that China’s monetary authority will be actively managing the day-to-day volatility in the banking system, recent events and upcoming challenges are putting financial institutions on the defensive.