One month ago, we first highlighted a troubling development for China"s banking system, one which we called the "Great Shadow Unwind" and which showed that entrusted loans, a broad proxy for China"s unregulated ‘shadow banking’ system, contracted for the first time since 2007, confirming Beijing"s ongoing crackdown of China"s runaway $8.5 trillion shadow banking system. Well, overnight, the PBOC released its latest Chinese loan data, and it had several notable highlights, most of which got lost in today"s overall noise.
First, the one aspect of the latest Chinese data most commentators focused on and discussed, was the collapse in China"s M2 aggregate to just 9.6%, which not only missed expectations of 10.4%, but was also the lowest print on record.
However, unlike most developed nations, M2 in China has largely become an anachronism from China"s pre-shadow banking past, which excludes many of the broad monetary-equivalents in circulation. This is how Goldman explained this morning why those concerned about the plunge in M2 growth shouldn"t lose much sleep: "We put more weight on the adjusted total social financing data, because M2 data are heavily distorted by borrowings between financial institutions which may have relatively limited impacts on the real economy, though TSF has its own problems-- such as not including all forms of financing, especially newly developed ones."
Touching on the plunge in M2, on the PBOC"s website, the central bank explained that slower M2 growth was a result of declining leverage, and the implementation of a "prudent, neutral monetary policy, and intensified supervision that has compelled the financial system to reduce leverage," adding that as deleveraging continues, "slower M2 growth than in the past will become a new normal."
Which, in turn brings us to the far more important, for China, loan number: Total Social Financing - a monetary aggregate that captures both traditional bank loans as well as shadow loans, including trusted, entrusted loans and undiscounted bankers accepetances, which in May likewise dropped to CNY 1.06tn, missing consensus estimates of CNY 1.19tn and down from 1.39 tn in April.
And while the PBOC has aggressively clamped down on shadow financing, the central bank has refrained from cutting off traditional bank loans to companies, aiming to support growth. And, sure enough, in May China"s new Yuan loan creation did beat estimates modestly, rising by CNY1.11tn vs CNY 1tn expected. This number is hardly anything to write home about however, because as Goldman explains, "strong broad credit growth is mainly a reflection of continued strength in credit demand and the willingness of the central bank to maintain just enough liquidity to the real economy to maintain growth at the current near-trend level. This is likely the main driver of stronger RMB loan growth in April and May, which offset the fall in non-loan credit in total social financing data."
But while loan growth was stable, it was the broader TSF which demanded further attention, not least of all because - by definition - it should be bigger than its loan component. Since that was not the case, it suggests that one or more of the other TSF components declined. But before that, here is a look at China"s broadest credit growth on a annual basis: just like M2, the slowdown in the overall growth rate is, while not quite as sharp, quite visible and is a bright red flag that China"s credit impulse is turning sharply negative.
So what decline?
The answer brings us back to the abovementioned entrusted loans, a topic we first brought up a month ago. As the chart below shows, not only did entrusted loans drop for the second month in a row, but in May, they posted the biggest drop on record, dropping by CNY28 billion.
However, this time it wasn"t just entrusted loans: bankers" acceptance bills, another key, if far more volatile, shadow funding conduit also posted a monthly decline in the past month, dropping by CNY124 billion.
For those unfamiliar, here is a breakdown of the three main "shadow" credit components, all unique to China:
- Entrusted loans: Loans organized by a bank between borrowers and lenders. These are essentially inter-enterprise loans due to the difficulties involved in direct borrowing and lending between commercial enterprises.
- Trust loans: Loans made by trust companies. Typical investors are high net worth individuals and corporations, and typical maturity of these products is two years. Trust loans are often used to finance infrastructure and real estate projects and are an important source of funding for private entities and risky borrowers who have difficulties in accessing bank loans.
- Undiscounted bankers’ acceptance: A type of short-term credit issued by a firm with a bank’s guarantee. The firm’s deposit at the bank serves as both the collateral for the credit and the source of payment at a future date. While normally used in commercial transactions, this is also a way for banks to move assets off balance sheet and to engage in high-risk lending.
And yet, neither the drop in entrusted loans, nor the decline in undiscounted bankers acceptance was the highlight of the latest Chinese data: China"s "Great Shadow Unwind" was last month"s story, and is a continuation of the previously discussed crackdown on shadow banking - which for now appears to be gaining traction - amid moves to contain excessive borrowing as Beijing tries to push all loan creation into the "open" via regulated pathways.
The real story of the latest loan data was the record collapse in net corporate bond financing, the latest and far more "tangible" threat to China"s debt-fuelled economy. As shown in the chart below, in May a quarter trillion yuan in corporate bonds matured, or was repaid, or defaulted, resulting in the biggest corporate debt drain in history.
This has now emerged as the latest major, and most imminent, threat facing China"s financial sector and $10 trillion corporate debt market.
What happened?
It turns out, amid the continued pressure on shadow banking, Beijing"s leverage crackdown has also forced local companies to confront their addiction to traditional short-term corporate bond sales that they use to roll over debt. And, as Bloomberg warns, the shock therapy is worsening the outlook for corporate defaults in the second half of this year, just as borrowing costs jumped to a two-year high.
