This note was originally published June 10, 2013 at 13:54 in Macro
- The pending introduction of a nationwide deposit insurance scheme and proactive regulations for dealing with commercial bank failures calls attention to the systemic risks facing China’s banking system. When taken in context with the outlook for interest rate liberalization and a bubbly property market, we are left continuing to hold a far-less-than-sanguine view of Chinese financials.
- As a reminder, we’ll be hosting a flash conference call this Wednesday at 11AM EST to discuss Chinese financial system risks in greater detail, having added CHIX (Global X China Financials ETF) to our Best Ideas list on the short side. We look forward to your participation and questions then.
- The sluggish MAY growth figures are in line with what we saw out of China’s recent PMI readings on both the manufacturing and non-manufacturing fronts and we continue to warn of A) incremental tightening (macroprudential or blunt instrument, if necessary) to stem rampant property price appreciation and B) a 2H13 slowdown in Chinese growth as conditions for credit growth deteriorate.
- While certainly hard to know for sure, it is our view that much of the equity market upside stemming from positive sentiment surrounding the various avenues for reform (economic, financial, fiscal and social) was priced in during the recent rally.
- For our latest thoughts on the Chinese economy and its banking system, please refer to the research notes hyperlinked at the bottom of this note.
PBOC, CBRC RAISING EYEBROWS (OURS AT LEAST)
This morning, we learned that the PBOC was out confirming that a deposit insurance system is ready to be launched after gathering much-needed political consensus. According to the central bank, the insurance system will help "increase the flexibility of commercial banks in terms of financial business innovation and risk control". Moreover, China’s regulation on the standardization of commercial bank bankruptcy – which has been deliberated on for five years – is expected to be submitted to the State Council in 2H13.
So let’s get this straight: Chinese authorities are A) implementing a deposit insurance scheme and B) finalizing regulations to facilitate commercial bank bankruptcies. Are we missing something or is Beijing preparing for some meaningful banking system headwinds over the intermediate-to-long-term?
In the context of the PBOC likely scrapping the deposit rate ceiling over the intermediate term, there have been concerns that smaller banks would be uncompetitive in a competing cost-of-funds environment. They would ultimately lose deposits and creditor faith as their ability to generate earnings growth declined amid slower or potentially negative financing growth.
The commensurate tightening of interbank liquidity is something we’ve been keeping an eye on; last week there was a rumor of a mid-sized bank failing to repay an interbank loan. Expect more to come on that front as we inch closer to the implementation of interest rate liberalization in China. Consensus has been celebrating/bidding up headlines on that front in the YTD, but we continue to hold a far less sanguine view:
- On scrapping the lending rate floor (current minimum = 70% of the benchmark): Consensus expects this to increase the supply of credit to SMEs by lowering the cost of funds for SOEs and allowing risk-based credit allocation to flourish. We think there is risk that SOEs just demand cheaper financing from the banks and that SMEs continue to get crowded out in the absence of regulatory quotas.
- On scrapping the deposit rate ceiling (current maximum = 110% of the benchmark): Consensus expects this to increase the return on household savings deposits (as do we), but fails to see the dangers of crowding out small-to-mid-sized lenders out of the market for deposits. Moreover, this would be an enormous blow to the systemic financial repression that underpins China’s investment economy (~46-47% of GDP) and higher real rates of return in safer, traditional savings deposits would slow the supply of yield-chasing funds to Trusts and WMPs – potentially exacerbating any liquidity constraints in those credit markets.
- On doing both at the same time: We’re not sure what consensus thinks here, but it’s obvious to us that lowering lending rates and increasing deposit rates at the same time will inevitably result in NIM compression – something that can only be offset from an earnings perspective by accelerating credit growth. In the context of subdued GDP targets, the Party’s economic rebalancing agenda, a bubbly housing market and an inevitable and potentially dramatic rise in NPLs over the long-term, a meaningful, sustained increase in credit growth appears unlikely.
RATTY MAY DATA
This weekend brought us some pretty ratty growth data out of China for the month of MAY. Perhaps the largest callout would be export growth slowing from +14.7% YoY in APR to +1% YoY in MAY, which is what we were calling for post the regulatory crackdown on fake invoicing. Back in line with reality, the MAY export growth figures may arouse global growth fears (exports to the US slowed to -1.6% YoY; exports to the EU slowed to -9.7% YoY).
In the context of slower capital flows stemming from a reduction in “fexports” (i.e. fake exports) and tighter interbank liquidity, the MAY credit growth data was also pretty subdued: total social financing growth slowed to +CNY1.19 trillion MoM from +CNY1.75 trillion prior as new loans ticked down to +CNY667.4 billion MoM from +CNY792.9 billion prior. That is unsupportive for fixed assets investment and industrial production growth, the both of which ticked down marginally.
All told, the sluggish MAY growth figures are in line with what we saw out of China’s recent PMI readings on both the manufacturing and non-manufacturing fronts and we continue to warn of A) incremental tightening (macroprudential or blunt instrument, if necessary) to stem rampant property price appreciation and B) a 2H13 slowdown in Chinese growth as conditions for credit growth deteriorate.
While certainly hard to know for sure, it is our view that much of the equity market upside stemming from positive sentiment surrounding the various avenues for reform (economic, financial, fiscal and social) was priced in during the recent rally.
For our latest thoughts on the Chinese economy and its banking system, please refer to the research notes hyperlinked at the bottom of this note.
- IS THE RECENT RALLY IN CHINESE EQUITIES SUSTAINABLE? (5/17): We do not think the recent strength in the Chinese equity market is sustainable, as China’s 2H13 growth outlook appears dicey at best.
- WHY IS CHINA GOOSING ITS EXPORT FIGURES AND HOW MUCH LONGER WILL IT CONTINUE? (5/8): Chinese firms are goosing exports to drive incremental liquidity into the banking system – a phenomenon that appears set to slow from here.
- TWO CHINAS? (5/1): Financial system headwinds continue to outweigh consumption tailwinds within the Chinese economy.
- REPLAY: Will China Break? (4/30): The Party’s use of state owned banks to drive economic growth through fixed asset investment has left the financial system loaded with bad assets. The bad assets mirror bad investments in the real economy. They also can limit the ability of Chinese banks to make new loans. Following the financial crisis, the Chinese government pushed too hard on the FAI growth lever, building infrastructure projects “for the next 10 years.” It has also left the banking sector choked with bad debts that may limit future lending. Those factors should slow Chinese FAI growth and slower Chinese FAI growth should be negative for commodity prices and resource-related profits, all else equal.
- CAN CHINA AVOID FINANCIAL CRISIS? (4/26): The risk of a Chinese financial crisis is heightened to the extent that financial sector reforms are not appropriately managed.
- REPLAY: EMERGING MARKET CRISES (4/23): We currently see a pervasive level of risk across the emerging market space at the country level and have quantified which countries are most vulnerable. China is particularly vulnerable to experiencing a financial crisis.
- IS CHINA CAREENING TOWARDS FINANCIAL CRISIS? (3/28): Systemic risks are present across China’s financial sector – as is the political will and fiscal firepower needed to avert a crisis.