A Tale of Two Tapers

Barry Eichengreen

11 July 2013
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CAMBRIDGE – The United States Federal Reserve and the People’s Bank of China are not typically seen as two peas in a pod. But they have had similar experiences in recent weeks – and neither has been a pleasant one.
The Fed’s bout of indigestion started with Chairman Ben Bernanke’s June 19 press conference, where he warned that the Fed’s purchases of long-term securities might start to taper off if the economy continued to perform well – specifically, if unemployment fell to 7%. Stock prices swooned. Yields on US Treasuries spiked. Emerging-market currencies weakened on fears that capital flows from the US would reverse direction.
Indeed, the reaction was so extreme and alarming that a parade of Fed officials felt compelled to clarify. To say that the Fed’s policy of “quantitative easingmight taper off, they explained, was different from saying that it would be halted. When and how purchases of long-term securities were reduced would depend on incoming data. In particular, there was no guarantee that 7% unemployment would be reached before the end of the year.
By coincidence, June 19 was the same day that the People’s Bank of China decided not to provide additional liquidity to the country’s strained credit markets. The interest rate that Chinese banks charge one another for short-term loans had begun rising two weeks earlier on rumors that two medium-size banks had defaulted on their debts. The interbank rate went from 5% to nearly 7%.
Investors expected that the PBOC would step in, as always, to prevent rates from rising further and slowing the economy’s growth.
Instead, the PBOC stood pat. Officials worried that banks had been lending too freely to property developers and large state-owned enterprises (which in many cases are one and the same). They were concerned that the banks, through their wealth-management arms, were borrowing excessively on the overnight market to finance high-risk investments.
In China, too, market reaction was violent. The Shanghai Composite, the country’s main stock index, tanked. Interbank rates shot up to 25%, raising deep concern about the stability of the financial system.
This was not what Chinese officials expected. Like their Fed colleagues, they found it necessary to clarify and backtrack. They reassured investors that they would “guide market interest rates into a reasonable range,” and backed their statements with credit injections.
Neither experience enhanced the reputation of the central bank in question. Though June 19 may not be a date which will live in infamy,” few central bankers will remember it fondly.
But central bankers, like the rest of us, should learn from their mistakes. What are the lessons of this one?
First, the June 19 episode reminds us that central banks’ communications strategies remain works in progress. The Fed has repeatedly sought to explain its policies better. But, if a few relatively anodyne words can spark such a powerful reaction, then investors evidently remain uncertain, if not confused, about the Fed’s intentions.
The PBOC performed even worse, having done nothing to prepare the markets for its new anti-speculation strategy. The Chinese authorities are seeking to develop the renminbi into a first-class international currency. But China’s June 19 episode is a reminder that the PBOC in particular and Chinese policy-making institutions in general have a long way to go before they succeed in instilling the necessary confidence in both the renminbi and themselves.
A second lesson is that central banks are wise not to overreact to the latest bit of news. The Fed’s statements suggesting an end to quantitative easing appear to have been grounded in very recent evidence that the economy was improving. Now that the markets have reacted adversely, some investors have begun to worry that, as a result, the economy is doing worse. The Fed should wait for more much more data to come in before adjusting either its policy or its rhetoric.
The PBOC, similarly, seems to have overreacted to data indicating a bank credit boom. In fact, some of this supposed evidence was misleading, because it reflected nothing more than a change in regulatory standards that had brought hidden loans to the surface. The PBOC would have been wise to wait for more data, so that it could distinguish the trend from the accounting glitch.
A final lesson is that monetary policy is a blunt instrument for addressing asset-market problems. In the absence of inflation, it was mainly warnings about new asset bubbles that pressured the Fed to curtail its purchases of long-term securities. Similarly, worries about property prices drove the PBOC’s abrupt change of course.
Bubbles should be a concern, but the June 19 episode in the US and China reminds us that addressing them is first and foremost the responsibility of regulators. Central bankers cannot afford to ignore them, but they should be wary of reacting too soon. In the meantime, they have bigger fish to fry.
Barry Eichengreen is Professor of Economics and Political Science at the University of California, Berkeley, and a former senior policy adviser at the International Monetary Fund. His most recent book is Exorbitant Privilege: The Rise and Fall of the Dollar and the Future of the International Monetary System.