With various Chinese interest rates - both secured and unsecured - surging, from Repo and Shibor...
... to short-term funding, as discussed yesterday when we most recently observed the historic inversion in China"s 1s10s curve...
... credit to China"s corporate issuers is suddenly grinding to a halt. In fact, non-banking firms sold 131 billion yuan ($19.3 billion) of bonds with a maturity of one year or less in May, the least since January 2014 and less than half of the same month last year, according to data compiled by Bloomberg which also adds that about 87% of the short note sales last month will be used for refinancing.
For those familiar with the lock up in US shadow markets during the financial crisis, this is a huge warning flag , as the growing asset-liability maturity mismatch is traditionally one of the biggest threats facing an overly indebted financial system. According to Bloomberg, Chinese firms" habit of relying on borrowing short-term money to repay maturing debt - one could call it a Ponzi scheme, and one would not be wrong - has pushed up such liabilities to a total of 5.2 trillion yuan on China’s listed non-financial companies’ balance sheets as of March 31, the highest on record. Meanwhile, with no sign of an end to the government’s campaign against leverage, the average coupon rate for bonds with a maturity of one year or less has risen to a massive 5.5% in June, deterring issuers from raising money to roll over debt. In fact, not only deterring, but making debt repayment in some cases impossible.
Unable to rollover maturities, an unknown number of Chinese companies may have no option but to default According to Ma Quansheng, of Fullgoal Fund Management, "small issuance of short-term bonds will be a normal phenomenon in the coming six months because cash supply will probably remain tight. Both default risks and the number of corporate bond defaults may increase."
To be sure, Chinese companies have managed to avoid repayment pressure so far in 2017 because thanks to loose funding environment last year, they were able to raise enough money. That, however, is no longer the case. Take for example one-year AAA rated company bonds, whose yield averaged 4.19% this year, up nearly 50% from 2.97% in 2016. According to HFT Investment Management, more note defaults may come "as the economy doesn’t look good." In the second half of this year, Chinese non-banking firms must repay 2.36 trillion yuan of bonds, according to Bloomberg data.
“The current rising borrowing costs may have a big impact on companies’ operations and finance,” HFT"s Lu Congfan told Bloomberg. "What can you do when you must refinance to repay maturing debt while facing such high borrowing costs? That would be a question challenging many local companies in the second half or next year.”
Still, some firms refuse to throw in the towel and are selling bonds despite the soaring yields. One such company is Xingjiang Guanghui Industry Investment, a AA+ rated automobile service provider, which issued one-year bonds at a whopping yield of 7.3% this month, the highest among all notes maturing in one year or less. A recent Moody’s report said that Xinjiang Guanghui’s short-term debt amounted to around 54 billion yuan as of Dec. 31, well exceeding its cash holdings. It is clear that if and when the debt can no longer be rolled over, it and many of its peers, will have no choice but to default.
Meanwhile, the worst issuers’ liquidity problems are getting worse by the day, according to China"s CIC Corp. About 14.6% of bond issuers’ cash and cash equivalents is less than 30% of their short-term borrowings as of March 31. The percentage is higher than the year-end level in 2015 and 2016, said CICC.
“Any temporary halt in high-leverage issuers’ access to the short-term bond market could trigger more defaults,” said Wang Ying, head of China research initiative at Fitch in Shanghai. “The government is showing more tolerance for corporate defaults. But if there is any sign of regional risk, it may intervene to prevent default risks from spreading.”
Which brings us back to the chart above: if the biggest net reduction, or drain, in corporate bonds on record is just the start, how far will this spread?
As for the final nail in China"s economy, it may have been the result of Yellen"s own rate hike earlier today: Chen Qi, chief strategist at private fund management company Shanghai Silver Leaf Investment Co., told Bloomberg said the surging borrowing costs will make matters even worse for struggling companies. Recall that in March, after the last Fed rate increase, China had no choice but to match it. Will it risk doing so again, knowing that the outcome could be a wave of corporate bankruptcies as Chinese corporations finds themselves starved of liquidity and locked out of the bond market?
“High-quality companies will still be able to borrow money from banks even if they cancel bond sales,” said Chen in Shanghai. “But it’s difficult for lower-quality companies to get money elsewhere. They may face something bad down the road.”
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Finally, the reason why all of the above matters for not only the Chinese, but global, economy is because as we showed two days ago, China"s credit impulse is already crashing and has already suffered its biggest drop since the financial crisis. As UBS calculated, "from peak to trough the deceleration in global credit growth is now approaching that during the global financial crisis (-6% of global GDP), even if the dispersion of the decline is much narrower."
If one adds tens, if not hundreds of billions in Chinese corporate bond defaults to the China, and thus global credit drain next, the global credit impulse, and global deflationary tsunami, may surpass that observed during the financial crisis. And ironically, this "credit crunch" will come at a time when the Fed, unlike back in 2009 when Bernanke had just launched QE1, is hiking rates and preparing todo what it has never done before: reduce its balance sheet without crashing the market.
