Abe’s warning

Japanese Prime Minister Shinzo Abe warned his counterparts at the G7 meeting in Japan that the world may be facing another “Lehman’s moment” (alluding to severe stresses in the financial system, indicated in his view by the weakness of commodity prices).

Once again, when we thought it would not be possible, Japanese policymakers surprise us with the paucity of their true understanding. It’s not Commodity Prices that worry us – they are simply the manifestation of an underlying process of rebalancing that the Japanese have correctly identified. It’s the perilous state of the Japanese banks and the ongoing damage being inflicted by Japanese monetary policy that is, to us, of most concern.

Mr Abe said, “We agreed on the perception that we are facing serious risks, that the world economy is facing serious risks”.

In that regard, he’s right, but the most worrying point is that Japanese Banks pose a substantial and worsening threat to Global Financial Stability. Here’s the picture:

Firstly, Yen 80 trillion of annual QE by the Bank of Japan (fully 15% of GDP each year) has left the Bank of Japan (BoJ) owning 27% of the outstanding STOCK of Japanese Government Bonds. They were purchased from banks that held them with a nice running “carry” (the difference between the cash rate they paid on their deposits liabilities used to fund them and the yield on the bonds themselves) that has now disappeared. Japanese banks, as a direct consequence of the Bank of Japan, now have approaching 20% of their entire ASSETS in cash and deposits:

Needless to say, those assets earn nothing.

Image 1

Secondly, Japanese licensed banks have 9.6% of their assets in Central Government Bonds – the yield on those bonds is now below the deposit rate paid to new deposits. That’s not good for earnings, when you pay a higher rate out than you get on your investment.

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Thirdly, the general loan rate for new loans is fast converging on the deposit rate paid to new deposits, and the margin on loans to the real economy is evaporating:

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Fourthly, banks are being “squeezed” from one side by the BoJ and “squeezed” on the other side by depositors: the level of cash in circulation in Japan relative to GDP is marching ever higher.

It stands at 18% versus 7% in 1990 and has trended higher continuously in the last 25 years:

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So, to recap:

  • Japanese banks hold extraordinary levels of non-earning cash on their balance sheets (in fact, the interest rate on the Yen 280 trillion of excess reserves held in the current account at the Bank of Japan is negative)
  • Government bonds yield less than the rate paid to depositors
  • New loan rates are barely above the rate paid to new depositors
  • The economy is becoming increasingly “cash based” – cash / GDP is way beyond international comparison
  • Non-Performing Loans, NPLs, as in China, are being concealed and understated

We’d say the likelihood of a “Lehman’s moment”, as Mr Abe notes, can’t be ignored… But we’d go further and urge Mr Abe to pay closer attention to the destruction of the Japanese Banks being propagated by the Bank of Japan’s QE policy. Any further QE, or a move to increasing negative official rates, just exacerbates the problem. Hopefully Mr Abe showed some charts like these and didn’t overplay the decline in commodity prices.

The Bank of Japan’s monetary policy is sowing the seeds for a systemic Japanese banking crisis – the TSE banks index is down 39% y/y for a reason.

Déjà vu

Last August, and again earlier this year, Chinese devaluation and the threat of a more serious decline in the Yuan (combined with USD strength) sowed the seeds of brief periods of significant drawdown in Global equity markets: the Global Index fell 12% in the month after last August’s trivial devaluation, and almost 14% in the weeks leading up to mid-February, when Yuan devaluation fears again re-surfaced.

Despite net outflows continuing apace through the first quarter – almost matching the entire outflow in the first 11 months of last year – and heavy Central Bank intervention, together with some tightening of controls at the margin, the Yuan actually strengthened in a move (vindictive, some speculators might say!) designed to head off speculative pressures and provide reassurance that all is well in the East. Another $1trillion in loans helped, but that’s neither here nor there in China these days. Move along, nothing to see here…

But we know differently. We know that you simply cannot grow credit $2.5 trillion annually with no corresponding nominal income growth; we know you cannot add capacity where there is already too much capacity; and that you cannot grow bank balance sheets at a rate annually equivalent to 40% of nominal GDP. Not if you want to keep your exchange rate fixed, you can’t.

