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China On The Verge Of First Corporate Bond Default Once More | Zero Hedge

China On The Verge Of First Corporate Bond Default Once More | Zero Hedge.

While everyone was focusing on the threat of tumbling debt dominoes in China’s shadow banking sector, a new threat has re-emerged: regular, plain vanilla corporate bankruptcies, in the country with the $12 trillion corporate bond market (these are official numbers – the unofficial, and accurate, one is certainly far higher). And while anywhere else in the world this would be a non-event, in China, where corporate – as well as shadow banking – bankruptcies are taboo, a default would immediately reprice the entire bond market lower and have adverse follow through consequences to all other financial products. This explains is why in the past two months, China was forced to bail out not one but two Trusts with exposure to the coal industry as we reported previously in great detail. However, the Chinese Default Protection Team will have its hands full as soon as Friday, March 7, which is when the interest on a bond issued by Shanghai Chaori Solar Energy Science & Technology a Chinese maker of solar cells, falls due. That payment, as of this moment, will not be made, following an announcement made late on Tuesday that it will not be able to repay the CNY89.8 million interest on a CNY1 billion bond issued on March 7th 2012.

FT reports:

The company has until March 7th to repay the interest, charged at an annual 8.98 per cent, the company said in a statement. “Due to various uncontrollable factors, until now the company has only raised Rmb 4m to pay the interest,” it said in the statement.

Trading in the Chaori bond, given a CCC junk rating, was suspended last July because the company suffered two consecutive years of losses. The company had a further RMB1.37bn loss in 2013, according to the results it posted on the exchange.

Just pointing out the obvious here, but how bad must things be for the company to be on the verge of default not due to principal repayment but because two years after issuing a bond, it only has 4% in cash on hand for the intended coupon payment?

Furthermore, as noted previously, China has so far been able to kick the can on its defaults for nearly three decades. Which is why suddenly everyone is focusing on this tiny company: Chaori Solar’s default – if it transpires – would mark the first time a company has defaulted on publicly traded debt in China since the central bank began regulating the market in the late 1990s. Bloomberg adds, citing Liu Dongliang, Shenzhen-based senior analyst at China Merchants Bank, that such a default would be the “first of a string of further defaults in China.”  FT continues:

Though the bond is relatively small, a default could deliver a sharp shock to risk management strategies in China vast corporate debt market, estimated by Standard&Poor’s to be $12tn in size at the end of 2013.

Any default could also slow down new issuance. A Thomson Reuters analysis of 945 listed medium and large non-financial firms showed total debt soared by more than 260 per cent, from Rmb1.82tn to Rmb4.74tn, between December 2008 and September 2013.

In January, a Chinese fund company avoided a high-profile default, reaching a last-minute agreement to repay investors in a soured $500m high-yield investment trust, in a case that had sent tremors through global markets.

Then again, those who follow China’s bond market will know that Chaori’s failure to pay interest would not really be the true first Chinese corporate default: recall as we reported almost exactly a year ago:

For the first time, a mainland Chinese company has defaulted on its bonds. SunTech Power Holdings has been clinging on by its teeth but after failing to repay $541mm of notes due on March 15th – and following four consecutive quarters of losses through the first quarter of 2012 and since then having failed to report quarterly earnings – owed to Chinese domestic lenders, the firm is restructuring. As Bloomberg reports, Chinese solar companies are struggling after taking on debt to expand supply, leading to a glut that forced down prices and squeezed profits – and most notably were unable to renegotiate its liabilities and obtain “additional flexibility” from creditors. This is highly unusual and perhaps is the beginning of a trend for Chinese firms.

So yes: a prior default, and one by a solar company no less. However, going back down memory lane again, ultimately Suntech had the same fate as all other insolvent corporations in China do – it got a post-facto bailout:

Struggling Chinese solar panel maker Suntech Power Holdings Co Ltd is set for a $150 million local government bailout, a step towards tackling its $2.3 billion debt pile that is at odds with Beijing’s effort to wean the sector off state support. The lifeline comes from the municipal government of Wuxi, an eastern city where Suntech’s Chinese subsidiary is headquartered, and follows Shunfeng Photovoltaic International Ltd’s signing of a preliminary deal to buy its bankrupt Chinese unit.

Curious why China’s local government continues to balloon at an exponential pace, and has doubled in roughly two years to roughly CNY20 trillion (that’s the real number – the official, made up one is CNY17.9 trillion or $3 trillion)? Because just like the Fed and ECB are the ultimate toxic bad banks in the US and Eurozone, respectively, in China all the bad debt ultimately disappears under the comfortable carpet of the broad “local government debt” umbrella. However, things like these must never be discussed in polite public conversation. Which is why despite what Guan Qingyou, an economist with Minsheng Securities said in his Weibo account that the “first default might not be a bad thing even that means more defaults might happen, because it is ultimately good for the market reform”, the reality is that once the dam breaks, it may well be game over for a country that only knows one thing – how to kick the can ever further.

There are additional considerations: As the FT also notes, “given the squeeze on credit supply already seen in January this year, corporate debt defaults could further slow momentum in China’s fixed asset investments.” In other words, the just announced 7.5% GDP target revealed ahead of the National People’s Congress will be impossible to achieve, should China be unable to fund the Capex to build its burgeoning ghost cities, should rates spike.

Which is why this too default will ultimately be made to disappear.

And the next one, and the one after that, because “now” is never the right time to make the right, but difficult decision.

But how much longer can China avoid reality? Not much if one consider this just crossed headline on Bloomberg:

  • CHINA TO SHUT 50,000 COAL FURNACES THIS YEAR, LI SAYS

Recall coal is the industry that China’s near-bankrupt Trusts have most of their exposure to.

And then there are our four favorite charts confirming the dire situation in China’s credit market:

 

 

 

 

 

For those who need a refresh course on why the Chinese situation is rapidly going from bad to worse, read these several most recent comprehensive articles on the topic:

Bank of America warns further that a more confident government means the start of defaults

With amazing speed in consolidating power in 2013, a more confident President Xi Jinping and team are expected to push for a wide range of reforms. 2014 will be the year for China seriously cleans up mounting local government and corporate debts which have been rapidly accumulated since late 2008. We believe the chance of some bond and trust loan defaults will rise significantly in 2014, especially as the more confident government sees the need for some defaults to develop a more disciplined financial market
 

China On The Verge Of First Corporate Bond Default Once More | Zero Hedge

China On The Verge Of First Corporate Bond Default Once More | Zero Hedge.

While everyone was focusing on the threat of tumbling debt dominoes in China’s shadow banking sector, a new threat has re-emerged: regular, plain vanilla corporate bankruptcies, in the country with the $12 trillion corporate bond market (these are official numbers – the unofficial, and accurate, one is certainly far higher). And while anywhere else in the world this would be a non-event, in China, where corporate – as well as shadow banking – bankruptcies are taboo, a default would immediately reprice the entire bond market lower and have adverse follow through consequences to all other financial products. This explains is why in the past two months, China was forced to bail out not one but two Trusts with exposure to the coal industry as we reported previously in great detail. However, the Chinese Default Protection Team will have its hands full as soon as Friday, March 7, which is when the interest on a bond issued by Shanghai Chaori Solar Energy Science & Technology a Chinese maker of solar cells, falls due. That payment, as of this moment, will not be made, following an announcement made late on Tuesday that it will not be able to repay the CNY89.8 million interest on a CNY1 billion bond issued on March 7th 2012.

