Welcome back to 2008. No, not here in the United States, but in China, where a banking crisis appears to still be brewing, in spite of the fact that short-term interest rates have backed away from the record levels they hit on Thursday, when for one brief moment, China’s ultra-short term lending rate – the Chinese version of LIBOR – spiked to a mind-boggling 28 percent. (After spending most of Thursday hovering at around 11 percent or 12 percent, it settled back down to 8.49 percent.) One measure of how dramatic the events of last week were: The Bank of China, one of the country’s largest financial institutions, had to declare publicly that it hadn’t defaulted on a loan.
While it may feel as if this is Lehman Brothers all over again, that’s not really the case. China’s government has the cash and the clout to ensure that a liquidity crunch doesn’t demolish the country’s entire financial infrastructure. If anything, the current crisis has been provoked by the central bank as a kind of melodramatic wake-up call to the financial institutions it oversees, as a reminder of what is amiss in China’s financial system and in particular the infamous shadow banking system, which has become as powerful a force there in recent years as it was in the United States before our own financial crisis.
At its heart, the problem seems to be that the evolution of China’s financial system hasn’t kept pace with that of its role in the global economy. That has been complicated by the central role of the government in handling the economy and monetary policy, which is far more hands on than in North America or Europe. For instance, only four years ago the Chinese government was prodding banks into lending to local governments to fund big infrastructure products, some of which would never have passed muster with a credit committee on their merits. There is the fact that China’s central bankers have chosen to encourage the development of the money market, as an open alternative to the former approach in which the People’s Bank of China simply told banks how much they could lend and on what terms. That has fueled the explosion in the repo market (in which banks use government bonds as security for ultra-short term loans) from a mere 11 trillion RMB six years ago to 136 trillion RMB by 2012.
Then there is the role of the retail investment community in China – a group that, some suggest, views an investment that they hold for more than 90 days as a long-term play. Little wonder, then, that these investors have flocked to a wave of new wealth management products, sold by banks and offering above-market yields. Now the banks that marketed those products are scrambling to find the cash to meet quarter-end repayments – and finding it tough.
Is the central bank trying to tell lenders – in a particularly heavy-handed manner – that they have been engaging in excessively risky lending? Fitch Ratings, which has chronicled the evolution of these products, warned that some financial institutions may be unable to pay back “in full and on time” the estimated $245 billion of these products coming due before the end of June. That may just be part of the problems: Across the board, China’s banks have become increasingly reliant on short-term funding to meet long-term obligations, a mismatch that becomes unmanageable when interest rates spike as they did earlier this week.
China’s monetary policymakers clearly opted to engineer their own crisis rather than wait for the markets to self-destruct on their own timetable. For days leading up to the near-paralysis of the markets on Thursday, they had rejected the pleas by banks to inject cash into the financial system. When they did eventually act – or at least, that’s the word on the street in Beijing and Shanghai – it wasn’t openly, via an announcement, but in a person-to-person communication, offering targeted cash infusions into some of the biggest Chinese institutions. That proved just enough to ward off catastrophe, but still leaves those short-term lending rates at roughly double their usual levels. In other words, it’s still enough to wreak havoc on those lenders that the government would like to see out of business or to which it wants to teach a memorable lesson.
What Chinese central bankers appear to be doing is teaching the financial institutions they oversee the hard way what it means to be part of a sustainable financial system. It’s tough love, as if a parent allowed their toddler to burn himself on the stove once or twice to teach him that it’s dangerous rather than simply telling him not to touch.
The ramifications for the rest of us? Well, the drama isn’t over. As the end of the month approaches, the need for short-term cash on the part of China’s financial institutions is likely to grow, and the central bankers, playing hardball, may not be willing to ante up. At the very least, the uncertainty will create turmoil not only in Chinese credit markets but also for stocks: already down several percentage points last week, the odds are that they are likely to fall still further.
Combined with the freefall in Brazil’s markets in response to that country’s own economic decline as well as a wave of protests in the country, it may be time (if you haven’t done so already) to scale back your involvement in emerging markets on a broad basis, or to look for a way to play some of the pockets of relative growth in that arena, such as the Philippines, via an ETF. Assets have been fleeing the asset class for several weeks, and the news from China suggests that is only likely to continue, and that you’ll have a chance down the road to jump back in at much, much lower prices.