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Dysfunctional bond market returns borrowers to shadowy loans

Year-end bank loans and shadow banking activities in China surged in an apparent move to fill the gigantic void left by a defunct bond market suffering from the major blow in December.

In December 2016, two dozen mainland securities houses were embroiled in a messy case of defaults on bond repurchase dealings, involving forgery of company seals and rogue employees, that ultimately necessitated the securities authority to step in to mediate a solution.

The dramatic volatility in the debt capital market during mid-December had led to the biggest free fall in treasury bond futures in recent years, with investors forced to sell their holdings in a bid to limit their losses, creating a vicious cycle of downward crumbling bond prices.

Data released by the People’s Bank of China on Thursday now confirms the negative spiral that had effectively shut down the Chinese bond market for companies looking to quench their liquidity needs before the arrival of the new year. Total social financing from corporate bonds turned out to show a net contraction of 130 billion yuan (US$18.73 billion) during the month versus November’s net issuance of 287 billion.

The shock from the volatility of the domestic bond market in December amounted to over 400 billion yuan in reduced funding compared with the previous month, equating to two-thirds of a 50 basis point cut in the reserve requirement ratio. That’s big.

Notably, the dysfunctional bond market forced borrowers to seek cash from the shadow banking sector, with entrusted loans more than doubling in the month to 410 billion yuan.

Chinese commercial banks, therefore, had to go out of their norms by greatly stepping up credit provision in the year-end, extending 1.04 trillion yuan (US$150.69 billion) in new yuan loans in December. The figure is more than 50% higher than the forecast of 676.8 billion yuan, the PBOC said on Thursday.

In another words, the bond market has already became such a crucial part of the Chinese banking system that regulators cannot afford to allow any more hiccups to occur in the coming year, despite challenges of rising defaults and higher yields on the horizon.

Trust in bonds

“We have seen an effort by Chinese regulators to further nurture and open up the onshore bond market, and having confident investors and issuers plays an irreplaceable role in that,” said Warut Promboon, Chief Rating Officer at Dagong Global Credit Rating in Hong Kong.

China has been granting foreign institutions access to its interbank bond market, developing Panda bonds, which are yuan-denominated bonds from non-Chinese issuers, as well as Silk Road bonds to meet the financing needs of building out President Xi Jinping’s One Belt One Road game plan.

“If regulations are not clear or when rules are not clearly-defined, the uncertainties will drive away these essential market participants,” he added.

Total social financing came in 1.6 trillion yuan for December, above the forecast of 1.3 trillion yuan, but only slightly smaller than the 1.7 trillion yuan from November.

Broad money supply (M2) grew 11.3% from a year earlier, essentially in line with the forecast of 11.4%.

Another key take-away from the December set of monetary statistics is that homegrown capital outflows is still riding high, with Chinese households and corporate combined continuing to accumulate net foreign currency assets.

Bank customers increased their non-yuan deposits by US$9.3 billion in December, while reducing foreign currency liabilities by US$16.6 billion.

These transactions amount to a capital outflow of US$25.9 billion, compared with US$18.4 billion in the preceding month.

“A weakening yuan against the US dollar serves as a major headwind for foreign investors looking to invest onshore, in our view” Promboon said. “Furthermore, with US rates on the rise, capital outflow could quicken and hence, some form of capital controls could be forthcoming.”

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