FT reports:

The company has until March 7th to repay the interest, charged at an annual 8.98 per cent, the company said in a statement. “Due to various uncontrollable factors, until now the company has only raised Rmb 4m to pay the interest,” it said in the statement.

Trading in the Chaori bond, given a CCC junk rating, was suspended last July because the company suffered two consecutive years of losses. The company had a further RMB1.37bn loss in 2013, according to the results it posted on the exchange.

Just pointing out the obvious here, but how bad must things be for the company to be on the verge of default not due to principal repayment but because two years after issuing a bond, it only has 4% in cash on hand for the intended coupon payment?

Furthermore, as noted previously, China has so far been able to kick the can on its defaults for nearly three decades. Which is why suddenly everyone is focusing on this tiny company: Chaori Solar’s default – if it transpires – would mark the first time a company has defaulted on publicly traded debt in China since the central bank began regulating the market in the late 1990s. Bloomberg adds, citing Liu Dongliang, Shenzhen-based senior analyst at China Merchants Bank, that such a default would be the “first of a string of further defaults in China.”  FT continues:

Though the bond is relatively small, a default could deliver a sharp shock to risk management strategies in China vast corporate debt market, estimated by Standard&Poor’s to be $12tn in size at the end of 2013.

Any default could also slow down new issuance. A Thomson Reuters analysis of 945 listed medium and large non-financial firms showed total debt soared by more than 260 per cent, from Rmb1.82tn to Rmb4.74tn, between December 2008 and September 2013.

In January, a Chinese fund company avoided a high-profile default, reaching a last-minute agreement to repay investors in a soured $500m high-yield investment trust, in a case that had sent tremors through global markets.

Then again, those who follow China’s bond market will know that Chaori’s failure to pay interest would not really be the true first Chinese corporate default: recall as we reported almost exactly a year ago:

For the first time, a mainland Chinese company has defaulted on its bonds. SunTech Power Holdings has been clinging on by its teeth but after failing to repay $541mm of notes due on March 15th – and following four consecutive quarters of losses through the first quarter of 2012 and since then having failed to report quarterly earnings – owed to Chinese domestic lenders, the firm is restructuring. As Bloomberg reports, Chinese solar companies are struggling after taking on debt to expand supply, leading to a glut that forced down prices and squeezed profits – and most notably were unable to renegotiate its liabilities and obtain “additional flexibility” from creditors. This is highly unusual and perhaps is the beginning of a trend for Chinese firms.

So yes: a prior default, and one by a solar company no less. However, going back down memory lane again, ultimately Suntech had the same fate as all other insolvent corporations in China do – it got a post-facto bailout:

Struggling Chinese solar panel maker Suntech Power Holdings Co Ltd is set for a $150 million local government bailout, a step towards tackling its $2.3 billion debt pile that is at odds with Beijing’s effort to wean the sector off state support. The lifeline comes from the municipal government of Wuxi, an eastern city where Suntech’s Chinese subsidiary is headquartered, and follows Shunfeng Photovoltaic International Ltd’s signing of a preliminary deal to buy its bankrupt Chinese unit.

Curious why China’s local government continues to balloon at an exponential pace, and has doubled in roughly two years to roughly CNY20 trillion (that’s the real number – the official, made up one is CNY17.9 trillion or $3 trillion)? Because just like the Fed and ECB are the ultimate toxic bad banks in the US and Eurozone, respectively, in China all the bad debt ultimately disappears under the comfortable carpet of the broad “local government debt” umbrella. However, things like these must never be discussed in polite public conversation. Which is why despite what Guan Qingyou, an economist with Minsheng Securities said in his Weibo account that the “first default might not be a bad thing even that means more defaults might happen, because it is ultimately good for the market reform”, the reality is that once the dam breaks, it may well be game over for a country that only knows one thing – how to kick the can ever further.

There are additional considerations: As the FT also notes, “given the squeeze on credit supply already seen in January this year, corporate debt defaults could further slow momentum in China’s fixed asset investments.” In other words, the just announced 7.5% GDP target revealed ahead of the National People’s Congress will be impossible to achieve, should China be unable to fund the Capex to build its burgeoning ghost cities, should rates spike.

Which is why this too default will ultimately be made to disappear.

And the next one, and the one after that, because “now” is never the right time to make the right, but difficult decision.

But how much longer can China avoid reality? Not much if one consider this just crossed headline on Bloomberg:

  • CHINA TO SHUT 50,000 COAL FURNACES THIS YEAR, LI SAYS

Recall coal is the industry that China’s near-bankrupt Trusts have most of their exposure to.

And then there are our four favorite charts confirming the dire situation in China’s credit market:

 

 

 

 

 

For those who need a refresh course on why the Chinese situation is rapidly going from bad to worse, read these several most recent comprehensive articles on the topic:

Bank of America warns further that a more confident government means the start of defaults

With amazing speed in consolidating power in 2013, a more confident President Xi Jinping and team are expected to push for a wide range of reforms. 2014 will be the year for China seriously cleans up mounting local government and corporate debts which have been rapidly accumulated since late 2008. We believe the chance of some bond and trust loan defaults will rise significantly in 2014, especially as the more confident government sees the need for some defaults to develop a more disciplined financial market
 

“The Pig In The Python Is About To Be Expelled”: A Walk Thru Of China’s Hard Landing, And The Upcoming Global Harder Reset | Zero Hedge

“The Pig In The Python Is About To Be Expelled”: A Walk Thru Of China’s Hard Landing, And The Upcoming Global Harder Reset | Zero Hedge.

By now everyone knows that the Chinese credit bubble has hit unprecedented proportions. If they don’t, we remind them with the following chart of total bank “assets” (read debt) added since the collapse of Lehman: China literally puts the US to shame, where in addition to everything, the only actual source of incremental credit growth over the same time period has been the Fed as banks have used reserves as margin for risk purchases instead of lending.

 

Everyone should also know that like a metastatic cancer, the amount of non-performing, bad loans within the Chinese financial system is growing at an exponential pace.

 

Finally, what everyone learned over the past month, is that as the two massive, and unresolvable forces, come to a head, the first cracks in the facade are starting to appear as first one then another shadow-banking Trust product failed and had to be bailed out in the last minute.

However, as we showed last week, and then again last night, the default party in China is only just beginning as Trust failures in the coming months are set to accelerate at a breakneck pace.

 

The $64K question is will the various forms of government be able to intercept and bail these out in time, as they have been doing so far despite their hollow promises of cracking down on moral hazard: after all, everyone certainly knows what happened when Lehman was allowed to meet its destiny without a bailout – to say that the CNY10 trillion Chinese shadow banking industry will not have far more dire consequences if allowed to fall without government support is simply idiotic.

But what could be the catalyst for this outcome which inevitably would unleash the long-overdue Chinese hard landing, and with it, a new global depression?

Ironically, the culprit may be none other than the Fed with the recently instituted taper, and the gradual, at first, then quite rapid unwind of the global carry trade.

Bank of America explains:

QE and the Emerging Markets carry trade

 

The QE channel has worked through Emerging Markets and China is a key vehicle. By lowering the US government bond yields to a bare minimum, and zero –ish at the short end, a search for yield globally ensued. Emerging market banks and corporates have gone on an international leverage binge, yet another carry trade, the third in 20 years. The first one was driven by European banks, financing East Asian capex – that ended in 1997. The second one was global banks and equity-FDI supporting mainly capex in the BRICs. That ended in 2008. This time, it is increasingly non-equity: commercial banks and more importantly, the bond market – often undercounted in the BoP and external debt statistics that conventional analysis looks at.

