PBOC Opaque Stress Test Catches Funds in Crossfire

China’s lack of transparency during a stress test on the nation’s banks became a cause of worldwide concern as it rocked bond and commodity markets and helped wipe out $4.5 trillion in global equity value.

While the Federal Reserve is signaling plans to pare stimulus that has kept U.S. overnight rates close to zero, the People’s Bank of China made no change to its goal of “prudent” monetary policy as borrowing costs whip-sawed. Chinese overnight rates jumped to a record 12.85 percent on June 20 amid speculation policy makers want to expose banks with mismatched financing and loan maturities. Asian emerging market stocks had their steepest weekly loss in 13 months, while their currencies dropped the most in almost two years.

“Investors globally are in the crossfire when the central bank punishes financial institutions with monetary policy for lending behavior the PBOC should have prevented,” said Andrew Elofson, a Seattle-based senior research analyst at DA Davison & Co., which has more than $34 billion in client assets under management and invests in U.S. shares that benefit from Chinese growth. “Allowing liquidity to dry up to communicate your message strikes us as a dangerous game.”

China’s cabinet, led by Premier Li Keqiang, said last week that finance companies must do more to support economic transformation and reduce risks, after administrative measures to crack down on property prices and local government investments were bypassed by so-called shadow banking activities. While the goal is to limit financial risk, the execution created confusion and panic, Elofson said. Global banks are seeking more timely releases on the PBOC’s open-market operations to all market participants.

Lack of Communication

“Behind the scenes, I can almost guarantee that the level of discussions between the PBOC and bank CEOs was probably quite intense in Beijing over the past few days,” Adrian Zuercher, head of emerging-market strategy at Credit Suisse (Hong Kong) Ltd., part of an asset management unit of Credit Suisse Group AG that oversees $450 billion, said in a June 20 interview. “But we haven’t seen big actions or communications yet. It could go out to the public and should be communicated properly to the financial markets.”

The central bank made no official comment on the changes in rates last week and didn’t respond to faxed questions from Bloomberg News. Yesterday, the PBOC published a statement dated June 17 in which it said there’s a reasonable amount of liquidity in the financial system and that banks should control risks from credit expansion, including those associated with maturity mismatches.

Controllable Risks

China’s liquidity risks are controllable and the central bank will closely monitor rates, Ling Tao, deputy director of the PBOC’s Shanghai branch, said at a briefing in Shanghai today. The PBOC will keep money-market rates at a reasonable level and seasonal forces that have driven them up will fade, the official said.

Speculation and denials filled the vacuum last week. The PBOC used reverse-repurchase agreements to inject funds into designated banks, financial news website Hexun reported June 21, citing a person close to the PBOC. Industrial & Commercial Bank of China Ltd. said later the same day that media reports claiming it received 50 billion yuan ($8.1 billion) of liquidity were “untrue.” Bank of China Ltd. also denied a 21st Century Business Herald report that it missed interbank payments on June 20.

Clear Rules

The PBOC should clearly explain its stance to stabilize market confidence, and provide clear rules so that investors and banks know the target and time period of financial adjustments, Hexun said in a commentary today.

“We need to have more transparency and communication with the financial market,” said Zhang Zhiwei, Hong Kong-based chief China economist at Nomura Holdings Inc. “There are a lot of rumors in the markets, and so even more volatility.”

The yield on China’s 10-year government bonds rose 13 basis points to 3.60 percent last week, while the one-year borrowing cost surged 51 basis points to 3.61 percent, inverting the so-called yield curve for the first time in ChinaBond data going back to 2007.

Currencies to Stocks

The yuan declined 0.4 percent from its 19-year high of 6.1210 per dollar reached on May 27 in Shanghai. It was steady at 6.1453 today. The Bloomberg-JPMorgan Asia Dollar Index slumped 1.2 percent last week, the most since September 2011. The MSCI EM Asia Index of stocks lost 4.4 percent last week, the biggest drop since the five days ended May 18, 2012, helping erode global stock market capitalization from the post-financial crisis peak of $57.98 trillion.

Speculation over the PBOC’s short-term liquidity operations, which are agreed on with large banks and disclosed a month later, helped cut money market rates in the past two days. The one-day repo rate has slid 685 basis points, or 6.85 percentage points, since an all-time high of 12.85 percent June 20, according to a daily fixing announced by the National Interbank Funding Center at 11 a.m. The gauge was 6 percent today, almost double this year’s average of 3.09 percent.

“Having now stepped back in to provide liquidity, perhaps the PBOC has made its point and there will be minimal fallout from the cash squeeze,” DA Davison’s Elofson said in a June 21 e-mail interview. “But investors would be wise to assume more tail risk in China.”

Tone Change

Rates also fell on a change in tone in a statement released yesterday, following a “recent” second-quarter policy meeting in Beijing. For the first time since September the PBOC’s monetary policy committee, led by Governor Zhou Xiaochuan, used the phrase “fine-tune.”

“I can’t see any disadvantage of transparency,” said Wee-Khoon Chong, a strategist at Societe General SA in Hong Kong. “The timing of disclosure of short-term liquidity operations may be shortened compared to the one-month lag now. Even if earlier disclosure might create some market volatility, that should be overshadowed by the benefit of a credible and transparent system.”

Risk is rising in China’s financial system as the shadow banking sector expands and financial institutions make more highly leveraged investments to boost profit, the official Xinhua News Agency said in an analysis published on June 23. 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 surge of 50 percent from the first five months of 2012.

Default Risk

The cost of protecting China’s five-year government debt from default jumped 33 basis points to 127 basis points last week in New York, according to prices from data provider CMA. The gauge climbed to 147 yesterday, the highest since January 2012. The contracts pay the buyer face value in exchange for underlying securities or the cash equivalent if a borrower fails to adhere to its debt agreements.

“I wouldn’t be surprised if they let one of the smaller financial institutions go,” Ayaz Ebrahim, a Hong Kong-based chief investment officer of Asia ex-Japan equities at Amundi Asset Management, which oversees about $1 trillion around the world, said in an interview yesterday. The government is not going to allow any of the big banks to fail, he added.

Bond Sales

The cash squeeze unsettled corporate treasurers and led to a slump in domestic bond sales. Issuance dropped to 175 billion yuan in June, the least in 17 months and down 52 percent from May, data compiled by Bloomberg show. China Development Bank Corp., the nation’s biggest policy lender, scrapped a bond sale planned for today.

“With the credit tightening and uncertainties on monetary policy, we will adjust our financing methods accordingly,” said Zhu Kebing, chief financial officer of Baoshan Iron & Steel Co., China’s biggest publicly traded steelmaker.

China International Capital Corp. cut its 2013 forecast for expansion in Asia’s biggest economy to 7.4 percent from 7.7 percent, while Goldman Sachs Group Inc. lowered its projection to 7.4 percent from 7.8 percent. Growth held below 8 percent for each of the past four quarters, the first time that has happened in at least 20 years, official data show.

“The PBOC’s policy transparency is less than the market has learned to expect from the Fed or ECB, but it is all we are likely to get until China gets closer to a real financial market onshore,” said Marshall Mays, director of Emerging Alpha Advisors in Hong Kong, which advises funds on investments of about $100 million. “There is still more of an outsider disadvantage than in some other markets.”

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