11, 2013 6:52 pm
Finance: Money for nothing
China’s $1tn shadow banking sector has become a concern and an opportunity
A businessman looks at his mobile phone as he walks in the financial area of Pudong in Shanghai©Reuters
Over the past six months, analysts working for Argyle Street Management have been fanning out across China to visit local bank branches. Argyle, a Hong Kong-based hedge fund, wanted to know more about some of the products these banks were selling to their clients – in particular high-yielding wealth management products.
It quickly became apparent that these products were very popular with the banks’ clients and it was easy to see why. They paid yields above 7 per cent, far more than the meagre amount offered on deposits. Less apparent was what these clients were actually investing in, or under what terms.


Some involved loaning money to buy land for property developments, despite banks not being allowed to lend money for land acquisition. Others involved investing in the pet projects of local governments, such as building roads in remote border areas or the debt of water pipelines. In many cases, the loans being offered to potential investors had virtually no conditions to protect the lenders, while the collateralif there was anyoften consisted of unnamed items or personal guarantees.

Hordes of retail investors are attracted by the 7 per cent yield,” one analyst reported to his boss after a visit to local bank branches in Shenzhen last month. Many WMPs were fully subscribed within hours.”

A week before, the same analyst came across another wealth management product promising a 12 per cent yield without a word on the actual underlying investment project. Investors don’t care about the underlying project,” he noted. “They think everything is backed by the government. One salesman told me that as long as the Communist party remains in power, these products are safe.”
Welcome to China’s shadow banking system, a booming sector whose size was recently estimated by a Chinese banking regulator at Rmb8.2tn ($1.3tn). But many analysts say the figure is much higher, with Deutsche Bank estimating that shadow banking accounts for 40 per cent of gross domestic product – or Rmb21tn.
Charlene Chu, a senior analyst at Fitch Ratings, estimates that one-third of all outstanding credit at the end of last year was held in “non-loan channels”, where information on asset quality and borrowers is extremely thin.

Hedge funds have not had much luck in mainland China, where strict rules make it difficult for investors to build negative stakes. But to many hedge funds, China’s shadow banking system looked like an unmissable opportunity to make money. Some compare the investment products the shadow banks create to the subprime debt that led to the meltdown in the US mortgage market and triggered the global financial crisis.
After much digging, investors at Argyle and other local hedge funds concluded that there would be a cascade of defaults on the projects behind these wealth management products – and that the banks would be forced to compensate clients in the name of social stability, wiping out their equity capital in the process.

These hedge funds are putting money behind that conviction by shorting the shares of some of the weaker banks, which are listed in Hong Kong. Their strategy recalls the way some hedge funds bet that the US mortgage boom would end badly.

“These wealth management products are CDOs with Chinese characteristics,” says Kin Chan, founder of Argyle, referring to collateralised debt obligations, the sort of complicated financial products that ended so disastrously in the US. If the projects go wrong, they will become the liability of the banks.”

As China struggles to reconcile the tension between its tightly controlled official banking system and those determined to circumvent their controls, hedge funds have become powerful, if unlikely, players. In a way, they are challenging the regulators. But they have also been the biggest beneficiaries of the People’s Bank of China’s efforts to reassert discipline over the country’s credit growth.
When the central bank took action in June, by letting rates rise in the market through which banks provide funds to each other, the negative bets of these hedge funds paid off handsomely. For a while at least, the interests of the two groups came together.

Today, much of the debt flowing from the banks to borrowers in China no longer involves simply taking depositors’ money and lending it to creditworthy applicants in a transparent process. Instead, it flows off the banks’ balance sheets via intermediaries, such as trust companies, to borrowers who would otherwise have difficulty obtaining the money. They charge rates that are often far higher than those officially sanctioned.

That is not always a bad thing. The shadow banks also provide flexibility to an inflexible financial system. Regulated interest rates mean that banks are reluctant to lend to private companies and new businesses that lack adequate collateral and cash flow, because they cannot charge enough for the risk to such untried borrowers.

Low payments on deposits mean households do not earn enough on their savings. Many wealth management products resemble money market funds in the US rewarding savings with rates that can be far higher than those paid on deposits, depending on how risky these products are.

Still, many analysts agree with Ms Chu’s conclusion that shadow banking activity is worrying. It represents a sort of window dressing, a way to conceal troubled loans. Because many of these products have a far shorter life than the projects they are meant to finance, there is always the possibility that the project will not be refinanced when the time comes. The existence of the shadow banks also complicates monetary policy, making controls on the growth of creditalready twice GDPfar less effective.

Given the lack of disclosure, transparency and meaningful collateral, it appears to the analysts at Argyle and other hedge funds that the collapse of many of these products will leave the banks on the hook.