 

Chart 9 shows the rise of EM external loans and bond issuance (both by residence and nationality). Since, end-3Q2008 to end-3Q2013, external borrowing from banks and bonds has risen USD1.9tn. Bank loans have risen by USD855bn and bond issuance in foreign currencies by nationality is up USD1,042bn. In the prior five-year period (i.e. end-3Q2003 – end-3Q2008), forex bond issuance rose only USD432bn. Clearly, the importance of external bond issuance is rising. See Table 5 for details.

 

In China, since, end-3Q2008 to end-3Q2013, outstanding external borrowing from banks and bonds has gone from USD207bn to USD849n – a net rise of USD655bn. Outstanding bank loans are up from USD161bn to USD609bn – a net rise of USD464bn. Bond issuance in foreign currencies by nationality is up from USD46bn to USD240bn – a net rise of USD191bn. In the prior five-year period (ie, end-3Q2003 – end-3Q2008), forex bond issuance rose only USD28bn in China. Clearly, the importance of external bond issuance is rising in China.

 

 

There is more to this story.

 

As mentioned earlier, for externally-issued bonds, USD1,042bn has been raised by the nationality of the EM borrower since end-3Q 2008, but USD724bn by residence of the borrower – a gap of USD318bn, or 44%. This undercount is USD165bn in China, USD100bn in Brazil, USD62bn in Russia, and USD37bn in India. The carry trade this time around was helped substantially by access to the bond market, especially from overseas affiliates of EM banks and corporations.

 

There are a lot of moving parts in the balance of payments that finally affect the change in international reserves at any EM central bank – eg, the current account, portfolio equity investment and direct equity investment, and debt flows – both from the bond market and lending from banks. We focus on the link between these debt flows and the international reserves in China. As Table 5 below shows, China’s external debt – from bond issuance and forex borrowing from banks – rose USD655bn during 3Q08-3013.

 

 

We posit that this large rise was in part driven by the carry trade offered up by QE – China banks and corporates issued substantial forex-denominated bonds, and borrowed straight loans from international banks. We recognize the caveat that correlation does not imply causation. The USD655bn rise in China debt issuance is highly correlated to the Fed’s balance sheet since late-2008. As Chart 11 shows, the rise in China debt issuance of USD 655bn has (along with FDI and the C/A surplus), boosted international reserves by USD1,773bn since late-2008. Also, as Chart 11 shows, the USD1,773bn rise in China international reserves mirrors the rise of USD2,585bn in the EM monetary base. Lastly, the rise of China’s monetary base of USD2,585bn correlates well with the USD10.9tr rise in China’s broad money expansion.

 

 

 

As the Fed tapers, and the size of its balance sheet stabilizes/contracts, we should expect this sequence to reverse. Confidence is a fragile membrane. Not only does the Fed’s balance sheet matter as a source of funds, but we believe so does the attractiveness of the recipient of the carry trade – and the trust in its collateral. As Gary Gorton puts it…

 

The output of banks is money, in the form of short-term debt which is used to store value or used as a transaction medium. Such money is backed by a portfolio of bank loans in the case of demand deposits, or by collateral in the form of a specific bond in the case of repo. The backing is designed to make the bank debt as close to riskless as possible — in fact, so close to riskless than nobody wants to really do any due diligence on the money, just transact with it. But the private sector cannot produce riskless debt and so it can happen that the backing collateral is questioned. This typically happens at the peak of the business cycle. If its value is questioned, it loses its “moneyness” so no one wants it, and cash is preferred. But as we know, if everyone wants their cash at the same moment, their demands cannot be satisfied. In this sense, the financial system is insolvent. (interview with the FT) 

 

What makes sense for an individual carry trade – borrow low, invest at higher rates – falls prey to the fallacy of composition, when too many engage in the same carry trade. And eventually question the underlying collateral, now huge, and potentially suspect. China is a case in point. If our colleagues David Cui and Bin Gao are right, the trust sector in Chinacould create rollover risks that reverse a gluttonous carry trade within China, but partly financed overseas. In China’s case, this trade was between low global interest rates, low Chinese deposit rates, expectations of perpetual RMB appreciation on the one hand, and higher investment returns promised by Trusts on the other. A part of the debt funds raised overseas, we suspect were put to work in this Trust carry trade. The HK-based banks are big participants in intermediating the China carry trade – as Chart 12 shows, their net lending to China went from 18% of HK GDP in 2007 to 148% in late-2013.

 

There are always fancy names given to carry trades – financial liberalization of capital accounts, the Bangkok International Banking Facility, currency internationalization, etc. We remain skeptics of these buzzwords.

 

 

 

The potential consequences of Trust defaults and a China carry trade unwind

 

1. If the EM carry trade diminishes as a consequence of a changed Fed policy and/or less attractive risk-adjusted returns in EMs as collateral quality is questioned, the sources of China’s forex reserve accumulation will need to change. Perhaps to bigger current account surpluses, more equity FDI and portfolio investment through privatization and more open equity markets. If that does not happen, expanding the Chinese monetary base might require PBOC to increase net lending to the financial system and/or monetize fiscal deficits (this last part has not worked so well in EMs).

 

2. Potential asset deflation is a risk, as the carry trades diminish/unwind. Property prices are at risk – the collateral value for China’s financial systems. This is not a dire projection – it simply seeks to isolate the US QE as a key driver of China’s monetary policy and asset inflation, and highlights the magnitudes involved, and the transmission mechanism. Investors should not imbue stock-price movements and property price inflation in China with too much local flavor – this is mainly a US QE-driven story, in our view.

 

3. Currently, China’s real effective exchange rate is one of the strongest in the world. Concerns about China’s Trust sector, and its underlying collateral value, sees some of this carry trade unwound, the RMB could be under pressure.

 

 

4. Given HK’s role in the China carry trade, HK property prices and its banking system should be watched carefully for signs of stress.

 

5. UK, US, and Japan banking systems have been active lenders to China since QE. They should be on watch if the Trust rollover risk materializes and creates a growth shock in China. See Chart 15.

 

 

 

6. Safe haven bids for DM government bonds, overseas property and precious metals might emerge from China.

 

Could the party go on? Yes, if for some reason a significant deterioration in the US labor market, or a deflationary shock from China, or any other surprise that could lead to a cessation of the US tapering could prolong this carry trade. This is not the house base case. We believe it is better to start preparing for a post-QE world. As one of our smartest clients told us: “the main theme in the past five years was QE. If that is coming to an end, investments and themes that worked in the past five years must therefore be questioned.” We agree.

* * *

Yes, Bank of America said all of the above – every brutally honest last word of it.

The question, however, in addition to “why”, is whether the Fed also agrees with BofA’s stunningly frank, and quite disturbing conclusion, perhaps finally realizing that aside from the US, the biggest house of cards that would topple once the “flow”-free emperor is exposed in his nudity, is that of the world’s largest “growth” (and credit) dynamo of the past two decades – China.Because, as noted above, if Lehman’s collapse was bad, a deflationary collapse brought on by Chinese hard landing coupled with a full unwind of the global carry trade, would be disastrous and send the world into a depression the likes of which have never before been seen.

Finally, for those who want the blow by blow, here is BofA’s tentative take of what the preliminary steps of the next global great depression will look like:

If we do experience a sizable default, the knee-jerk market reaction will be cash hoarding since it will strike as a big surprise. Thus, we expect the repo rate to rise first, while the long term government bond would get bid due to risk aversion flows.

