Chinese Credit Markets Trigger Déjà vu

by on March 2, 2014 6:39 pm BST

The Chinese credit markets are triggering déjà vu for some analysts as banks tighten lending between each other and investors choose to hold government debt. George Soros and Bill Gross, founder and CIO of Pacific Investment Management Co. (PIMCO), are foreseeing similar results in China now as seen in the United States prior to the 2008 financial meltdown.

The liquidity tightening from the People’s Bank of China (PBOC) was aimed to stop the large shadow banking industry, but it could be the thing that topples the house of cards. The PBOC withdrawn 100 billion yuan from the financial system last week, adding to the 558 billion yuan in the previous two. The money supply shrank 1.2 percent in January, the lowest levels since 1996. “A consistent rally in sovereign debt will be more likely if we start seeing more defaults in shadow banking or credit products, which will lead to flight-to-quality flows and also likely PBOC easing,” said Bin Gao, head of Asian rates at Bank of America Merrill Lynch.

The spread on the two-year sovereign yield and similar interest rate swaps hit 121 bps on February 19. According to data from Bloomberg, this was the widest since 2007. Earlier in the week, the cost of locking in the three-month Shanghai interbank offered rate for one year hit an eight-month high of 94 bps.

Patrick Perret-Green, strategist at Australia & New Zealand Banking Group, is also drawing parallels to the 2008 meltdown. “Shibor-repo is similar to Libor-OIS. Shadow banking is sub-prime. Credit spreads are widening as they did in 2007. Money growth is softening as tightening bites.” In comparison, US banks held cash as defaults on subprime mortgages ultimately led to two Bear Stearns funds to file for bankruptcy in 2007. The gap between LIBOR, in dollars, and the OIS rate gaped 364 bps in 2008.

Default concerns have been growing over the last couple months, and the result has been a 337 bps increase in the fiver-year corporate AA-rated note. There has been a shift to safety. According to the state-runed news agency Xinhua, at least 200K steel-trading firms will collapse due to a credit crisis.

A credit crisis is brewing, and the result with undoubtedly be of epic proportions.