And that’s where recent developments are interesting, the Chinese officially target the Yuan against the CFETs index – against a basket of 13 currencies (about one quarter USD weighted) and the Yuan has depreciated 1.3% since the end of March (5.9% year to date). From the mid-January low, the Yuan appreciated 2.1% against the USD through the end of March but has depreciated 1.2% versus the USD subsequently. They’ve unwound half the appreciation of the prior weeks.

Quietly, and under the radar, the Chinese have been letting the Yuan slide against the CFETs basket and, probably more importantly for the market, against USD.

Graph 1

This USD strength is seen in the broad USD appreciation in recent weeks: the next chart shows the percentage of currencies in the US effective exchange rate basket that the US has appreciated against in the last 20 days: the USD has appreciated against 80% of the currencies in its own basket.

Graph 2

We are seeing broad USD strength, broad Yuan weakness and, significantly, the Chinese quietly letting the Yuan slide against the USD.

This feels like déjà vu from our standpoint.

The global economy is already at low altitude, the median annual growth rate in our broad national sample is just 1.9% with over half growing less than 2% annually, and appears to be losing speed, again over half have growth slowing. Another round of Yuan/USD weakness into that mix is likely to precipitate just the same reaction as we saw last summer and earlier this year. Perhaps it’s time to seek out that tin hat again…

Severe Stress

We have written at length, and in great detail, over the last nine months about the stresses in the Chinese banking system and the threat to both Chinese and global stability.

As if more proof were needed the following chart, showing the volume of interbank lending in China, illustrates the extent of the pressure on a banking system that is enormously over-extended in an economy that is overleveraged and with extreme overvaluation in equities, real estate, and increasingly, government bonds (10 year government bonds currently yielding less than one percentage point more than US 10 year government bonds).

Yes, in November 2015 (latest data) Chinese interbank lending hit Yuan 8769 billion (or Yuan 8.8 trillion, about $1.4 trillion)


In year on year terms the level of lending has exploded.


Now, interbank lending has typically been a way for Chinese banks to get around PBOC (People’s Bank of China) restrictions on balance sheet growth and leverage (loans can be made via other banks and are off balance sheet and circumvent loan/deposit ratio limits and capital requirements). The PBOC has tried on several occasions to address this loophole in the structure of regulations to little or no effect.

The enormous increase in interbank lending can only mean the following: the banking system is creaking under the strain of capital flight and tightening domestic liquidity conditions and that bad loans must be piling up at an alarming rate.

How should banks respond to this sort of scenario? Well, look at US banks after the subprime crisis. US banks reduced their credit market debt outstanding by approximately $3 trillion between the end of 2008 and the end of 2015. They reduced debt to add approximately $1 trillion in equity. Eminently sensible – swap debt for equity and deleverage.

What have Chinese banks actually done? Well, step forward anyone who wants Chinese bank equity… I don’t see a crowd. So, the Chinese response has been to increase bank leverage (when they are talking about deleveraging the system). Extremely worrying.

Consider that the balance sheet of Chinese depository corporations (“banks”) is $31 trillion, or three times Chinese GDP, and has quadrupled since the global credit crisis began in 2008. There you begin to see just how important Chinese banks are – they have a balance sheet equivalent to 30% of global GDP. Moreover, they are very inefficient lenders. In the last four quarters alone they expanded their balance sheets by $4.3 trillion when Chinese GDP grew just $0.5 trillion… which means just one thing, lots and lots of bad/non-performing loans in the pipeline.