 

However, what follows will be quite uncertain, aside from PBoC injecting liquidity and easing monetary policy to help short term rate come down. It has been proven again and again the Chinese government will get involved and be proactive. The bond market reaction will be different depending on the government solution.

Alas, at that point, not even the world’s largest bazooka will be enough.

At this point one should conclude that reality – through massive, unprecedented liquidity injections – has been deferred long enough. It is time to let the markets finally return to some semblance ofuncentrally-planned normalcy: there is a reason why nature abhors a vacuum. Even if it means the eruption of the very painful grand reset, washing away decades of capital misallocation, lies and ill-gotten wealth, so very overdue.

China Folds On Reforms – Bails Out 2nd Shadow-Banking Default After “Last Drop Of Blood” Threats | Zero Hedge

China Folds On Reforms – Bails Out 2nd Shadow-Banking Default After “Last Drop Of Blood” Threats | Zero Hedge.

As we showed over the weekend, it is abundantly clear that for all the talk of reform, Chinese authorities have found the gap between words and deeds uncrossable. First, Chinese authorities bailed out the relatively small CEG#1 Trust (for fear of contagion); second, the PBOC injects CNY 375 bn into short-term repo to save banks from a liquidity crisis at year-end; third, total social financing rose by the largest amount on record in January (despite all the talk of deleveraging following the Plenum); and now, fourth, thanks to a CNY 2bn loan (to an entirely insolvent coal company), Chinese authorities have bailed out a 2nd wealth-management product – this time even smaller.

We noted the “technical default” of Jilin Trust last week, and despite its de minimus size, China Development Bank loaned CNY 2bn to the verge-of-bankruptcy Liansheng coal company, and thus bailed out investors in the trust –  piling on the moral hazard.

The Jilin Trust default, as we noted last week, was the second notable ‘technical’ default among Chinese wealth management products recently and caused consternation among investors:

Investors in the Jilin Trust product are demanding that CCB also take responsibility for compensating investors, 21st Century Business Herald reported on Friday.

Bankers have warned that China’s lenders are exposed to vast swathes of loans extended by their non-bank partners and sold to bank clients as off-balance-sheet wealth management products. Though banks are not legally responsible for repaying investors in such cases, they may face pressure to do so in order to maintain their reputations and uphold social stability.

“A few days ago, we went looking for CCB. CCB’s leader in Shanxi still says it’s not his responsibility. In the end, if they really don’t take responsibility, we’ll go to CCB and fight a war to the last drop of blood,” the paper quoted an unnamed product investor as saying.

Investors told the paper that all paperwork and fund transfers related to their purchase of the Jilin Trust product had occurred on CCB’s premises and CCB sales staff had verbally assured investors that the product carried no risk. They also said their willingness to invest was based on their confidence in CCB as a large state-owned bank.

And so what do the Chinese authorities do? Instead of letting a small trust face actual losses, they do what JPMorgan warned would “amplify future losses”

Via Bloomberg,

China Development Bank lent 2b yuan to coal company Shanxi Liansheng, which owes almost 30b yuan to lenders including banks, trusts and asset management firms, 21st Century Business Herald reports, citing unidentified people.

The policy bank is the co.’s largest creditor, with 4.51b yuan in outstanding loans, the report says

The loan will be used to repay maturing trust products sold to retail investors: report

Three local firms will also pay 3b yuan to buy 50 percent of Liansheng, which is based in the northern province of Shanxi, the report says, without identifying cos buying stake

Funds from the stake sale will also be used to repay maturing trust products: report

Repayment of bank loans and single trusts will be delayed

Liansheng, the largest private coal miner in Shanxi, is owned by Chinese entrepreneur Xing Libin, according to the report

Liansheng borrowed more than 5b yuan through 6 Chinese trust firms including Jilin Province Trust and Chang’an Trust, China Securities Journal reports separately, citing unidentified people.

As a reminder, this is what one analyst said of the Chinese coal industry that just got yet another bailout:

Shares of China’s biggest listed coal producers have dropped to their lowest valuations on record as falling fuel prices make it harder to repay debt.

China’s coal industry is “dead,” said Laban Yu, a Jefferies Group LLC analyst in Hong Kong with an underperform rating on all three stocks. “There are 10,000 producers in China. A lot of them are taking on debt. It gets harder and harder to service debts when coal prices keep falling.

Of course, it’s not over yet – as the following chart shows, there are a lot more “maturing” trusts to come in the next 3 months alone…

Allowing investors to be bailed out merely exacerbates the risk-taking mentality and solidifies a belief in a government back-stop (to 10%-yielding highly risky loans to an insolvent industry!!)…

As we previously noted,

…borrowers are facing rising pressures for loan repayments in an environment of overcapacity and unprofitable investments. Unable to generate cash to service their loans, they have to turn to the shadow-banking sector for credit and avoid default. The result is an explosive growth of the size of the shadow-banking sector (now conservatively estimated to account for 20-30 percent of GDP).

Understandably, the PBOC does not look upon the shadow banking sector favorably. Since shadow-banking sector gets its short-term liquidity mainly through interbanking loans, the PBOC thought that it could put a painful squeeze on this sector through reducing liquidity. Apparently, the PBOC underestimated the effects of its measure. Largely because Chinese borrowers tend to cross-guarantee each other’s debt, squeezing even a relatively small number of borrowers could produce a cascade of default. The reaction in the credit market was thus almost instant and frightening. Borrowers facing imminent default are willing to borrow at any rate while banks with money are unwilling to loan it out no matter how attractive the terms are.

Should this situation continue, China’s real economy would suffer a nasty shock. Chain default would produce a paralyzing effect on economic activities even though there is no run on the banks. Clearly, this is not a prospect the CCP’s top leadership relishes.

So the PBOC’s efforts are merely exacerbating the situation for the worst companies…

China’s Liquidity Bubble Hits A Record: China Banks Issue 50% More Loans Than Fed And BOJ QE Combined | Zero Hedge

China’s Liquidity Bubble Hits A Record: China Banks Issue 50% More Loans Than Fed And BOJ QE Combined | Zero Hedge.

Overnight the PBOC released the latest Chinese bank loan and liquidity data for the month of January. Those who have been following our recent series on Chinese liquidity injections will know that when it comes to the real source of global liquidity, it is China that is the true unprecedented juggernaut, putting both the Fed and the BOJ’s puny QE programs to shame (see “Chart Of The Day: How China’s Stunning $15 Trillion In New Liquidity Blew Bernanke’s QE Out Of The Water“, “Some Stunning Perspective: China Money Creation Blows US And Japan Out Of The Water“). And January’s data was simply the final exclamation mark in a decade-long series in which China’s prosperity has been simply the result of an exponentially increasing amount of loan and liquidity creation by the Chinese semi-national and government backstopped financial system.

Here are the numbers:

Total Chinese loan creation in January was CNY 1.32 trillion, or $218 billion. While January traditionally sees a pick up in loan creation (and demand), the 174% increase in bank loans from December was an unprecedented number, was above the CNY 1.1 trillion, and CNY 250 billion more than a year ago. More notably, this was the largest monthly bank loan injection since January 2010. The last time China scrambled to inject massive amounts of bank loans was in late 2008 and early 2009 when the world was ending, and it was China’s money that stabilized the global financial system far more so than the Fed’s whose QE 1 did not begin in earnest until March 2009.

The far broader monetary aggregate, Total Social Financing, which is the most encompassing calculation of credit and liquidity created in China in any one month, rose to CNY 2.58 trillion. This was more than double the December’s $1.23 trillion, and beat last January’s CNY 2.545 trillion. In fact, this month’s broad liquidity creation was the largest monthly amount in China’s history!

