PBOC Sacrifices Growth as Bank Curbs Invert Swaps

China’s interest-rate traders are the most pessimistic on economic growth in 21 months, as Fitch Ratings says policy makers are focused on fixing the nation’s banks to avert an industry crisis.

The five-year interest-rate swap, which exchanges fixed payments for the floating seven-day repurchase rate, was 42 basis points below the one-year rate as of 4:54 p.m. in Shanghai, the biggest discount since September 2011, data compiled by Bloomberg show. The shorter contract jumped 38 basis points today to 4.4 percent after the finance ministry’s 10-year bond sale drew the lowest bid-to-cover ratio since August 2012.

“The PBOC is doing the opposite of what the banks were hoping it would do,” said Ju Wang, a senior strategist at HSBC Holdings Plc in Hong Kong. “It is focusing on cleaning up the banks’ balance sheets and the financial system in spite of the liquidity squeeze.”

An inverted swap curve is a further sign of waning confidence about the prospects for the world’s second-largest economy, after Goldman Sachs Group Inc., Morgan Stanley and UBS AG cut their 2013 growth forecasts. A report yesterday showed property prices are defying government lending curbs and Fitch said the cash shortage reflects a crackdown on shadow banking that will slow expansion.

“We are going to have banking sector problems,” Charlene Chu, Fitch’s head of China financial institutions, said in a Bloomberg Television interview in Hong Kong yesterday. “Those can manifest either in a crisis or they can manifest in slow growth.”

Money Rate

China’s seven-day repurchase rate, a gauge of interbank funding availability, has averaged 6.2 percent in June, the most since the National Interbank Funding Center began compiling a weighted average in 2006. The one-year swap rate rose the most since June 2008. HSBC expects the swap curve to stay inverted until the end of July.

A slowdown in capital inflows has contributed to the cash shortage. Yuan positions at local financial institutions accumulated from sales of foreign exchange, an indication of capital flows into China, rose 66.86 billion yuan in May, the central bank reported on June 14. That was the smallest gain since November.

Failed Auctions

The cash crunch led to failures of debt auctions by the Ministry of Finance and the Agricultural Development Bank of China this month. The central bank added a net 92 billion yuan to the financial system last week, down from 160 billion yuan in the five days through June 6, Bloomberg data show. The PBOC has refrained from using reverse-repurchase agreements to inject funds since Feb. 7.

That has boosted borrowing costs for Chinese companies, with three-month AAA commercial paper rates increasing 102 basis points this month to 4.92 percent, according to Chinabond data.

Regulators are forcing trust funds and wealth management plans to shift assets into publicly traded securities, taking so-called shadow banking funds away from property developers and local-government finance vehicles. The China Banking Regulatory Commission told banks in March to cap investments of client money in debt that isn’t publicly traded at 35 percent of all funds raised from the sale of wealth management products.

Shadow Banks

Fitch’s Chu said shadow banks had thwarted efforts to cool the economy. The increase in money supply has exceeded the government’s 13 percent target every month this year, rising 15.8 percent in May. Aggregate financing, a measure of credit that includes trust loans, stock and bond sales, totaled 9.1 trillion yuan in the last five months, a 50 percent jump from the first five months of 2012.

The cash crunch is “emblematic of some of the shadow banking issues coming to the fore as well as some of the tight liquidity associated with wealth management product issuance, and the crackdown on some shadow channels,” said Chu.

The cost of insuring sovereign notes in China against non-payment jumped 17 basis points since the end of March to 90.5 yesterday, according to data provider CMA, which is owned by McGraw-Hill Cos. and compiles prices quoted by dealers in the privately negotiated market.

Swelling Credit

The size of China’s shadow banking industry may have started to shrink following the curbs, with official data on June 9 showing trust loans fell to 99.2 billion yuan in May. This accounted for 8.4 percent of aggregate financing, down from 16 percent in December.

Chu earlier estimated China’s total credit, including off-balance-sheet loans, swelled to 198 percent of gross domestic product in 2012 from 125 percent four years earlier, exceeding increases in the ratio before banking crises in Japan and South Korea. In Japan, the measure surged 45 percentage points from 1985 to 1990, and in South Korea, it gained 47 percentage points from 1994 to 1998, Fitch said in July 2011.

Domestic government bond markets are showing relatively few signs of stress. Yields for 10-year government debt rose four basis points this month to 3.48 percent, Chinabond data showed. The yuan appreciated 0.1 percent in June and 0.03 percent today to 6.1269 against the dollar, according to the China Foreign Exchange Trade System.

Slowing Growth

PBOC Governor Zhou Xiaochuan said on April 20 that the nation needs to “sacrifice short-term growth” to make reforms in the economy, while new Premier Li Keqiang told German business leaders on May 27 his country is confronted by “huge challenges” as it seeks 7 percent annual growth this decade, down from more than 10 percent in the previous 10 years.

A weak economy, coupled with easing inflation, will give the central bank room to loosen monetary policy, according to Ming Tan, a Hong Kong-based analyst at Jefferies Group Inc.

China’s trade and inflation data for May trailed estimates. Exports rose 1 percent from a year earlier, down from 14.7 percent in April, while imports dropped 0.3 percent. The median estimates of analysts were for 7.4 percent export growth and 6.6 percent import gains. The consumer price index rose 2.1 percent, down from 2.4 percent in April.

“Recent weak macro data and low CPI figures may prompt the central bank to loosen more,” Tan wrote in a research note on June 17. “We believe the PBOC will most likely inject more liquidity through open-market operations.”

Chinese property prices rose at the fastest pace in more than two years in major cities in May, constraining the ability of policy makers to ease credit. New home prices in Beijing, Shanghai and Guangzhou posted the biggest gains since at least January 2011, and 69 of the 70 cities tracked by the government showed increases, the most since August 2011.

“Rising property prices make it difficult for policymakers to loosen monetary policy in the short term,” said Zhang Zhiwei, Hong Kong-based chief China economist at Nomura Holdings Inc., who previously worked at the International Monetary Fund. “We expect the government to continue focusing on containing financial risks in the next month.”

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