China’s black box

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First there is a drip, then another, then another, then a drop. American’s saw this in the summer as 2008 as news of Lehman Brothers, Bear Stearns, and AIG’s eventual demise struck the banking sector as the nations subprime mortgage loan market collapsed under their feet. The firms had taken on extraordinary amounts of risky financial instruments, without truly knowing what exactly they were owning. Today, we have placed measures to strengthen our own banking sector, but on the other side of the globe, we may be witnessing the same situation plaguing the world’s second-largest economy, China. Back in May, the People’s Republic quietly took control of Baoshang Bank, a small regional bank near Mongolia, which had suffered devasting losses from a wave of corporate defaults that occurred in 2018. The country’s Insurance and Banking Regulators along with the Central Bank announced the firm posed a serious credit to the nation. Such a move did not garner much attention from US investors, however, the action taken by the government is incredibly rare, as it was the first bailout of a Chinese Bank since the 1990s. What is even more concerning is that since 2017, the PBOC has aggressively eased financial standards and cut reserve ratios for smaller banks to avoid just this outcome.

            The second shoe to drop in the recent six months came as Jinzhou Bank, with over $100 Billion in assets, was partially seized by the Government of China as liquidity concerns continued to mount. Much like Baoshang, the bank had been struck by immense losses on corporate loans as a result of the Chinese Government relaxing of financial regulations. The result of such an issue led to a near freeze on interbank loans for regional banks in China. The Government Bond Repo Rate, which is the rate in which Chinese banks can issue short term loans amongst each other, shot up over 1000% overnight. It is clear based upon such an event that trust amongst banks has fallen to historically low levels as greater liquidity concerns continue to plague the nation’s financial sector. The overnight funding market is a critical aspect of any developed nation’s economy, and once this trust erodes, it creates a massive problem for the government to help ensure liquidity. Such events ring similar to what occurred to the United States following the collapse of Lehman Brothers, as it has gotten much harder for corporate bonds and mortgage-backed securities to be accepted as collateral for repo financing as lenders increasingly demand top-quality bonds such as Chinese sovereign bills and policy banknotes as pledges. Such expensive borrowing costs for these small regional bans could not come at a worse time as China’s economy continues to slow and the Nation’s Current Account deficit continues to rise.

Jinzhou is also the largest bank in a group that revolves around another concern, the number of banks that delayed their 2018 Annual Reports. According to Barclay’s, a group of 19 banks ranging in sizes was forced to delay the release of their annual reports as the firms conducted strategic reviews of their businesses. Jinzhou was the second-largest bank on this list with over 723 Billion Yuan on its balance sheet. Whenever a firm is forced to delay such a critical piece of information, it uncertainly raises a multitude of red flags surrounding the viability of the firm.

In the first two cases I’ve mentioned, the drastic measures taken by the Government were widely unnoticed by both Chinese citizens and the international investing community. However, just a few weeks ago, the failures of these banks were more widely recognized as depositors at Henan Yichuan Rural Commercial Bank did what may be one of the worst-case scenarios for the Chinese government; started a run on the bank. Although the bank only represents 4% of the total Chinese banking sector, this couldn’t keep depositors from demanding their money. The Wall Street Journal ran multiple stories about these depositors demanding their money, and the empty promises that bank managers were offering to try and keep their cash with the bank. Such drastic actions such as a bank run is another crack in what appears to be a systemic problem for the People’s Republic of China. For decades, the Chinese economy has been a black box, but as they continue to enter the world stage, these structural flaws are being uncovered. Such a wave of bad defaults on loans meant to stimulate an economy at over 6% GDP growth for years is not surprising in the slightest. What is yet to be seen is exactly what the extent these issues face National Banks. Investors are not accurately accounting for just how serious these issues in China could be for the entire world, as the country continues to grow their economic power.

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