 

Here is what Reuters had to say about the overnight data:

January’s lending surge aside, China’s central bank has consistently signaled in recent months that it wants to temper credit growth to slow a rapid rise in debt levels across the economy.

 

It has focused in particular on keeping short-term interest rates elevated to force banks to stop lending to speculators or high-risk borrowers.

 

Analysts polled by Reuters in January said they expect China’s economy to grow 7.4 per cent this year, an enviable performance for a major economy, but still the worst for China in 14 years. The economy grew 7.7 per cent last year.

Here’s the problem: one can’t put the January lending surge aside, as it came at a time when for the second time in six months the PBOC tried to taper, only to be forced to not only bail out its money markets, but is on the verge of a bankruptcy tsunami involving its shadow banking products, the first of which it also bailed out despite repeated warnings this time it means business and would let it die. In this context, the January number is precisely what it appears: the bank’s logical response to a liquidity crunch as the Chinese regime finds itself in the same spot that the Fed has been in for the past 5 years – it must keep the monetary spice flowing, or else the party is over. And just like the Fed, and now the BOJ, so too does China not want to deal with the fall out if all it takes to created yet another quarter of increasingly subpar economic growth is another record of funny money conceived out of thin air.

The only problem is that it is becoming increasingly difficult to hide all the pieces of funny money, most of which result in bad and otherwise impaired loans, under the rug. And just to show the problem in its context, here is how China’s banks created some 50% more in bank loans in January than the QE credit money created by both the Fed and the BOJ combined.

And finally, here is China’s nearly half a trillion in total liquidity added to the system in just one month (some deleveraging, right?) looks compared to the Fed and the BOJ’s much maligned and unprecedented uncovnentional monetary policy.

Chinese Capital Markets Frozen As Bad Loans Soar To Highest Since Crisis | Zero Hedge

Chinese Capital Markets Frozen As Bad Loans Soar To Highest Since Crisis | Zero Hedge.

Chinese capital markets are quietly turmoiling as debt issues are delayed and demand for “Trust” products – the shadow-banking-system’s wealth management ‘investments’ – is tumbling. AsNikkei reports, since January, 9 companies have postponed or canceled issuance plans (around $1 billion) and is most pronounced in privately-owned companies (who lack an implicit government guarantee). This, of course, is exactly what the PBOC wanted (to instill some fear into these high-yield investors – demand – and thus slow the supply of credit to the riskiest over-capacity compenies) but as non-performing loans in China surge to post-crisis highs, fear remains prescient that they will be unable to “contain” the problem once real defaults begin (as opposed to ‘delays of payment’ that we have seen so far).

Via Bloomberg,

Chinese banks’ bad loans increased for the ninth straight quarter to the highest level since the 2008 financial crisis, highlighting pressures on asset quality and profit growth as the world’s second-largest economy slows.

Non-performing loans rose by 28.5 billion yuan ($4.7 billion) in the last quarter of 2013 to 592.1 billion yuan, the highest since September 2008, the China Banking Regulatory Commission said in a statement on its website yesterday.

Chinese banks are struggling to keep soured loans in check and extend earnings growth as the slowing economy and government efforts to curb shadow financing make it harder for borrowers to repay debt.

“China’s economic growth turned downward with the new leadership switching policy focus to reform and risk management from emphasizing stable expansion,” said Wang Yichuan, a Wuhan-based analyst at Changjiang Securities Co. “Naturally the bad loans will increase along with the change. We expect the deterioration to continue for two more years.”

Chinese banks added 89 trillion yuan of assets, mostly through loans, in the past five years, equivalent to the entire U.S. banking industry’s, CBRC data show. By comparison, U.S. commercial banks held $14.6 trillion of assets at the end of September, according to the Federal Deposit Insurance Corp.

Investors are increasingly concerned that China’s investment through borrowing since 2008 may trigger a financial crisis

Via Nikkei,

Concerns over potential defaults on high-yield financial products are making Chinese companies put some debt issues on hold due to wary investors, as well as posing a potential new risk to the global economy.

Since January, nine companies have postponed or canceled issuance plans for a total of 5.75 billion yuan ($948.24 million) in bonds and commercial paper, equivalent to about 2% of the debt issued over the period.

This is most pronounced among privately operated companies, whose lack of government backing has meant less interest from potential investors than hoped.

Demand has been dulled by worries over defaults on so-called wealth management products, a feature of China’s shadow banking system.

Broader credit risks have driven interest rates up, and the gap between corporate debt and more-creditworthy government bonds is widening. Average yields on AA-rated seven-year corporate bonds reached 8.44% in mid-January.

So even if companies offer bonds, they will be unable to raise money if they cannot pay these higher rates.

“There’s a possibility that the Chinese government will step in to keep the negative impact from spreading,” says Hiromichi Tamura, chief strategist at Nomura Securities, “but if these types of repayment delays continue, they could trigger a global stock market downturn.”

It Begins… Another High-Yield Chinese Shadow Banking Trust Defaults | Zero Hedge

It Begins… Another High-Yield Chinese Shadow Banking Trust Defaults | Zero Hedge.

While the eyes of the world were focused on the now infamous “Credit Equals Gold #1” Chinese wealth management product – it’s imminent default and last-minute bailout by ‘investors’ unknown – thecoal industry in China continued to collapse (as we noted here). We noted at the time how bailing out current high-yield product investors would merely amplify the problems down the line and it seems that Chinese authorities have heard that message. As Reuters reports, a high-yield investment product backed by a loan to a debt-ridden coal company failed to repay investors when it matured last Friday, state media reported on Wednesday.

Via Reuters,

A high-yield investment product backed by a loan to a debt-ridden coal company failed to repay investors when it matured last Friday, state media reported on Wednesday, in the latest sign of financial stress in China’s shadow bank sector.

It matured on Feb. 7, but CCB passed on an announcement from Jilin Trust saying ‘We currently can’t be certain when (Liansheng) funds will be returned,'” the official Shanghai Securities News quoted an unnamed investor in the trust product as saying.

Though the maturity date has already passed, producing a technical default, Jilin Trust appears to be working to recover investor funds.

“Restructuring isn’t bankruptcy. As far as we know, there is no problem with the firm’s assets. The firm is in negotiations with investors,” the paper quoted an unnamed Jilin Trust official as saying.

Backed by China’s 2nd largest lender China Construction Bank (note we discussed the largest shadow-bank here), the product is as follows:

The fourth tranche of Jilin Trust’s product is name “Songhua River #77 Shanxi Opulent Blessing Project” raised 289 million yuan from investors in February 2012, promising a 9.8% yield – we will see if this technical default results in actual losses for investors.

backed by a coal-industry loan to Shanxi Liansheng Energy Co Ltd…

Shares of China’s biggest listed coal producers have dropped to their lowest valuations on record as falling fuel prices make it harder to repay debt.

China’s coal industry is “dead,” said Laban Yu, a Jefferies Group LLC analyst in Hong Kong with an underperform rating on all three stocks. “There are 10,000 producers in China. A lot of them are taking on debt. It gets harder and harder to service debts when coal prices keep falling.

and the risk of more defaults is not going away – in fact will onkly get worse in the next 3 months!!

For those who have forgotten, below is a quick schematic of what a WMP looks like:

As Michael PettisJim ChanosZero Hedge (numerous times), and now George Soros have explained. Simply put –

“There is an unresolved self-contradiction in China’s current policies: restarting the furnaces also reignites exponential debt growth, which cannot be sustained for much longer than a couple of years.”

