A new specter is haunting China’s financial system: the negotiable certificate of deposit. An explosion in banks’ use of the bondlike loans, whose durations range from a month to a year, is testing Beijing’s resolve to cure the economy of its addiction to debt-fueled growth and investment booms.
As authorities push up key short-term interest rates in their campaign to deflate asset bubbles swelled by borrowed money, the interest rates charged on these NCDs is rising so fast that it is starting to expose banks to the risk of investment losses and abrupt funding squeezes.
This is causing worries about a potential repeat of the crippling cash crunch of 2013. “NCDs carry a lot of risk, and if not handled properly they could lead to a systemwide liquidity crisis,” said Liu Dongliang, senior analyst at China Merchants Bank.
Banks, mostly small or midsize ones, have been raising record sums via NCDs, selling 4.4 trillion yuan ($639 billion) worth this year, 65% more than in the same period of 2016. They use the proceeds to buy higher-yielding, longer-term assets like corporate bonds or investment products issued by fellow banks.
NCDs initially offered banks the attractions of low cost and no collateral requirements, but since October the average cost of issuing the AA-rated three-month NCDs has risen to 4.72% from 2.90%—in some cases exceeding yields on AA-rated one-year corporate bonds.
The market took off last year, when issuance hit 13 trillion yuan, up from 5.3 trillion yuan in 2015 and just 899 billion yuan in 2014.
This boom came just as Beijing scored an initial victory in cutting down banks’ use of another form of short-term loan—repurchase agreements, or repos—for similar speculative purposes. The total transaction value of repos, which use bonds as collateral, fell to 35.8 trillion yuan in February from a record 59.8 trillion yuan in August, when the People’s Bank of China began tightening. The PBOC cut the fund supply for the most popular overnight and seven-day repos, raised the borrowing costs and imposed restrictions on leveraged investment using the tool.
Financial institutions ranging from banks to brokerage firms to private-equity funds had borrowed enough via repos to leverage their bets as much as four to five times, seeking to maximize returns from dwindling bond yields.
“You could say that NCDs have replaced repos as the new toy for banks to add leverage,” said Wang Ming, a partner at Shanghai Yaozhi Asset Management Co., a bond fund that manages 2 billion yuan in assets.
As issuance costs rise, more Chinese banks are being forced to sell new NCDs just to repay old ones. “When your borrowing cost is getting close to 5% and your bond is yielding only a little over 4%, you must be borrowing money to prevent a liquidity crisis,” Mr. Wang said.
Even without the fresh pain of rising interest rates, the mismatch between the NCDs’ short lifespan and the bonds’ longer duration leaves banks with a liquidity hole needing constant plugging.
The pressure is imminent: According to research firm Rhodium Group, 1.53 trillion yuan in NCDs mature this month, while calculations by analysts at China International Capital Corp. indicated that around half of the NCDs outstanding would mature between February and May.
The worry is that if one bank has trouble rolling over its NCDs or defaults on them, it could cause chaos like that of 2013, when widespread panic pushed the cost of overnight loans to a record 25%.
NCDs, WMPs, etc: we can’t keep track. What is clear is that an inverted yield curve where very short term instruments can no longer fund slightly longer maturity instruments (and everything is highly leveraged) can easily lead to a liquidity crisis. As long as it can, China will take the easy way out and favor easy liquidity over market discipline. How long that is we have no idea.