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Takeaway: Contrary to consensus perception, the real headwinds facing China’s banking system are structural (i.e. NOT cyclical) in nature.

This note was originally published June 25, 2013 at 11:52 in Macro

IS CHINA THE NEXT CYPRUS? - chiner

SUMMARY BULLETS:

  • As outlined in a research note published early yesterday afternoon, we do think China’s cyclical banking system woes are: A) near fully priced in on an immediate-term basis and B) near fully understood by market participants – inclusive of today’s front-page WSJ callout. As such, we would expect to see a relief rally of sorts at some point over the immediate-term, as speculators follow through thanks to additional clarity out of the PBoC and what may morph into USD-debauching, anti-tapering headlines out of the Federal Reserve.
  • We are however, inclined to fade any relief rally as the SHCOMP approaches its immediate-term TRADE line of resistance up at 2,123. That’s approximately +5.2% higher from today’s closing price – which actually took out the near 4Y lows established in DEC ’12. It remains our view that the real headwinds facing China’s banking system are structural (i.e. NOT cyclical) in nature.
  • For those of you seeking a greater understanding of those risks, please review our recent short-China presentation, as well as the compendium of hyperlinked research notes and slide decks found at the conclusion of this note. As always, if you or anyone on your team has questions on China, please feel free to reach out to us via email at any time. We always look forward to engaging in thoughtful dialogue with clients.

CHARTS OF THE DAY

A 5Y chart of China’s Shanghai Composite Index tells a pretty rough tale of a country in economic transition (click HERE & HERE for historical context):

IS CHINA THE NEXT CYPRUS? - dd

A 6Y chart of China’s Shanghai Composite Index tells an even rougher tale of an economy with a formerly world-beating, internationally-attractive growth model that is now squarely in the rear-view mirror (click HERE & HERE for historical context):

IS CHINA THE NEXT CYPRUS? - 2

A 10Y chart of China’s Shanghai Composite Index overlaid with Cyprus’ FSTE Stock Exchange 20 Index tells a rather damning tale of two countries that once lived large on financial excesses and are now facing up to the harsh realities of rapid credit expansion and adverse selection – not the least of which is structural liquidity constraints across the financial system (click HERE, HERE & HERE for more details):

IS CHINA THE NEXT CYPRUS? - 3

THE PBoC [FINALLY] COMES TO THE RESCUE… WELL, SORT OF

Down another -5.8% on its overnight lows, the SHCOMP rallied sharply intraday to close essentially flat on a rumor that the PBoC CSRC, CBRC and CIRC were going to hold a joint press conference to discuss recent market developments and banking liquidity. For now, that mega joint press conference remains a Hilsenrath-style rumor – and somewhat unlikely given the generally silo’ed nature of China’s regulatory branches.

Also supportive of the intraday rally in Chinese equities and the pacifying of money market rates was commentary out of Ling Tao, deputy head of the PBoC’s Shanghai branch, which was affirmed by a broader PBoC statement (bold emphasis our own):

  • “The People’s Bank of China has provided liquidity to some financial institutions to stabilize money-market rates and will use short-term liquidity operations and standing lending-facility tools to ensure steady markets.”
  • “With the elimination of seasonal and emotional factors, interest-rate fluctuations and the tight liquidity situation will gradually ease.”
  • “Financial institutions’ cash reserves stood at about 1.5 trillion yuan ($244 billion) as of June 21, compared with the 600 billion yuan or 700 billion yuan sufficient under normal circumstances to cover payment and clearing needs. The present liquidity is not insufficient.”
  • “We’ll closely monitor the change of liquidity within the banking system going forward, flexibly adjusting liquidity management based on international payments and the liquidity demand-and-supply situation.”
  • “The PBOC will strengthen communications with market institutions, stabilize expectations and guide market interest rates within reasonable ranges.”
  • “Banks should handle fluctuations in liquidity calmly and avoid irrational behavior.”
  • “The PBOC will provide liquidity support to those banks with temporary needs if they are lending to help the economy. For banks with liquidity-management problems, the PBOC will take corresponding measures according to circumstances to ensure broader market stability.”

