China credit warning
Signs of bank stress internationally
China credit warning
The UK Telegraph newspaper highlighted yesterday a rise in China’s credit to gdp gap, a warning sign that it risked a banking crisis.
The chart showing China well out of kilter is in the Bank of International Settlements’ Quarterly Review, out yesterday after a media briefing on Friday, yet it didn’t warrant special mention from the bank’s own experts.
Telegraph columnist Ambrose Evans-Pritchard wrote: “China has failed to curb excesses in its credit system and faces mounting risks of a full-blown banking crisis, according to early warning indicators released by the world’s top financial watchdog.
A key gauge of credit vulnerability is now 3 times over the danger threshold and has continued to deteriorate, despite pledges by Chinese premier Li Keqiang to wean the economy off debt-driven growth before it is too late.”
The International Monetary Fund warned in June that Chinese debt levels were alarming and “must be addressed immediately”, but Chinese corporate debt alone had reached 171% of gdp.
Nevertheless, China was of less interest in the quarterly review than the UK & Europe. Under the heading, Markets pass Brexit test, the bank noted: “Markets recovered quickly from the shock of the Brexit vote.”
Bank stress evident
Perhaps more important than both China & Brexit at the moment, the Bank of International Settlements’ economic advisor & head of research, Hyun Song Shin, told the media briefing that signs of investor confidence appeared side by side with market anomalies normally associated with stress in financial markets.
“One such anomaly is the breakdown of ‘covered interest parity’ – one of the best established laws in international finance, which states that the interest rate implicit in the foreign exchange market should coincide with interest rates in the money market. This relationship started to break down during the great financial crisis of 2007-09. Since mid-2014, the gap between these 2 measures of the funding cost for the $US has widened further. Market players who borrow dollars in FX markets by pledging yen or euros pay more to borrow dollars than they would on the money market.”
Mr Shin said the violation of covered interest parity raised 3 questions:
- Why has the gap opened up and widened in recent months?
- Why does the gap not disappear through textbook arbitrage, where someone borrows at the low interest rate and lends at the higher interest rate?
- Should we be concerned by this breakdown of a time-honoured textbook rule?
As to why the gap has opened up, the findings in a bank research paper suggested that the divergence of monetary policy across the major advanced economies had played a key role: “Banks, pension funds & life insurance companies from those economies with low or negative rates have sought to pick up yield by purchasing dollar assets. The search for yield has taken on the character of a ‘flight from zero’ as these institutions have compressed US yields, while their attempts to hedge the resulting foreign exchange risk have pushed the basis wider.
“Perhaps more puzzling is why this gap has not closed in the usual way through arbitrage. The persistence of the gap suggests that banks & other financial intermediaries do not have enough capital available to take on such transactions, or at least are putting such a high price on the use of their balance sheet to make the trade uneconomical at these spreads. Since hedge funds or other unregulated entities are also reliant on dealer banks to put on leveraged trades, the banking sector remains the focus of attention.”
Mr Shin said the report in the quarterly review didn’t address the question of whether this gap should raise concern, but some reflections were possible: “The persistent deviation from covered interest parity may not be a concern for policymakers in itself, but policymakers should take note of it as an indicator of the workings of the banking sector. If banks put such a high price on balance sheet capacity when the financial environment is largely tranquil, what will happen when volatility picks up? If they react to resurgent volatility by reducing their intermediation activity, as happened during the 2007-09 crisis, the banking sector may become an amplifier of shocks rather than an absorber of shocks. For this reason, it would be important to keep a close eye on this formerly rather esoteric corner of the foreign exchange market.”
Ambrose Evans-Pritchard in the Telegraph, 18 September 2016: BIS flashes red alert for a banking crisis in China
BIS Quarterly Review
BIS September charts
Research paper: Covered interest parity lost: understanding the cross-currency basis
Attribution: Bank of International Settlements, Telegraph.