In markets where investors are highly leveraged, things tend to happen slowly at first, then fast. China is having one of those moments, and as with the 2008 crisis, it can't be pinned on one event.
On Monday, the Shanghai Composite Index sank 2.5 percent, then extended that decline Tuesday before rebounding to close little changed. The one-year government note yield rose 7 basis points to 2.72 percent, on top of Monday's 15 basis-point increase. The root cause may be banks.
There's clearly a liquidity squeeze on Chinese lenders. Nothing new there: Financial institutions tend to face higher demand for cash in December, and this year that's been exacerbated because Chinese New Year falls early -- the holiday, when many people withdraw deposits to buy gifts and travel, begins Jan. 28.
Perhaps more important, banks also want to boost the deposits they can account for as of Dec. 31, when they close their books. Financial institutions struggled to meet a loan-to-deposit ratio ceiling of 75 percent, and that cap was scrapped in June. None of the banks wants to show that the amount they lend is completely disconnected from what they have in the coffers, however. Which may explain why short-term deposit rates are far higher than longer-term ones.
In simple terms, this is a seasonal cash crunch. The issue is that this time it's on steroids, because it comes after several months when the People's Bank of China increased short-term rates. This boosted funding costs for wealth-management products and for investors using leverage to buy everything from stocks to bonds to iron ore. As some of the trades begin to offer negative returns, these investors are selling. Curiously, Hong Kong is going through a similar issue because of the impending Federal Reserve rate increase.
Then the vicious circle of leverage begins: Assets being sold drop below agreed levels, triggering margin calls -- or the requirement that someone borrowing money to buy securities post more cash to back up the loan. To meet those calls, investors sell more of their securities, putting further pressure on prices and prompting new margin calls. The slump in Chinese stocks last year was exacerbated by just such a dynamic.
Investors must now hope that China has learned the lesson from that rout and will use its pension funds to steady the market. Otherwise, if this selloff really is the result of a liquidity squeeze, it's unlikely to stop before February, when people return from the holiday.
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