Canary in the Credit Coal Mine

February 25th, 2014 7:05 pm | by John Jansen |

This Bloomberg article tells the story of widening credit spreads and the signal that wider spreads may be sending. It also makes an apt comparison to the turmoil in the credit markets which began here in August 2007 as the first wave of the global financial crisis swept across the shore. Soon it would be a tsunami.

Via Bloomberg:

Crisis Gauge Rises to Record High as Swaps Avoided: China Credit
2014-02-25 16:00:01.2 GMT

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By Kyoungwha Kim
Feb. 26 (Bloomberg) — China’s credit-market gauges are
triggering alarm bells, as banks grow cautious in lending to
each other while investors prefer the safest government bonds.
The spread between the two-year sovereign yield and the
similar-maturity interest-rate swap, a gauge of financial
stress, reached 121 basis points on Feb. 19, the widest in
Bloomberg data going back to 2007. Two days later, the cost to
lock in the three-month Shanghai interbank offered rate for one
year reached an eight-month high of 94 basis points over similar
contracts based on repurchase agreements, which are considered
safer because they involve government securities as collateral.
Billionaire investors George Soros and Bill Gross have
drawn parallels between the situation in China now and that in
the U.S. before the 2008 financial crisis, when traders gauged
lending appetite by monitoring the difference between the London
Interbank Borrowing Rate and the overnight indexed swap. Premier
Li Keqiang’s efforts to curb leverage in the world’s second-
largest economy by driving up borrowing costs need to be handled
carefully to avoid wrecking confidence in the financial system,
according to Nomura Holdings Inc.
“What I do see are increasing parallels between China and
the U.S. in the run-up to the global financial crisis,” said
Patrick Perret-Green, a London-based strategist at Australia &
Banking Group Ltd. “Shibor-repo is similar to Libor-OIS. Shadow
banking is subprime. Credit spreads are widening as they did in
2007. Money growth is softening as tightening bites.”

Widening Spreads

In July, 2007, U.S. banks began to hoard cash when defaults
on subprime mortgages led two Bear Stearns hedge funds to seek
bankruptcy protection, pushing up borrowing costs. The gap
between the three-month Libor in dollars and the OIS rate soared
to a record 364 basis points in October 2008.
The yield on China’s two-year government bonds declined 19
basis points this month to 3.63 percent on Feb. 24. The spread
to the similar-maturity swap averaged 110 basis points last
month, the most on record, and was at 104 basis points on Feb.
24. In February last year, it averaged 25.
“There is a big flight to quality,” said Wee-Khoon Chong,
Singapore-based head of rates strategy Asia ex-Japan at Nomura.
“In times of stress, you sell credits, sell longer-dated bonds
into shorter ones and you are going to the government bond
market. If the default situation gets out of control, yields are
going to fall a lot.”

PBOC Tightening

Growth in the world’s second-biggest economy slowed in the
fourth quarter to 7.7 percent from 7.8 percent in the previous
three months as the central bank drove up money-market rates to
curb excesses by a less-regulated shadow banking sector that
includes trust companies and wealth-management products.
The People’s Bank of China drained 100 billion yuan ($16.3
billion) from the financial system this week, following a
withdrawal of 558 billion yuan in the previous two weeks. Money
supply growth, measured by funds readily accessible for
spending, fell to 1.2 percent in January, the lowest in central
bank data going back to 1996.
“A consistent rally in sovereign debt will be more likely
if we start seeing more defaults in shadow banking or credit
products, which will lead to flight-to-quality flows and also
likely PBOC easing,” said Bin Gao, head of Asian rates at Bank
of America Merrill Lynch in Hong Kong.
Nomura’s Chong forecast lenders’ reserve-requirement ratios
will be cut to 19 percent this year from 20 percent as higher
borrowing costs slow growth.

Trust Products

About 5.3 trillion yuan of trust products will come due
this year, up from 3.5 trillion yuan in 2013, Haitong Securities
Co. estimated last month. Assets in all trusts surged 46 percent
in 2013 to a record 10.9 trillion yuan, the China Trustee
Association said in a Feb. 13 statement.
China averted its first trust default in at least a decade
in January as investors in a 3 billion yuan high-yield product
sold by China Credit Trust Co. were bailed out days before it
came due. Another investment product created by Jilin Province
Trust Co. and backed by a loan to coal company Shanxi Liansheng
Energy failed to repay investors when some tranches matured,
Shanghai Securities News reported.

Deleveraging Debt

At least a third of China’s 200,000 steel-trading firms
will collapse because of the credit crisis which started at the
end of 2011, the official Xinhua news agency said Feb. 7, citing
industry estimates. The debt troubles come as the government
looks to deleverage debt, remodel the economy to focus on
consumption and cut pollution levels.
The PBOC signaled on Feb. 8 that volatility in money-market
rates will persist and borrowing costs will rise, while saying
it will enhance monitoring of local government financing
vehicles, industries with overcapacity and property developers
to prevent default risks from spreading. This came as the
difference between five-year sovereign notes and AA rated
corporate notes widened to 337 basis points on Feb. 12, the most
in two years.
Increased money-market turmoil and the outlook for slowing
growth are serving as catalysts for a rally in government bonds
as banks increase buying, according to Yii Hui Wong, a
Singapore-based strategist at BNP Paribas SA. The rise in the
short-end will spread to five-year notes, she forecast.
The economy will probably expand 7.5 percent this year, the
slowest since 1990, according to the median estimate in a
Bloomberg survey. That may further fuel bank bad loans, which
surged 28.5 billion yuan in the final quarter of 2013 to 592
billion yuan, the highest since September 2008, according to
China Banking Regulatory Commission data.
Credit-default swaps on Bank of China rose 32 basis points
to 153 this year while those on Industrial & Commercial Bank of
China Ltd. climbed the same amount to 165, according to CMA
prices.

Global Investors

Demand for sovereign notes is also supported by global
investors as China opens up its domestic capital markets and
foreign funds look for a harbor from a sell-off in emerging
markets sparked by the Federal Reserve’s reduction in stimulus.
“Offshore investors take a longer-term view, and they
don’t feel that the government can’t handle the situation
because it’s still a very controlled economy,” BNP’s Wong said.
“If the central government wants to do something, then it can.
Government bonds at these levels are very attractive.”
Sovereign bond risk is rising, with CDS contracts insuring
China’s debt against non-payment reaching 105 basis points on
Jan. 24 in New York, the highest since Aug. 30, according to CMA
prices. The yuan fell 0.46 percent, the most since Nov. 1, 2010,
to 6.1266 per dollar in Shanghai yesterday, according to China
Foreign Exchange Trade System prices.
“The drop in the cash bond yield was due to investors
downgrading their forecasts of 2014 growth,” said Tim Condon,
head of Asian research at ING Groep NV in Singapore. “Some of
the credit-spread widening also could be a flight to safety by
investors unnerved by the increased foreign-exchange
volatility.”

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