The “eerie resemblances” – as Soros previously noted – to the US in 2008 have profound consequences for China and the world – nowhere is that more dangerously exposed (just as in the US) than in the Chinese shadow banking sector as explained above.

The bottom-line is that China seems to be testing the reaction of markets to small ‘technical’ defaults (such as this one)…

Technical defaults caused by repayment delays have occurred before, but market watchers say that China’s shadow bank sector is still waiting for a precedent-setting default in which investors are forced to absorb substantial losses.

Such an event could shatter the widespread assumption that even high-yielding investments carry an implicit guarantee from state banks. But Jilin Trust is apparently still looking for ways to recover investors’ funds.

The question is – doe s the PBOC really think that desparate borrowers will stop borrowing – and contract the size of the shadow-banking system reining in the out of control credit creation (and its subprime-like consequences)…

As we previously noted,

…borrowers are facing rising pressures for loan repayments in an environment of overcapacity and unprofitable investments. Unable to generate cash to service their loans, they have to turn to the shadow-banking sector for credit and avoid default. The result is an explosive growth of the size of the shadow-banking sector (now conservatively estimated to account for 20-30 percent of GDP).

Understandably, the PBOC does not look upon the shadow banking sector favorably. Since shadow-banking sector gets its short-term liquidity mainly through interbanking loans, the PBOC thought that it could put a painful squeeze on this sector through reducing liquidity. Apparently, the PBOC underestimated the effects of its measure. Largely because Chinese borrowers tend to cross-guarantee each other’s debt, squeezing even a relatively small number of borrowers could produce a cascade of default. The reaction in the credit market was thus almost instant and frightening. Borrowers facing imminent default are willing to borrow at any rate while banks with money are unwilling to loan it out no matter how attractive the terms are.

Should this situation continue, China’s real economy would suffer a nasty shock. Chain default would produce a paralyzing effect on economic activities even though there is no run on the banks. Clearly, this is not a prospect the CCP’s top leadership relishes.

So the PBOC’s efforts are merely exacerbating the situation for the worst companies…

However, this just hit the wire…

  • *CHINA BANS BOND TRADE BETWEEN PROPRIETARY, WMP ACCOUNTS

Which sounds ominously like the PBOC won;t allow banks to bail their own WMP investors out and take the risky crap back on their off-balance-sheet books… i.e. The PBOC wants real defaults… not ‘technical’ defaults

How Dangerous Is China’s Credit Bubble for the World? |

How Dangerous Is China’s Credit Bubble for the World? |.

February 7, 2014 | Author 

Global Meltdown Predicted by Charlene Chu

Following on the heels of a report that appeared in the Telegraph on the topic, William Pesek at Bloomberg has recently also written an article about Charlene Chu (formerly with Fitch, nowadays with private firm Autonomous Research) and her opinions on China’s shadow banking system and the dangers it represents. The article is ominously entitled “China, the Death Star of Emerging Markets”. 

China has recently made unwelcome headlines, as one of the shadow banking system’s countless ‘wealth management trusts’ which was evidently invested in a bankrupt venture (in this case in a coal company – reportedly a great many such investments in insolvent coal mines exist) was about to go belly-up and then was bailed out at the last minute. Here is a recent article by Mish on the trust that was ironically named “Credit Equals Gold Number 1”. At first it was reported that the trust wouldn’t be bailed out, but in the end its 700 investors were able to ‘breathe a sigh of relief’ as Tom Holland remarked in the South China Morning Post (SCMP). However, Holland also cautioned  that by bailing out this trust, China has laid the foundations for a much bigger crisis down the road, as moral hazard has increased considerably as a result.

 


 

shadow banking chinaThe size of shadow-bank lending relative to China’s GDP, via the SCMP

 


 

 

 

 

Interestingly, Holland actually disagrees on a major point with Charlene Chu and Pesek. Let us first look at what Pesek writes:

 

“On any list of banking accidents waiting to happen, China is assured a place at the very top. But could a crash there take the entire global economy down with it? Absolutely, says Charlene Chu, who until recently was Fitch’s headline-generating analyst in Beijing. Chu has fearlessly trod into an area that China is trying desperately to keep off limits: its vast shadow-banking system. Now that she’s working for a private firm that doesn’t have to rely to governments for revenue, as do rating companies, Chu is free to speak completely openly. And is she ever.

“The banking sector has extended $14 trillion to $15 trillion in the span of five years,” Chu, who is now with Autonomous Research, told the Telegraph. “There’s no way that we are not going to have massive problems in China.” What’s more, she added, China “could trigger global meltdown.”

The travails of Greece continue to preoccupy the world, but its $249 billion economy is a rounding error compared to China’s $8.2 trillion one. In December 2005, for example, China announced its output had unexpectedly grown by $285 billion. In other words, it had suddenly found an economy bigger than Singapore’s that its statisticians hadn’t known about. Today, simply put, a Chinese crash would make the 2008 collapse of Lehman Brothers seem like a mere market correction.

The kind of meltdown Chu suggests is possible would end Japan’s revival, slam economies from South Korea to Vietnam, savage stock and commodity prices everywhere, force the Federal Reserve to end its tapering process and prompt emergency national-security briefings in Washington. So feel free to obsess over Turkey and Argentina, but the real “wild card” is the world’s second-biggest economy.”

 

(emphasis added)

As noted above, that certainly sounds quite ominous.

 

Opinions Differ …

Not so fast, says Tom Holland. While agreeing that China will eventually face a credit crisis and quite possibly a severe economic downturn, he points to the fact that the closed capital account and China’s vast foreign reserves make a ‘global contagion’ event of such enormous magnitude unlikely. This particular scare story he avers, is not something to worry about, which he inter alia tries to buttress by comparing China’s situation to Indonesia’s prior to the Asian crisis. Below are a few relevant excerpts from his article:

 

“As a headline, it was certainly eye-catching. “Currency crisis at Chinese banks could trigger global meltdown,” declared a story in the Sunday edition of London’s Daily Telegraph. The article noted nervously that foreign currency borrowing by Chinese companies has almost quadrupled in just four years to more than US$1 trillion.Any substantial appreciation of the US dollar – and many analysts are indeed expecting gains this year – could open up a dangerous cross-currency mismatch, forcing Chinese borrowers to default and inflicting shattering losses on international lenders, the story warned.

[…]

The chance that China will suffer a currency crisis at any time in the foreseeable future is precisely zero. And even if the country were struck by crisis, there would be no danger of a global financial meltdown. It is certainly true that China’s foreign liabilities have grown rapidly in recent years; a quadrupling since 2009 is about right. But, if anything, the Telegraph’s figure of US$1 trillion is rather too modest. According to Beijing’s State Administration of Foreign Exchange, at the end of 2013 China had foreign liabilities of a thumping US$3.85 trillion; roughly 40 per cent of its gross domestic product.

But the lion’s share of those liabilities – some US$2.32 trillion – consists of highly illiquid inward foreign direct investment. That money is staying where it is. On top of that, a further US$374 billion is foreign portfolio investment in China’s stock and bond markets. That’s money that has flowed in under Beijing’s qualified foreign institutional investor program, whose rules impose strict limits on the size and frequency of repatriation payments. However, that still leaves around US$1.15 trillion in short-term foreign liabilities, consisting largely of loans from international banks.

