Money-markets ructions expose a vulnerability that still hasn’t been patched: dependence on low-quality collateral
By Nathaniel Taplin
Markets are a psychological phenomenon—a set of beliefs about how the world works and what things are worth. When assumptions are challenged, the results can be stomach-churning.
Unnoticed by most of the world, this is what happened in China last month. After regulators took over a small bank called Baoshang—and upended assumptions of state backing by announcing probable haircuts for creditors—short-term borrowing rates spiked. The episode laid bare the fragility of China’s gargantuan interbank money market, whose daily transactions come to about 3.3 trillion yuan ($479 billion).
It also highlighted a vulnerability that still hasn’t been patched: Some nonbank financial institutions—a category that includes brokerages, insurers, funds and shadow banks like trusts—appear too dependent on low-quality collateral such as corporate bonds to backstop short-term borrowing. This raises risks for China’s money markets and struggling corporate borrowers alike.
After big cash injections by the People’s Bank of China, average short-term borrowing costs in China’s money markets fell sharply. But some individual lenders still are charging usurious rates. On Friday, the closing rate for the 21-day collateralized interbank repo was 10%. A day before, the one-month repo closed at 18.5%—a universe away from the weighted average rate, which was below 3%.
One little bank takeover, and suddenly a lot of assumptions go up in smoke. Photo: china stringer network/Reuters
These are the aftershocks of June’s monetary earthquake. In the midst of the panic, some lenders nearly stopped taking corporate bonds as collateral at all. Nonfinancial corporate bonds are a small portion of overall interbank repo collateral—government and policy-bank bonds accounted for close to 90% in 2016, according to the Reserve Bank of Australia. But when much of the remainder became useless overnight, it was enough to cause major problems.
Worryingly, just as money markets are getting twitchy, corporate creditworthiness is getting more precarious. There were more than twice as many bond defaults in the first half of 2019 as a year earlier, according to Enodo Economics. Next time money markets get spooked, corporate-bond collateral may look even more dubious, and authorities may have to intervene even more forcefully to reassure lenders.
Alternatively, interbank borrowers may now try to wean themselves off all but the highest-rated bond collateral. There are already hints of this: The yield premium of three-year AA-rated medium-term notes over their AAA counterparts has widened by about a fifth of a percentage point since late May, according to Wind, after narrowing continuously for most of the year.
By making credit less accessible to embattled small companies, this could ultimately mean a weaker recovery, or that more-aggressive monetary policy is necessary to turn things around. At the very least, the reverberations from the regulatory takeover of Baoshang Bank will be around for a while. The next time money markets panic about counterparty risk, it might be even tougher to calm them down.
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