That does not pose a huge risk for the large state-owned banks. But second-tier banks listed in Hong Kong or in mainland China, including China Merchants, China Minsheng Banking and tiny Huaxia, are vulnerable. That opinion is shared by Ms Chu, who notes that these smaller banks have less ability to absorb losses and more of their balance sheets are tied up with shadowlike activities.
Early this year, many hedge funds began putting on bearish positions by shorting the shares of these banks. Clearwater Capital, a fund that has historically invested in distressed debt, began buying credit default swap protection on China and other credit indices as a proxy for the illiquid banks. 

The fee to borrow shares was surprisingly low, brokers say. So while Chinese share prices generally have fallen this year, those of these banks fell even more. The sector has reported a 30 per cent decline, underperforming the Hang Seng index by 14 per cent.

That made the debt market nervous, sending the cost of buying credit insurance in the credit default swap market higher. Meanwhile, because these second-tier banks lack the nationwide deposit-gathering branches of the state-owned behemoths, their borrowing costs began to rise as well.

Then, other Asian banks began to cut back the credit facilities they made available to the second-tier Chinese banks, increasing pressure on them. It was a stark illustration of the way such bearish hedge fund bets can feed on themselves and become self-fulfilling prophecies. In sounding the alarm, these funds have added to the risk factors for China in the struggle to tame a system showing the strain of preserving artificially cheap capital for privileged borrowers and artificially poor returns for most savers.

Investors began to become cautious about supplying capital to these banks,” says Liu Ligang, chief economist for China at ANZ. All foreign banks are reviewing their Chinese counterparties’ credit risk.” The chief executive of one big Asian bank adds that he has cut back his credit lines to these Chinese banks. “If the bank isn’t one of the top five, anything can happen,” he said.

China Minsheng Banking has proved to be the most popular in this reverse popularity contest. Of all the banks covered by JPMorgan, it had the fastest growth in its interbank assets, as well as the highest weighting of interbank liabilities to total interest bearing liabilities, according to a June 25 report.
Until recently, few hedge funds could have anticipated the extent to which the PBoC’s policy moves would transform their good trades into great trades. After all, many hedge funds have been bearish about China for a long time without making money. The stock market has not gone anywhere in 10 years but because so many mutual funds are obliged to invest in China – and investing in the country inevitably means investing in its banksgoing short has been perilous.

For the past few months, officials at the PBoC and the Chinese Banking Regulatory Commission have been voicing concern over the excessive growth of credit in the economy. In May, they backed up their words with actions and began cracking down on the use of false trade invoices. Monetary conditions tightened, although not enough to raise alarms.

But money supply and credit growth continued at a pace that exceeded the regulators’ desired target.

. . . 

By the third week of June, when bank liquidity came under pressure as a result of tax and other technical factors, the central bank had still done nothing to help cash-strapped banks as it has in the past. Interest rates in the interbank market soared to almost 14 per cent from an earlier 3 per cent rate.

Until then, everyone had looked on the People’s Bank of China as the sugar daddy,” says the head of China for one of the European banks. “And then suddenly they weren’t there.”

The stock market dropped more than 5 per cent in a single day, while individual bank shares dropped even more. In the wake of PBoC inaction, China’s bank shares moved to an all-time low, trading at less than their book value, according to Morgan Stanley. “Some banks are not doing a good job in liquidity management,” warned Shang Fulin, head of the CBRC. “They should pay attention.”

Alarmed, the central bank caved. “The PBoC engineered a liquidity squeeze because they wanted to teach the banks a lesson,” says Mr Liu of ANZ. “But then they were forced to extinguish the fire. They didn’t want a Lehman. They had to backtrack.”

On June 25, China Minsheng Banking, which had fallen 30 per cent in three months, held a conference call to reassure investors that its liquidity and asset quality were stable.

At the same time, some hedge funds quietly took off their shorts. “It may go on for longer but I have already made so much money,” says the head of one regional fund, adding that holders of shares were calling in their shares to engineer a short squeeze.

Others, however, have kept their negative bets on, sure that there is worse to come.