[…]

In 2014, China has no such problems [compared to Indonesia prior to the Asian crisis, ed.] . External debt is small relative to GDP. And with US$3.82 trillion in foreign reserves at the end of last year, Beijing can cover China’s near-term foreign liabilities more than three times over. Sure, the shrinkage of the central bank’s balance sheet were it actually forced to sell assets in order to fund the country’s external liabilities would inflict a painful monetary tightening on China’s domestic economy.

But with Beijing sitting on such a large pot of foreign reserves, such an extreme crisis is hardly likely. And even if it did happen, there would be no “global meltdown”. Despite the opening of recent years, Beijing’s controls on the free flow of capital mean China’s financial sector remains relatively closed, and the exposure of the global financial system to the country is low.

That’s not to say there wouldn’t be casualties from a sudden strengthening of the US dollar against the yuan, or from a marked slowdown in China’s domestic economy. At the end of October last year Hong Kong’s banking system was owed US$300 billion by mainland banks and another US$100 billion by mainland companies. Clearly the local pain would be intense. But a Chinese currency crisis triggering global meltdown? Happily not.”

 

(emphasis added)

Readers may recall that we have also recently mentioned the exposure of Hong Kong’s banks to Mainland China. We believe Mr. Holland is correct in one sense, but we also think he underestimates the contagion potential.

 

Contagion Through Many Different Channels

It is true that China’s closed capital account as well as the government’s tight control over the financial system makes China’s situation fundamentally different from that of countries with open capital accounts from whence foreign investors can at anytime flee in droves if they get cold feet over an overextended bubble.

In fact, we have  pointed out in the past that the great degree of central control over the economy (and especially the banking system) which China’s government enjoys makes it inherently more difficult to time a putative demise of the credit bubble than elsewhere – and such things aren’t easy to time to begin with.

However, a sharp decline in the yuan’s exchange rate may be seen as necessary by China’s leadership if a crisis threatens social stability (and with it the party’s rule) in China. China has already devalued a great deal on one occasion (in 1994), an event that in hindsight seems to have precipitated a chain reaction (first the yen followed the yuan lower, and then the currency pegs in various ‘Asian Tiger’ economies went overboard).

Today, China is a far bigger player in the world economy than in 1994, and we believe that Mr. Holland underestimates how today’s economic and financial interconnectedness may produce contagion effects even in light of the closed capital account and China’s large reserves. We also don’t necessarily regard  the exposure of Hong Kong’s banks as a de facto ‘internal affair’, as the territory is outside of the ambit of China’s capital controls and the yuan. It is not only Hong Kong’s banking system that one must worry about though. Consider what would happen if China were indeed forced to draw down its reserves to serve the $1.5 trillion in short term foreign liabilities, or a sizable chunk thereof. Given that this would inevitably result in a much tighter domestic monetary policy (provided the PBoC doesn’t take inflationary measures independent of its forex reserves), all sorts of malinvestments in China would be revealed as unsustainable. A number of industries would be faced with a major bust, and it is a good bet that commodity imports would plunge.

However, once that happens, one must immediately begin to worry about Australia’s banks, which have financed a giant housing bubble  on the back of the country’s commodities boom and in turn rely greatly on short term foreign funding. So there would immediately be a crisis in both Hong Kong’s and Australia’s banking systems, and it does not take a great leap of the imagination to see how contagion could spread further from them. Naturally many other raw materials exporting countries would also be hit hard, we mainly picked Australia as an example because its banks are so reliant on short term foreign funding, so they would presumably be among the first in line.

Lastly, here is a recent chart of NPLs in China’s official banking system (listed banks only, i.e. the biggest ones):

 


 

Statistic_id235732_non-performing-loan-npl-ratio-of-chinas-listed-banks-2012NPLs at China’s biggest banks – this looks good! In fact, it looks too good – click to enlarge.

 


 

As can be seen, NPLs at the major banks have declined to a negligible percentage (compare this with crisis-stricken Spain’s near 13% or so NPL ratio, which is understated to boot). However, there are plenty of credible rumors that China’s banks are keeping loans that would normally be regarded as dubious alive by all sorts of tricks. Not only that, they are definitely backing a great many of the ‘shadow banking’ businesses, which have developed in China mainly in order to circumvent  restrictions on banking activities.

In view of everything that is known about credit growth in China, we would regard this extremely low NPL ratio as a contrary indicator even if it were credible.

 

Conclusion:

No-one knows for sure how big a problem China’s economy will eventually face due to the massive credit and money supply growth that has occurred in recent years and no-one know when exactly it will happen either. There have been many dire predictions over the years, but so far none have come true. And yet, it is clear that there is a looming problem of considerable magnitude that won’t simply go away painlessly. The greatest credit excesses have been built up after 2008, which suggests that there can be no comfort in the knowledge that ‘nothing has happened yet’. Given China’s importance to the global economy, it seems impossible for this not to have grave consequences for the rest of the world, in spite of China’s peculiar attributes in terms of government control over the economy and the closed capital account.

 


 

ShanghaiShanghai’s A-share index (which is heavily weighed toward banks) continues to wallow near its lows of the past several years – click to enlarge.

 


 

Addendum:

The BIS is currently ‘warning regulators and governments’ about excessive borrowing and shifts in borrowing patterns by emerging market-based companies.

Why, thanks boys for this timely intercession! What would we do without you?

 

 

Charts by: SCMP and Forbes / Pricewaterhouse-Coopers, BigCharts

A Walk-Thru The First Shadow Bank Run… 250 Year Ago | Zero Hedge

A Walk-Thru The First Shadow Bank Run… 250 Year Ago | Zero Hedge.

Plain vanilla bank runs are as old as fractional reserve banking itself, and usually happen just before or during an economic and financial collapse, when all trust (i.e. credit) in counterparties disappears and it is every man, woman and child, and what meager savings they may have, for themselves. However, when it comes to shadow bank runs, which take place when institutions are so mismatched in interest, credit and/or maturity exposure that something just snaps as it did in the hours after the Lehman collapse, that due to the sheer size of their funding exposure that they promptly grind the system to a halt even before conventional banks can open their doors to the general public, the conventional wisdom is that this is a novel development (and one which is largely misunderstood). It isn’t.

As the NY Fed’s blog (whose historical narratives are far more informative and accurate than its attempts to “explain away” the labor force participation collapse) recounts, the first tremor in the shadow banking system took place not in 2008 but some 250 years ago… during the Commercial Credit crisis of 1763, whose analog today is the all too shaky and largely unregulated core shadow banking system component: Tri-Party Repo.

From the NY Fed blog, by James Narron and David Skeie:

Crisis Chronicles: The Commercial Credit Crisis of 1763 and Today’s Tri-Party Repo Market

During the economic boom and credit expansion that followed the Seven Years’ War (1756-63), Berlin was the equivalent of an emerging market, Amsterdam’s merchant bankers were the primary sources of credit, and the Hamburg banking houses served as intermediaries between the two. But some Amsterdam merchant bankers were leveraged far beyond their capacity. When a speculative grain deal went bad, the banks discovered that there were limits to how much risk could be effectively hedged. In this issue of Crisis Chronicles, we review how “fire sales” drove systemic risk in funding markets some 250 years ago and explain why this could still happen in today’s tri-party repo market.

