China 8217 s shadow banking amp resurging interbank rates

China’s interbank rates are on the rise again and the government isn’t in a hurry to temper them back down. Seven months after we wrote about the Shanghai Interbank Offered Rate (SHIBOR) hitting 6-year highs, rates are it again as China’s shadow banking struggles to meet the rush for  new credit.

Shadow banking emerged as a result of the decline in lending rates relative to savings rates, which eroded state-controlled banks’ profits from the rate spread. Consequently, banks were forced to create high-yield savings vehicles, such as wealth-management products (WMPs) offering high returns and risk, aimed at drawing fresh source of capital. Assets under these high-return funds and trusts have reached $1.7 trillion in Q3 of last year (expected to reach $2 trillion by year-end), benefiting from the lenders and savers’ rising needs. WMPs have now surpassed the more regulated and lower-yielding money- market funds, and are estimated to make up about half of total new funding for the economy.

Local vehicles, global movements

The other source of higher interest rates emerges from local government financing vehicles (LGFVs), as provinces seek to shore up investments and meeting growth targets.  Not only local government liabilities are estimated to have reached around $3 trillion, but the non-performing element is also advancing. Rising interest rates are a natural consequence.

USD-denominated debt

LGFVs are also increasingly borrowing outside the their first USD-denominated debt before exchanging the proceeds to RMB. This new technique seems plausible as long as credit rating is robust and the RMB remains stable against the USD.  This brings to mind the Asian currency crisis, which was exacerbated by local players borrowing in cheaper USD until local currencies turned lower, raising the cost of debt, triggered defaults and turned currency declines into crash. Such is one reason why China’s currency is unlikely to decline in value anytime soon.

The oft-mentioned day of reckoning scenario is when the rise of non-performing loans combines with WMP’s inability to deliver on high returns. One way Chinese authorities are addressing the escalation of debt from LGFVs is by forcing loans to be rolled onto the bond market, which would boost bonds and weigh on rates. But this depends on the effectiveness of recent regulation such as Doc 107.

Another SHIBOR squeeze

Looking at the price of credit, Chinese interbank rates are requiring more action to keep them down. Banks will be forced to satisfy savers’ appetite for yields before regulators are forced to stop the mean-reversion towards event risk. But given regulators’ slow progress, that is unlikely for now, especially that authorities are partly seeking the implications of higher rates on off-balance sheet borrowing. Today’s release of the better than expected China December industrial output figures have reportedly helped boost the damaged Aussie. But recurring ascent in Chinese rates is far from ruled out and so is the ascent of the Aussie above 0.90.