(Bloomberg) -- Bond traders in China are rethinking counterparty risks as shock waves from a government takeover of a bank ripple through the country’s financial markets.
It’s now getting harder for corporate bonds to be accepted as collateral for repo financing as lenders increasingly demand top quality bonds such as Chinese sovereign bills and policy bank notes as pledges. Traders are having second thoughts on taking even AAA rated short-term bank debt as security in the wake of last month’s seizure of Baoshang Bank Co.
That’s clogging up funding among China’s financial institutions, which have already caused borrowing costs to spike for brokerages and smaller banks. The timing couldn’t be worse with liquidity generally tight at the quarter-end, and further adds to the wide-ranging ramifications of the bank seizure. All this could mean higher defaults, according to Bloomberg Economics.
“Non-bank financial institutions are actually the biggest buyers of corporate bonds in China, and if their funding chain breaks, demand for bonds, particularly those that can hardly be pledged for borrowing, will certainly get hurt," said David Qu at Bloomberg Economics in Hong Kong. “Weaker companies will suffer a rising cost when selling new bonds, which may eventually lead to higher default risks.”
A trader at a Beijing-based brokerage, who asked not to be named as he is not authorized to speak publicly, said its counterparty just tightened the collateral for repo lending to only AAA rated negotiable certificates of deposits -- a type of short-term debt sold by banks -- whereas just a few days ago AA+ rated ones were accepted.
Another trader said most of his counterparties now require government bonds as collateral as it will be very hard for corporate bonds to be accepted as pledge for borrowing.
Regulatory Reaction
In a sign of a jittery market, two non-bank institutions quashed speculations they couldn’t raise funds. Shanghai Haitong Securities Asset Management Co. said June 12 it didn’t default on any bond repurchase agreement, neither did it face a liquidity crunch. The following day, Lianxun Securities Co. made a similar announcement saying its bond transactions were normal and it had sufficient capital.
China Foreign Exchange Trade System, which runs the nation’s interbank bond market, will conduct anonymous auctions of the bonds used as collateral in a defaulted repo transaction, according to an announcement that appeared on the CFETS website on Monday. Repo failures have been rare in the past, according to Yang Hao, fixed income analyst at Nanjing Securities Co., adding that the move provides a standard method for collateral disposal.
Authorities held a meeting on Sunday with some of the country’s leading brokerages to discuss options to address liquidity risks, telling institutions to not suspend all their repo lending businesses, according to a report from 21st Century Business Herald, citing unnamed institutional investors.
That is in response to the fact that China’s seven-day and 14-day "overall interbank market" pledged repurchase rates, which indicate non-bank institutions’ financing conditions, surged to 15% on Tuesday, a level deemed extremely high, according to traders. The liquidity injections from the central bank in recent weeks have largely benefited large banks, market participants say.
Tight Liquidity
In China, the funding flow goes like this: big national banks lend to smaller regional lenders, which then provide financing to non-bank peers such as brokerages and funds. They in turn use the money to invest in corporate bonds.
“Smaller banks play a key role in this chain,” said Ming Ming, chief fixed-income analyst of Citic Securities Co. Right now investors are quite "risk averse and everyone wants to mitigate counterparty risks. If things get worse, China’s financial market liquidity could collapse,” he added.
(Updates with ‘Regulatory Reaction’ section.)
To contact Bloomberg News staff for this story: Tongjian Dong in Shanghai at tdong28@bloomberg.net;Yuling Yang in Beijing at yyang329@bloomberg.net
To contact the editors responsible for this story: Neha D'silva at ndsilva1@bloomberg.net, Lianting Tu, Chan Tien Hin
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