Early Credit Wrappers

One of the primary financial credit instruments of the 1760s was the bill of exchange—essentially a written order to pay a fixed sum of money at a future date. Early forms of bills of exchange date back to eighth-century China; the instrument was later adopted by Arab merchants to facilitate trade, and then spread throughout Europe. Bills of exchange were originally designed as short-term contracts but gradually became heavily used for long-term borrowing. They were typically rolled over and became de facto short-term loans to finance longer-term projects, creating a classic balance sheet maturity mismatch. At that time, bills of exchange could be re-sold, with each seller serving as a signatory to the bill and, by implication, insuring the buyer of the bill against default. This practice prevented the circulation of low-credit-quality bills among market participants and created a kind of “credit wrapper”—a guarantee for the specific loan—by making all signatories jointly liable for a particular bill. In addition, low acceptance fees—the fees paid to market participants for taking on the obligation to pay the bill of exchange—implied a perceived negligible risk. But the practice also resulted in binding market participants together through their balance sheets: one bank might have a receivable asset and a payable liability for the same bill of exchange, even when no goods were traded. By the end of the Seven Years’ War in 1763, high leverage and balance sheet interconnectedness left merchant bankers highly vulnerable to any slowdown in credit availability.

Tight Credit Markets Lead to Distressed Sales

Merchant bankers believed that their balance sheet growth and leverage were hedged through offsetting claims and liabilities. And while some of the more conservative Dutch bankers were cautious in growing their wartime business, others expanded quickly. One of the faster growing merchant banks belonged to the de Neufville brothers, who speculated in depreciating currencies and endorsed a large number of bills of exchange. Noting their success (if only in the short term), other merchant bankers followed suit. The crisis was triggered when the brothers entered into a speculative deal to buy grain from the Russian army as it left Poland. But with the war’s end, previously elevated grain prices collapsed by more than 75 percent, and the price decline began to depress other prices. As asset prices fell, it became increasingly difficult to get new loans to roll over existing debt. Tight credit markets led to distressed sales and further price declines. As credit markets dried up, merchant bankers began to suffer direct losses when their counterparties went bankrupt.

The crisis came to a head in Amsterdam in late July 1763 when the banking houses of Aron Joseph & Co and de Neufville failed, despite a collective action to save them. Their failure caused the de Neufville house’s creditors around Amsterdam to default. Two weeks later, Hamburg saw a wave of bank collapses, which in turn led to a new wave of failures in Amsterdam and pressure in Berlin. In all, there were more than 100 bank failures, mostly in Hamburg.

An Early Crisis-Driven Bailout

The commercial crisis in Berlin was severe, with the manufacturer, merchant, and banker Johann Ernst Gotzkowsky at the center. Gotzkowsky’s liabilities were almost all in bills of exchange, while almost all his assets were in fixed capital divided among his silk works and porcelain factory. Berlin was able to mitigate the effects of the crisis when Crown Prince Frederick imposed a payments standstill for several firms. To prevent contagion, the prince also organized some of the first financial-crisis-driven bailouts after he examined the books of Gotzkowsky’s diverse operations. Ultimately, about half of Gotzkowsky’s creditors accepted 50 cents on the dollar for outstanding debts.

Meanwhile, banks in Hamburg and the Exchange Bank of Amsterdam tried to extend securitized loans to deflect the crisis. But existing lending provisions restricted the ratio of bank money to gold and silver such that the banks had no real power to expand credit. These healthy banks were legally limited in their ability to support the credit-constrained banks. To preserve cash on hand, Hamburg and Amsterdam banks were slow to honor bills of exchange, eventually honoring them only after pressure from Berlin. The fact that Amsterdam and Hamburg banks re-opened within the year—and some even within weeks—provides evidence that the crisis was one of liquidity and not fundamental insolvency.

The crisis led to a period of falling industrial production and credit stagnation in northern Europe, with the recession being both deep and long-lasting in Prussia. These developments prompted a second wave of bankruptcies in 1766.

Distressed Fire Sales and the Tri-Party Repo Market

From this crisis we learn that it is difficult for firms to hedge losses when market risk and credit risk are highly correlated and aggregate risk remains. In this case, as asset prices fell during a time of distressed “fire sales,” asset prices became more correlated, further exacerbating downward price movement. When one firm moved to shore up its balance sheet by selling distressed assets, that put downward pressure on other, interconnected balance sheets. The liquidity risk was heightened further because most firms were highly leveraged. Those that had liquidity guarded it, creating a self-fulfilling flight to liquidity.

As we saw during the recent financial crisis, the tri-party repo market was overly reliant on massive extensions of intraday credit, driven by the timing between the daily unwind and renewal of repo transactions. Estimates suggest that by 2007, the repo market had grown to $10 trillion—the same order of magnitude as the total assets in the U.S. commercial banking sector—and intraday credit to any particular broker/dealer might approach $100 billion. And as in the commercial crisis of 1763, risk was underpriced with low repo “haircuts”—a haircut being a demand by a depositor for collateral valued higher than the value of the deposit.

Much of the work to address intraday credit risk in the repo market will be complete by year-end 2014, when intraday credit will have been reduced from 100 percent to about 10 percent. But as New York Fed President William C. Dudley noted in his recent introductory remarks at the conference “Fire Sales” as a Driver of Systemic Risk, “current reforms do not address the risk that a dealer’s loss of access to tri-party repo funding could precipitate destabilizing asset fire sales.” For example, in a time of market stress, when margin calls and mark-to-market losses constrain liquidity, firms are forced to deleverage. As recently pointed out by our New York Fed colleagues, deleveraging could impact other market participants and market sectors in current times, just as it did in 1763.

Crown Prince Frederick provided a short-term solution in 1763, but as we’ll see in upcoming posts, credit crises persisted. As we look toward a tri-party repo market structure that is more resilient to “destabilizing asset fire sales” and that prices risk more accurately, we ask, can industry provide the leadership needed to ensure that credit crises don’t persist? Or will regulators need to step in and play a firmer role to discipline dealers that borrow short-term from money market fund lenders and draw on the intraday credit provided by clearing banks? Tell us what you think.

* * *

Fast forward to today when we find that the total collateral value in the Tri-Party repo system as of December amounts to $1.6 trillion.

… or 10% of US GDP. What can possibly go wrong.

Marc Faber Fears “A Vicious Circle To The Downside” Is Just Beginning | Zero Hedge

Marc Faber Fears “A Vicious Circle To The Downside” Is Just Beginning | Zero Hedge.

It’s not just tapering that is putting pressure on markets,” Marc Faber warns in thie brief clip. “Emerging economies have practically no growth and we have a slowdown in China that is more meaningful than strategists are willing to believe,” he adds and this is “causing a vicious circle to the downside” in inflated asset markets as most of the growth in the world over the last five years has come from emerging markets. Faber suggests Treasuries as a safe haven in the short-term; but is nervous of their value in the long-term as “debt is becoming burdensome on the system.”

“A lot of economic growth was driven by soaring asset prices”

 

On Treasuries:

For the next three to six months probably they are a better place to be than equities,”

 

I don’t like [10-year Treasurys] for the long-term because the maximum you can earn is something like 2.65 percent per annum for the next 10 years, but Treasurys are expected to rally because of economic weakness and a stock market decline. In the last few years at least there was a flight into quality – that is, a flight into Treasurys.”

On China and shadow banking defaults:

China can handle it by printing money but it will again have unintended negative consequences… but the

problem is real… but it’s not just in China…”

Faber warned of the risks of the present global credit bubble and said another slowdown could follow on the back of rising consumer debt levels – which had previously helped to create growth.

Total credit as a percent of the global economy is now 30 percent higher than it was at the start of the economic crisis in 2007, we have had rapidly escalating household debt especially in emerging economies and resource economies like Canada and Australia and we have come to a point where household debt has become burdensome on the system—that is, where an economic slowdown follows.”

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