Rating agencies: Bearer of unpalatable truths

On June 18, Fitch, the rating agency, held its annual global banking conference at the Four Seasons Hotel in Hong Kong. The presentations included the standard outlooks for banks in Asia-Pacific, Canada, Europe and the US. But most people were there to hear Charlene Chu, a diminutive analyst with the demeanour of a student, give a presentation on Chinese banks: ‘Why Shadow Banks Are a Concern’.
Systemic risk is rising,” Ms Chu warned her well-heeled audience, focusing on the mid-tier banks given that “their credit exposure is high, off-balance-sheet activity substantial, loss absorption capacity modest and liquidity thinning”. Since joining Fitch in Beijing in 2006 after a five-year stint at the Federal Reserve Bank of New York, and degrees from Yale, Ms Chu has attracted a huge following among hedge funds looking for insight into China’s banking system.

While many investors draw far more dire conclusions than does Ms Chu, she has been embraced because she was one of the first to sound the alarm about the issues that plague China’s financial system.

“The banking industry risk remains one of the largest vulnerabilities,” she wrote in her first report for the rating agency seven years ago. Key weaknesses include widespread corruption and ineffectual corporate governance, underdeveloped risk management and internal control systems, weak accounting and legal frameworks, and poor [albeit gradually improving] profitability, asset quality and capital.”

She was among the earliest analysts to write about the wealth management products that are among the most contentious issues facing China. Analysts are debating whether these are as toxic as some of the structured products in the US six years ago.

Ms Chu’s sobering views have given Fitch an uncharacteristic visibility. Not all China watchers agree with her and some quibble over her calculations but in a world where most analysts have been seen as cheerleaders all too often, her sober assessments cannot be dismissed easily.

Copyright The Financial Times Limited 2013

Getting Technical


Charts Say the Stock Rally Is for Real


Technical indicators have not looked this good in a while, but Ben Bernanke and the Fed still control the market.


Ever since the market started to move higher last November, technical indicators such as volume, momentum and market leadership seemed to be at odds with the rally. The stock market went up, and that was all that mattered.

Or was it? The Federal Reserve had a lot to do with it as the Fed continued to pump liquidity in to the system via its open-ended bond-buying program (called quantitative easing or QE). As long as the printing presses rolled, stocks went up.

So with the technicals going positive over the past few days as the May-June correction ended, we have a perverse reason to worry. Why now, after eight months of rallying? Could it be that the market has finally given in to the siren call of endless Fed stimulus? Does it believe that the last Fed campaign dubbed "QE to infinity" was named literally?

But let's get to the charts and the positive developments that have occurred since last Wednesday's column (see Getting Technical, "Up or Down? Decision Time for the Market," July 3).

The Standard & Poor's 500 index moved smartly above all of the resistance features outlined last week (see Chart). These include the falling trendline from the May peak, the 50-day moving average and the gap on the chart from the June 20 market slide. The index is also back above its former rising trendline drawn from the November low, so the June breakdown is now fully negated.


Standard & Poor's 500

Market breadth, as measured by the New York Stock Exchange advance-decline line, a running tally of how many stocks go up and down each day, is also moving higher. So is the net number of 52-week highs. Indeed, both the full NYSE 52-week highs minus lows data and the common-stock only data, with bond equivalents and exchange-traded funds removed, are climbing once again.

Key sectors such as the banks, represented by the SPDR S&P Bank ETF (ticker: KBE) are at multiyear highs. Retail, as represented by the SPDR S&P Retail ETF (XRT), recently broke through resistance to all-time highs. Even the iShares PHLX Semiconductor ETF (SOXX) continues to outperform the market after surviving Monday's Intel (INTC)-induced selloff.

Other than these three, the only sector of the critical group I call the "four horsemen" to show technical trouble is home building. But the iShares U.S. Home Construction ETF (ITB) is still holding above a very important technical price floor.

After the close Wednesday, Fed Chief Ben Bernanke will speak and take questions. Guessing what he will say is a fool's game, but if he does back down from his suggestion that he will pull back on bond buying (taper), investors will cheer. And if he leans more toward tapering, investors will jeer.

For now, traditional bull market sectors such as financials, semiconductors and consumer discretionary are in the lead, as this column reported in earlier stories on chip stocks and the consumer discretionary ETF. Small company stocks are outperforming big stocks, and the Russell 2000 cleared resistance with its first-ever close above 1,000 last Friday. It does appear that the market has finally gotten its act together in a more textbook way.

It seems strange to worry about a more positive structure in the market, but maybe that is just a different wall of worry than we are used to having. Has the market changed for the better, or is this change really the capitulation of the bears?

For now, we have to take the charts at face value and expect July to live up to its better-than-average reputation. But after the market digests what Ben Bernanke has to say, seat belts may be required.