IS CHINA THE NEXT CYPRUS? - 5

It’s worth noting that the final point should be taken in the context of Chinese authorities seemingly preparing the country to handle a large-scale, domestic banking crisis – which we still view as improbable over the intermediate-to-long-term.

It’s also worth noting that the “if they are lending to help the economy” clause should be taken as a direct shot across the bow to lenders that have been contributing to widespread speculation in China’s fixed assets investment bubble (i.e. all of them). We reiterate our view that Chinese policymakers no longer consider FAI as a sustainable or desired engine for economic expansion and employment/labor income growth.

Moreover, that policy shift is extremely negative for industrial commodity prices and anything tangentially linked to the mining CapEx bubble (email us if you’d like to connect with our Industrials Sector Head, Jay Van Sciver, regarding his list of short ideas within this theme).

WHERE TO FROM HERE?

As outlined in a research note published early yesterday afternoon, we do think China’s cyclical banking system woes are: A) near fully priced in on an immediate-term basis and B) near fully understood by market participants – inclusive of today’s front-page WSJ callout. As such, we would expect to see a relief rally of sorts at some point over the immediate-term, as speculators follow through thanks to additional clarity out of the PBoC and what may morph into USD-debauching, anti-tapering headlines out of the Federal Reserve.

IS CHINA THE NEXT CYPRUS? - 4

We are however, inclined to fade any relief rally as the SHCOMP approaches its immediate-term TRADE line of resistance up at 2,123. That’s approximately +5.2% higher from today’s closing price – which actually took out the near 4Y lows established in DEC ’12. It remains our view that the real headwinds facing China’s banking system are structural (i.e. NOT cyclical) in nature.

For those of you seeking a greater understanding of those risks, please review our recent short-China presentation, as well as the compendium of hyperlinked research notes and slide decks found at the conclusion of this note. As always, if you or anyone on your team has questions on China, please feel free to reach out to us via email at any time. We always look forward to engaging in thoughtful dialogue with clients.

Darius Dale

Senior Analyst

 

  • IS OUR BEARISH THESIS ON THE CHINESE FINANCIAL SYSTEM PRICED IN YET? (6/24): On an immediate-term basis, yes. On an intermediate-to-long-term basis, no. A crisis appears unlikely, but structural headwinds will remain.
  • THE CHINESE FINANCIAL SYSTEM IS FREAKISHLY STRESSED (6/19): There appears to be no end in sight for desert-like liquidity conditions across the Chinese financial system.
  • REPLAY PODCAST AND SLIDES: ARE YOU SHORT CHINA [AND OTHER EMERGING MARKETS] YET? (6/12): We think the outlook for Chinese credit growth is structurally impaired. Moreover, we anticipate that growth in non-performing loans will accelerate sustainably over the long term. Lastly, we believe that net interest margins across the Chinese banking industry face immense regulatory headwinds that may ultimately have dire consequences for China’s fixed assets investment bubble. At a bare minimum, investors should steer clear of these obvious value traps over the intermediate-to-long term. Moreover, we continue to believe assets linked to Chinese industrial demand will remain under pressure for the foreseeable future.
  • IS CHINA PREPARING FOR SYSTEMIC FINANCIAL RISK? (6/10): Recent policy developments call attention to the systemic risks facing China’s banking system. Additionally, MAY growth data came in soft.
  • IS A RATE HIKE(S) COMING DOWN THE PIKE IN CHINA? (6/4): No change to our dour view of China’s TREND-duration growth outlook or the pending bifurcation of FAI and consumption growth.
  • 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.
  • BEST IDEAS UPDATE LONG CHINA (NOT); SHORT YEN (4/19): We anticipate the impact of recent and pending regulatory measures to continue weighing on both economic growth and investor sentiment across the Chinese economy.
  • 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.