China’s financial sector is experiencing a period of significant turbulence. The sudden disappearance of 40 banks, in a single week, raises serious concerns about the stability of the country’s banking system and the potential for global repercussions.
Key themes:
- Treacherous time for the Chinese banking sector
- US 10-year Treasury yields slip to a four-month low
- JSE rebounds after three sessions of losses
- ECB and SARB hold interest rates steady
- Euro holds at a four-month high
The state of the financial sector in China
In the week ending 24 June, China’s financial landscape experienced an unprecedented shake-up, with 40 smaller banks being swiftly absorbed by larger institutions. Notably, 36 of these banks were taken over by Liaoning Rural Commercial Bank. This massive consolidation highlights severe vulnerabilities within China’s banking sector and draws parallels to the United States’ (US’s) savings and loan crisis of the 80s and 90s.
Factors driving the crisis:
Property market downturn
A significant downturn in China’s real estate market is a major contributor to the crisis. Over-leveraged developers and local governments have struggled to repay loans, leading to widespread financial instability. Property values have plummeted, and numerous construction projects have been halted, placing additional strain on the economic system. The value of Chinese developers’ dollar-denominated bonds has declined by 87% over the past two years, erasing $135.5 billion in value from $154.9 billion of outstanding notes.
Poor risk controls
Many of the collapsing banks were smaller rural lenders with inadequate risk management practices. These institutions hold a large proportion of their portfolios in non-performing loans (NPLs), with some banks admitting that up to 40% of their portfolios are bad loans, significantly higher than the official NPL ratio of around 2%.
Economic slowdown
Both domestic and international factors are driving China’s economic slowdown. Domestically, the real estate sector’s troubles have dampened consumer spending and reduced business confidence. Internationally, ongoing trade tensions, particularly with the US, have disrupted supply chains and further destablised the economy.
The scale of the problem
According to The Economist, approximately 3,800 banking institutions in China are at risk, holding assets worth C¥55 trillion ($7.5 trillion), accounting for 13% of the country’s banking system. These banks have been poorly managed for years, accumulating vast amounts of bad loans due to lax lending practices and inadequate risk management. Many of these loans were extended to developers and local governments, making these banks highly susceptible to the real estate market crisis.
Measures taken by Chinese regulators to mitigate risks
Stricter regulatory oversight
Chinese regulators have enforced stringent oversight and regulatory frameworks to curb financial risks. These measures include deleveraging efforts, curbing shadow banking activities, tightening lending standards, enhanced supervision, regular inspections, and audits. However, while necessary, these measures have also contributed to a slowdown in credit growth and exacerbated the economic downturn.
Formation of bad banks
Regulators have created institutions like the Liaoning Rural Commercial Bank to absorb failing banks. Five similar entities were established over the past ten months to handle struggling small banks. However, critics warn that this approach may lead to more systemic risks as these new entities could become more extensive versions of the same problematic banks.
Crackdown on bad practices
The National Financial Regulatory Administration has intensified its crackdown on practices that obscure the true extent of bad debts. This includes regulating asset management companies previously used to offload toxic loans, imposing fines, and increasing oversight on banks engaging in deceptive practices.
Shortening bond durations
Regulators have instructed some rural lenders to shorten the average duration of their bond holdings. This move aims to manage risks more effectively and maintain stability in the banking sector amid volatile debt markets.
Global implications
The current landscape in China may also have notable knock-on effects globally, including slower economic growth, increased financial market volatility, disruption of global supply chains, and structural changes in global trade patterns.
As China navigates these turbulent times, the effectiveness of government policies and the broader international economic environment will be crucial in determining the outcomes. The world will closely monitor China’s financial stability and its impact on the global market.
GLOBAL FINANCIAL MARKETS UPDATE
US Bonds rally on rate cut bets
The yield on the 10-year US Treasury note hovered near 4.17% on Thursday, close to a four-month low, on the back of increasing market expectations that the US Federal Reserve (Fed) will vote for multiple rate cuts this year. Initial unemployment claims rose to a one-month high in the second week of July, while continuing claims hit their highest level since November 2021. These US labour market indicators, combined with moderating inflation, create a backdrop conducive to rate cuts. Consequently, funds futures now significantly favour three 25-basis point rate cuts by the end of the year, with the first cut fully priced in for September.
The United Kingdom’s (UK’s) 10-year Gilt yield dropped to 4.05%, its lowest level in three weeks, as traders evaluated new economic data as a prediction of the Bank of England’s (BoE’s) next move on interest rates. The latest inflation and labour market data may complicate the BoE’s decision. Despite a cooling job market and slower wage growth, services inflation remains high at 5.7%, above the BoE’s forecast. The cooling jobs and wage numbers have seen the market now price in a 40% chance of a rate cut on 1 August, up from 30% after the inflation data was released.
