China Everbright Bank placed itself directly in the firing line when reports it had defaulted started to circle

Swimming naked in China

David Keohane

| Jun 10 12:19 | 5 comments | Share

China Everbright Bank placed itself directly in the firing line of terrible puns last week when reports it had defaulted started to circle.

Thankfully, Anne Stevenson-Yang from J Capital read into the news a bit further than most:

The interbank defaults last Thursday provided definitive, if indirect, proof that the cash coming into China is for financial investment and interest arbitrage. It masquerades as a trade surplus but is not. With the tightening of the domestic central bank credit window, Chinese banks are heavily dependent on these inflows for the cash they need to roll over loans. That is why the banks immediately went into distress when regulators decided to clamp down on fraud on the trade account.She estimates that maybe 7 per cent of trade flows might be faked — some $50bn flowing in and out of China every month. It’s export fraud and it’s not like the regulators don’t know about it. But there is a balance and it may be that the inflows were getting excessive and putting significant upward pressure on the renminbi:

This was bloating the money supply as the central bank sterilized the currency, and it was killing the exporters, making China uncompetitive in sectors that were already increasingly leaving the country for cheaper manufacturing environments.

Maybe there are more parochial concerns as well. Whatever the leadership’s calculus, the channel tightened, and cash started to dry up in May. Yesterday, I was in Shenzhen, where one money broker’s comment was, “A new channel will open up. But before that happens, this is painful.”

May trade data showed that, with fewer fraudulent transactions, trade is lackluster: exports rose 1% YoY, compared with the 14.7% reported in April. By value, exports were down by $11.5 billion compared with April. Even so, it’s unlikely that all the fraudulent transactions were washed out of the numbers. Growth from China’s free trade zones was 46%–much lower than the 253% in April but still unlikely to represent reality.

And we’re back to Everbright and the need to fill a cash-hole:

On Thursday, one of the mid-tier banks–those that are most strapped for cash–China Everbright Bank, defaulted on a 6 bln RMB repayment to the Industrial Bank (called Xingye in Chinese, NOT the ICBC). Everbright had to pay a fine, because the loan deal had been struck between branches of Everbright and Industrial, which is not technically allowed. This sort of bilateral deal evades the central bank’s quota on interbank market transactions. Industrial then defaulted on its obligations in a domino effect. The default appears to have driven Industrial, and then Industrial’s creditors, into the interbank market, and rates shot up.

The PBOC, according to an article on Sina, promised the banks some more cash via a short term liquidity operation, which they call SLO, but then regulators changed their minds in the afternoon. This suggests just how fraught the policy process must be right now.

Not clear what got this started—a need for cash before the three-day holiday starting Monday? Something more long-term? Already, earlier in the week, the central bank had issued a notice requiring banks to raise their reserve deposits. The notice warned that the chance was very slight, but there was a chance nevertheless of default.

The recent defaults have been denied by the banks but, if real, they represent an ongoing fight between the banks and the government. Curb financial “innovation” too much and you risk killing growth, let it run rampant and it can get bad quickly.

As debt rises and banks struggle, regulators are keen to stop the banks striking deals between one and other where the regulators can’t see what’s going on. Totally unsurprisingly, that’s what they have been doing via fake letters of credit, loans that are never counted, and their own temporary WMPs.

From Stevenson-Yang again:

The credit expansion, of course, is well in excess of actual economic growth. Since banks are not getting paid back anywhere near as much as they lend, they need ever more cash simply handed to them by the central bank to make sure no one comes up short when depositors demand their money. The two systems—credit expansion and liquidity operations—are finely calibrated and intended to stay in symbiosis.

Since May 31, the two systems have been out of whack. The SHIBOR interbank rate started ticking up, and, by June 7, yield curves inverted. In human-person language, that means that banks believed that lending money to each other overnight was riskier than lending to some dodgy property developer in Gansu for six months. That is really scary.

There was a bit of schizophrenia in the regulatory interventions. On the June 6, the overnight rate went to 10% before closing at a crazy 8. Consider this against the fact that your overseas bank maybe earns 3% on a 15-year mortgage: Chinese banks apparently consider the risk of lending to each other for 12 hours about three times as high as you buying a house. So this was a sign that banks really needed cash. The next day, the PBOC injected 160 billion RMB of net new currency so that the banks didn’t have to worry that their teller windows would have to shut. This was the largest injection since February of this year.

At the same time, word went out that PBOC was going to bring down its quota for new injections. On June 7, the PBOC announced that it would halt SLOs.

The notice that the central bank would end its short-term liquidity operations in a way doubled-down on risk: the authorities are telling banks that they are like froward children, and they get no more second chances.

Stevenson-Yang has yet to succumb to any sense of doom though and thinks the PBOC’s injection on June 7 will probably be enough to bring short-term rates down.

The last time this happened, in 2011, the PBOC just maintained net currency injections in modest amounts throughout the period. Interbank lending volume declined, while yields spiked. When volume recovered, yields dropped.

And it may just be that this slip-up over liquidity may have had less to do with particular concerns about debt than with the central government’s desire to recapture control over the banks.

Is that less scary? From where we’re sitting that’s a rather high stakes game being played.