Hope In Chinese Bond Market Sell-off

August 20, 2013

Sell-off triggered after government deters shadow banking system.

The recent sell-off in China’s $4 trillion bond market generated concern that China’s economic health might be deteriorating, but it could turn out to be good news in the longer run if it proves to be a symptom of a shake-up in the country’s banking system.

China’s bond market has grown fivefold in the past decade, according to Wall Street Journal estimates, and it stands close behind the U.S.’ and Japan’s in terms of size. But the Chinese bond market isn’t like most other debt markets we know, and it’s those differences centered on the country’s banking system that are now attracting attention.

As a quick background, governments usually expand their fixed-income markets to become less dependent on banks for their cash needs, but in China, banks are the main holders of government-issued bonds. That makes banks the government’s biggest lenders.

What’s more, these banks have fostered a sort of buddy-system of lending where local- and state-run groups enjoy loans at below-market rates, while private businesses are left out in the cold without access to funding at the same competitive rates. That lending model has not only led government-run agencies into a spending binge they probably couldn’t afford in a normal rate environment, but also pushed private companies toward what’s known as a “shadow-banking” system.

Comprising smaller banks, wealth management products, hedge funds and the like, this shadow banking segment is the one funding China’s private enterprise, but a new government there that took office earlier this year is now trying to crack down on that system by forcing banks to lend to all players.

To do so, the government cut off some of the money supply to banks in an effort to get their attention, creating a liquidity crunch that sent many to the bond market in an effort to raise much-needed cash, said KraneShares’ managing director Brendan Ahern.

That leveling of the playing field when it comes to lending is expected to allow for real economic growth down the line even if it has to mean pain in the short-term, Ahern said.

“There’s a credit bubble in China—there’s been a gorging on debt from municipalities to build things like parks, sidewalks and bridges to nowhere, really,” said Ahern, noting that these loans—all at artificially low rates—are becoming a problem longer term because they’ve fostered an era of more financial speculation than growth, he noted.

“What happened in late June and July was that the Bank of China left the banks twisting in the wind for a full week stranded for cash,” Ahern said, noting that banks were literally turning off ATMs as they ran out of physical cash, leading many to sell bonds to raise money, triggering the bond sell-off.

“This is where the government was telling the banks to address the problem, but whether they will be able to get them to reform remains to be seen,” Ahern said.

As geopolitical think tank Stratfor recently put it in a research note, the lending-driven growth model China has carried out for the past decade is no longer sustainable.


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