South Africa’s 10-year bond yield stood at 9.82%. The market-friendly outcome of May’s election has led to an impressive rally in South African bonds, providing some relief for the government’s substantial debt burden. The South African Reserve Bank (SARB) has maintained its key interest rate at a 15-year high of 8.25%, despite calls for a cut from two policymakers.
Russell 2000 steals the limelight
The US’s S&P 500 edged up 0.3%, and the Nasdaq gained 0.6% in early trade on Thursday, following a tech-selloff-induced plunge the previous day, driven by a strong rotation towards riskier corners of the market as investors position for interest rate cuts. The Russell 2000 Index (a stock market index that measures the performance of the 2,000 smallest companies included in the Russell 3000 Index) gained 12% during the previous five sessions, dwarfing the 1.6% gain on the S&P 500 over the same time frame. While Thursday initially saw some reprieve following the sell-off – assisted by strong performances by semiconductor companies, Taiwan Semiconductor Manufacturing Company, Nvidia, AMD, and Broadcom – the market closed broadly weaker by the end of the day. The S&P 500 lost nearly 1%, with almost every major group in the Index having edged lower.
The UK’s FTSE 100 rose over 0.5%, driven by signs of a cooling UK labour market and hopes for an interest-rate cut, while Germany’s DAX increased by 0.4%, as investors digested the European Central Bank’s (ECB’s) decision to keep interest rates steady. Notable performers included vehicle manufacturers, Porsche, Mercedes-Benz, BMW, and VW, while industrial technology company, Siemens, saw a significant decline.
The South African JSE index trimmed some early gains, rising by 0.2% to trade below the 80,600 level on Thursday. This movement followed SARB’s decision to maintain its key interest rate at a 15-year high of 8.25% for the seventh consecutive meeting. Among corporate highlights, group platinum metal producer, Anglo American Platinum, surged over 4%, while telecommunications firm, MTN, and diversified gold producer, Gold Fields, were notable decliners, falling by 2.9% and 1%, respectively.
Gold steady near all-time highs
Brent crude futures climbed to around $85.50/barrel, driven by a larger-than-expected drawdown in US crude inventories and dovish comments from Fed officials. These factors have boosted optimism about US rate cuts, which could enhance oil demand. Geopolitical tensions, including an attack on a Liberia-flagged tanker by Yemen’s Houthis, also supported oil prices.
Gold prices rose towards $2,470/ounce, lingering near record highs, as market optimism grew regarding potential Fed rate cuts. Fed officials have increasingly indicated confidence in achieving their inflation targets, suggesting that rate cuts could occur as early as September.
Euro supported by ECB
Thursday saw the US Dollar Index hover just above the 104 mark, following declines earlier in the week, reflecting market anticipation of multiple Fed rate cuts, ultimately weighing on the greenback. The dollar did, however, manage to rebound sharply towards the latter part of the trading session, as investors took a breather to assess manufacturing data and recent comments from central bankers.
The British pound weakened against the dollar, affected by soft wages data which led to a modest increase in expectations of an interest rate cut by the BoE in early August. UK inflation steadied at 2% in June, which was better than forecasted, but not enough to shift the market sentiment significantly. Services inflation remained elevated, and the unemployment rate held at a high level, which will complicate the BoE’s decision.
The euro dipped slightly towards the end of the trading session but remained near a four-month high following a strong morning session. The ECB’s cautious stance and ECB President, Christine Lagarde’s comments, indicating that September’s decision is still open, have led to uncertainty about future rate cuts, bolstering the euro.
The South African rand traded rangebound, near the R18.20/$ mark for most of Thursday’s trading session, before coming under pressure on the back of a stronger dollar in overnight trade. While the SARB maintained its cautious approach on Thursday afternoon by keeping rates steady, investor sentiment seems cautiously optimistic about a potential rate cut later in the year, despite the higher inflation reading in May. Investors now await firm guidance on policy from the newly created GNU, while keeping a keen eye on global factors. The rand remains well-positioned for further strength as we head into the latter part of the year.
Key Indicators:
USD/ZAR: 18.32
EUR/ZAR: 19.94
GBP/ZAR: 23.70
GOLD: $2,421.30
BRENT CRUDE: $84.61
Sources: Bloomberg, Refinitiv/Reuters, The Economist and Trading Economics.
Written by: Citadel Advisory Partner and Citadel Global Director, Bianca Botes.