Someone sent us a quote from JPMorgan that finally explains the origins of the tight interbank liquidity conditions in China. It's roughly what analysts have been suggesting.
JPMorgan: - ... there is an additional reason for the tight liquidity, in the form of a
crackdown on illegal bond trading by regulators. In recent years, wealth
management products (WMP) have become an important channel for Chinese banks
to attract deposits. Most wealth management products are short-maturity (65% are
below 3 months, and 20% range from 3-6 months). The maturity dates of such
products are usually at the quarter-end, to meet regulatory requirements on loan-to-deposit ratios. Due to competition in providing high returns for WMP, banks were
forced to buy high-yielding bonds with 1-5-year maturities to serve as underlying of
the WMP. Examples of such bonds are lowly rated credit papers with poor liquidity,
or non-standard securities such as discounted bills and bank loans. This resulted in a
term mismatch between the maturity of WMP and their underlying asset.
To avoid any squeeze from this mismatch upon maturity of the WMP, small banks
started to engage in a kind of sale-and-buyback operation of the underlying bonds,
consisting of two steps. In step 1, bonds were sold before quarter-end in a “fake”
sale to a friendly counterparty, with the aim to obtain cash to pay back the maturing
WMP. In a second phase of the trade, the bond was then bought back using cash from
new WMP issues. But in May the regulator banned this practice, as part of a general
clampdown of the abuses in the WPM market. Part of the interest rate squeeze we are
observing today is due to the difficulty in liquidating the (illiquid) underlying bonds
before the maturity date of WMP at June-end. The demand for cash has therefore
risen significantly, at least from the small banks. Note that China’s larger banks do
not have problems accessing liquidity, but that primarily the small banks are
suffering.
As
discussed earlier, it is clear that the PBoC does not have a good handle on banks' risk-based capital and the smaller banks in China have been playing the game of regulatory capital arbitrage. This is similar to US banks using off-balance-sheet vehicles funded with commercial paper to "convert" long-dated illiquid assets into short term (less than 365 days) exposure.
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