And, for all those who think the Chinese can use their $3.3 trillion in foreign reserves to bail out the banks, perhaps the following information might be helpful. Assuming just 20% of Chinese bank assets are non-performing at peak (and that number is very, very modest by historical Chinese standards) and with a 50% recovery rate, you write off $3 trillion for the banks (0.2 * $31 trillion = $6.2 trillion and 0.5 * $6.2 trillion = $3.1 trillion). A relatively benign credit event cleans out PBOC reserves (assuming there is no further flight). If you think those FX reserves give the PBOC ample firepower to hold up their banking system then you are possibly guilty of wishful thinking and blind optimism.

Keeping to the USD peg, keeping real rates high enough to stem the capital outflow, deleveraging the financial system and keeping the economy motoring? These are impossibly incompatible objectives. Only one way out (as we highlighted many months back) – a significant decline in the Yuan (20% plus) that exports all of China’s problems to Japan and the West in a deflationary tsunami.



Less than meets the eye…

When is policy easing not much of policy easing? In China.

The Chinese cut the prime rate and the reserve requirement for banks last week by 0.25% and 0.5% respectively.

That brings the rate cut to 1.25% for the year and the reserves requirement cut to 2.5%.

On face value, this is quite an aggressive move after a 2% devaluation in the exchange rate a few months ago.

However, in our view, there is far less to the easing than meets the eye.

Here’s why:

The deposit base of Chinese financial institutions is approximately $20 trillion. Up to the end of September, the reserve ratio (RR) cut will have released about $407 billion of liquidity into the system. This combined with an incremental $105 billion coming from last week’s cut gives a year-to-date injection of approximately $512 billion.

However, as the following chart (October’s reserve data is not yet available, this data only goes through end of September and thus does not include the impact of last week’s RR cut) shows, in the period through the end of September the central bank lost $329 billion of foreign exchange reserves as capital flowed out of the country.


A loss of reserves represents a loss of domestic liquidity that must be offset against the RR cut to see the proper extent of liquidity injections from the central bank. Quite clearly, in the first nine months of the year 80% of the People’s Bank of China’s (PBOC) liquidity injections from RR cuts flowed straight out of the door; just about $80 billion of liquidity appears to have been injected net from a relatively swift policy easing. That amount is actually irrelevant in a $10 trillion economy under such banking system stress. It is almost certain that reserves declined again in October, probably offsetting more than half of that month’s RR liquidity release.

Moreover, with the GDP deflator and the negative producer price inflation, the nominal prime lending rate has not declined at a pace to even match the price deflation, leaving real lending rates higher than they were at the start of the year.

In addition, despite the devaluation, the real effective exchange rate is also higher over the last twelve months and since the beginning of the year.

All in all, less than meets the eye when you look at the true nature of Chinese monetary policy. Higher real rates, a higher effective exchange rate and a trivial increase in domestic liquidity. Why might that be so?

Well one reason, perhaps, is that the PBOC is trying to fight two fires with one extinguisher. The capital outflow puts downward pressure on the yuan such that the PBOC must defend it if it is to maintain the dollar currency peg. It needs high real interest rates to hold capital in, but the consequence of higher real interest rates for horribly leveraged domestic corporates on wafer thin (if any) margins are painful. It appears that the rate cuts and the RR cuts are intended to show willingness to support the economy under stress without also compromising the peg.

As always, something must give. Will the Chinese allow the system to fail for the sake of the peg? No, we don’t think so. It reinforces our view that the yuan will be devalued significantly in coming quarters. The paradox is that the more they cut rates… the faster capital flows away, the greater the pressure on the peg and the greater the stress in the system that necessitates even more RR cuts. It’s a vicious cycle where cuts necessitate more cuts; easier to let the yuan weaken.

Of course, when you get almost 30% of your imports from China, and their currency weakens, the Japanese will come under increasing pressure for an even more aggressive QE stance to show that they are doing something, anything, to address a deflation storm heading their way. A weaker yuan also implies a weaker yen.