Bond traders in China are rethinking counterparty risks as shock waves from a government takeover of a bank ripple through the country’s financial markets.
It’s now getting harder for corporate bonds to be accepted as collateral for repo financing as lenders increasingly demand top quality bonds such as Chinese sovereign bills and policy bank notes as pledges. Traders are having second thoughts on taking even AAA rated short-term bank debt as security in the wake of last month’s seizure of Baoshang Bank Co.
That’s clogging up funding among China’s financial institutions, which have already caused borrowing costs to spike for brokerages and smaller banks. The timing couldn’t be worse with liquidity generally tight at the quarter-end, and further adds to the wide-ranging ramifications of the bank seizure. All this could mean higher defaults, according to Bloomberg Economics.
“Non-bank financial institutions are actually the biggest buyers of corporate bonds in China, and if their funding chain breaks, demand for bonds, particularly those that can hardly be pledged for borrowing, will certainly get hurt," said David Qu at Bloomberg Economics in Hong Kong. “Weaker companies will suffer a rising cost when selling new bonds, which may eventually lead to higher default risks.”
While China’s financial markets have generally been used to corporate defaults, the first bank seizure by policy makers in more than 20 years has shaken the market assumption of credit risk for the sector.
“Bank failure always causes greater concern given systemic fears," said Owen Gallimore, head of credit strategy at Australia & New Zealand Banking Group, suggesting greater pressure on the private sector ahead.
Authorities announced the Baoshang takeover on May 24, citing credit risks. The central bank later said the seizure was an isolated case, while revealing the move was triggered by a misappropriation of funds by Tomorrow Group. The investment conglomerate is being probed by Chinese officials, according to people familiar with the investigation.
Still, China’s seven-day and 14-day "overall interbank market" pledged repurchase rates, which indicate non-bank institutions’ financing conditions, surged to 15% on Tuesday, a level deemed extremely high, according to traders. The liquidity injections from the central bank in recent weeks have largely benefited large banks, market participants say.
Tight Liquidity
A trader at a Beijing-based brokerage, who asked not to be named as he is not authorized to speak publicly, said its counterparty just tightened the collateral for repo lending to only AAA rated negotiable certificates of deposits -- a type of short-term debt sold by banks -- whereas just a few days ago AA+ rated ones were accepted.
Another trader said most of his counterparties now require government bonds as collateral as it will be very hard for corporate bonds to be accepted as pledge for borrowing.
In China, the funding flow goes like this: big national banks lend to smaller regional lenders, which then provide financing to non-bank peers such as brokerages and funds. They in turn use the money to invest in corporate bonds.
“Smaller banks play a key role in this chain,” said Ming Ming, chief fixed-income analyst of Citic Securities Co. Right now investors are quite "risk averse and everyone wants to mitigate counterparty risks. If things get worse, China’s financial market liquidity could collapse,” he added.
Latest comments