Thread by Adam Wolfe

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Everyone is excited about the prospect of China’s reopening. Households have been sitting on a pile of cash and might go out and spend it in the coming months. GDP growth could pop.

Why are financial regulators worried about financial stability then?

Let me explain 1/
As we’ve seen in other countries, China’s household hold savings rate jumped sharply when the pandemic started. It came down a bit in 2021, when it seemed like things were normalizing. But it rose again with this year’s lockdowns 2/
The actual savings rate is probably well below 37% b/c richer households tend to hide their income & spending as corporate transactions. But the trend looks right. We can see this in the PBoC’s depositor survey, too. Desired savings rose in the pandemic. 3/
Where did that money go? Certainly not housing! Nor stocks (at least until last month).
It seems to have mostly gone to bank deposits, money market funds, and wealth management products (WMPs). 4/
This caused an influx of liquidity into China’s money and credit markets. We can see this in repo rates. The 7-day rate is the target of the PBoC’s interest rate corridor, so should stick close to the PBoC’s reverse repo rate. But it had fallen well below that this year 5/
We can see this in terms of repo volume, too. Repo volumes spiked in early 2020, then normalised, then hit new highs this year. That was mostly due to the rise in household savings, which found their way into the money market and pushed down bond yields. 6/
Low repo rates and high repo volumes created some bubbly conditions in China’s credit markets. For example, spreads for corporate bonds that trade in the interbank market hit new lows earlier this year 7/
But the prospect of economic reopening has households feeling better. So they are starting to shift their savings out of longer-term deposits, money market funds, and WMPs. That’s mean repo rates have moved higher, and are now in line with the PBoC’s target 8/
And herein lies the worries about financial stability. First, higher bond yields and spreads will raise corporate borrowing costs. But that’s manageable and should be more than offset by higher revenue growth. 9/
The worry is more like something we saw in the UK bond market. Money market funds are probably OK. But WMPs may be holding illiquid assets or leveraged positions that need to be unwound as clients pull their funds out. 10/
This is particularly worrying right now, b/c of regulatory changes implemented last year. To reduce moral hazard and excess risk-taking, WMPs can no longer guarantee the principle invested by clients. WMPs must be priced on a net asset value basis that is updated regularly. 11/
Moreover, WMPs are marketed based on 5 different risk buckets. R1 are riskless, guaranteed products, but don’t really exist anymore. R5 are extremely risky, high-yield products, and clients should have been informed about the risks before buying 12/
It’s the R2 bucket that is the most worrying. These are low-risk funds that are marketed as usually having no losses. But they usually offer an interest rate above the risk-free rate for the term period for the WMP. 13/
So R2 WMPs are either taking duration risk or credit risk to juice returns for investors, or they’re adding leverage. Not too much, sure. But enough that the rise in recent rise in bond yields means a lot of them now have NAVs below par. 14/
The worry is that households aren’t used to seeing NAV losses. Some WMPs don’t have minimum holding periods. And a lot more have 1-3 month holding periods. 15/
So mark-to-market losses on WMPs could trigger a redemption wave that causes the funds to sell more bonds, causing more WMP redemptions, and more forced selling… you know how this ends. 16/
So do China’s regulators. CBIRC chief Guo Shuqing: “Due to the market's optimism about the prospects of an economic recovery, bond yields have risen, which has caused fluctuations in the net value of some banks' WMPs.” 17/ www.pbc.gov.cn/goutongjiaoliu/113456/113469/4717897/index.html
Guo then said, “the overall risk is completely controllable,” which, of course, is regulator speak for "we are deeply worried about this!" 18/
Those worries explain why the PBoC cut the required reserve ratio for banks, freeing up more liquidity. This chart shows the difference between a 1y interbank borrowing rate and the policy 1y lending rate. The PBoC doesn’t want tight liquidity. 19/
I have no doubt that the PBoC will step in and be the lender of last resort to keep WMP redemptions from blowing up the credit markets. This is not 2013. We won’t see another Shibor crisis. The PBoC knows what’s going on in the money and credit markets this time. 20/
But I have no idea how big a problem this will be. Yet another reason why things are getting really interesting in China! I wrote about this last week for @asr_london clients, and will be tracking the issue closely there. Might be a good time for a trial! www.absolute-strategy.com/
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