Photographer: Qilai Shen/Bloomberg

China’s Leverage Love Affair Is Tricky to Break, PBOC Finds

  • Continued lending, leverage expansion spurs fresh measures
  • PBOC will be cautious, but it might still be ‘a wild ride’

Reining in China’s record debt binge was never going to be easy. The need for stronger action is becoming clear at China’s financial regulators, with further steps likely thanks to leverage that continues to mount.

First in the line of fire was the bond market, which had its worst month since 2010 in December as officials tightened up liquidity in money markets. This week, smaller banks got caught in the cross hairs as some were said to have missed debt payments amid a surge in interbank rates, spurring an injection of emergency cash from the central bank. And more bond pain is in store after a shift in collateral rules.

“They’re trying to manage an orderly tightening but without causing too much disruption,” Richard Jerram, chief economist at bank of Bank of Singapore Ltd., said in an interview on Bloomberg Radio. “The process is still relatively immature and you are going to have these periods of disruption.”

Results are still pending for policy makers in their campaign to tame a debt pile that’s ballooned to about 264 percent of gross domestic product, according to Bloomberg Intelligence estimates. Racked up in the wake of the global financial crisis as China leveraged its way to a stable growth rate, President Xi Jinping and his lieutenants have made conquering financial risks one of their top priorities this year, with stakes high ahead of a twice-a-decade reshuffle in the Communist Party’s senior ranks.

“We expect the risk of stepped-up deleveraging to be quite real,” said Christy Tan, head of markets strategy and research for Asia at National Australia Bank Ltd. in Hong Kong. “There is higher impetus to deliver some concrete results” at the autumn party gathering, she said. In the stock market, “financials are understandably more susceptible to selling pressure.”

Financial shares have indeed underperformed this week, though the broader benchmark CSI 300 index fared better than other regional markets. One fillip for China has been the still-selective tightening strategy at the People’s Bank of China, which has left benchmark lending rates unchanged. Regulators are instead employing a plethora of at times perplexing tools to stem speculative bets, including the manipulation of money-market liquidity.

Credit Binge

But lending growth continues apace. A gauge of outstanding credit that tracks social finance plus local-government bond issuance expanded by 15.4 percent in February from a year earlier, according to data compiled by Bloomberg Intelligence.

It’s a fine line for the PBOC to walk, as corporate defaults have continued to rise -- there’s been at least eight onshore this year -- and it’s also had to contend with a tightening bias at the U.S. Federal Reserve that could put downward pressure on the yuan. There’s likely to be more defaults this year because debt levels are unsustainable, says James McCormack, global head of sovereign ratings at Fitch Ratings Ltd.

A QuickTake explainer on China’s debt bomb

The PBOC wants to get lenders to feel pressure about cutting leverage, said Ding Shuang, chief China economist at Standard Chartered Plc in Hong Kong. Monday’s squeeze was a warning that “defaults can happen,” and will grow in frequency this year, he said. “It’s something that must happen if China is serious about deleveraging.”

Measures to rein in leverage and rebalance the economy away from a reliance on investment-led growth have been extremely slow, Michael Pettis, professor of finance at the Guanghua School of Management at Peking University in Beijing, said in an interview with Bloomberg Television Thursday.

“At this rate it will take them 10 to 15 years to get to a reasonable level and they clearly don’t have 10 to 15 years,” said Pettis, former head of emerging markets at Bear Stearns Cos. in New York. “They may have three years perhaps four at most in terms of the debt.”

For his part, PBOC Governor Zhou Xiaochuan told reporters during the National People’s Congress this month that taming the credit binge will be a “medium-term process.” Some analysts interpreted that as kicking the deleveraging can down the road yet again. One upside of the PBOC’s strategy is there’s “relatively few blow-ups,” wrote BI economist Tom Orlik.

The PBOC does have a window to squeeze harder on the deleveraging front, thanks to stable economic growth rates and reflation in the vast manufacturing sector that’s made debt servicing easier for the nation’s industrial base. Last week, it raised the rates it charges in open-market operations and on its medium-term lending facility.

For Goldman Sachs Group Inc. credit strategists, it all suggests that investors should be “defensive,” preferring short-dated investment grade credit instruments over high yielding debt.

China’s shadow banking lenders have been especially hit this week as the money-market squeeze saw their borrowing costs swell to a record versus that for large Chinese banks. The tightness was exacerbated by cash hoarding on the part of banks as the quarter comes to a close, said Tommy Xie, an economist in Singapore at OCBC Bank.

Grab the Defibrillator, China’s Going to Need It: Gadfly

Monday’s events could play out again at the end of June, when the Fed is due to review key rates, Xie said. For now, analysts are betting that China’s central bank will ensure enough stability that there isn’t a repeat of the 2013 credit crunch that triggered a selloff in the nation’s stocks.

“It’s still too early to tell if the PBOC’s efforts to reduce interbank leverage will ultimately be successful,” said Andrew Polk, director of China research at Medley Global Advisors LLC in Beijing. “The PBOC will continue to be cautious, but that doesn’t mean it won’t be a wild ride.”

— With assistance by Emma O'Brien, Yinan Zhao, Narae Kim, Helen Sun, Zheng Wu, Kevin Hamlin, and Jeff Kearns

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