BEIJING (Reuters Breakingviews) - Chinese bond investors are finding that trouble comes in threes. First a U.S. rate hike, then a squeeze on short-term lending that dried up fixed-income liquidity, and finally a scandal at a brokerage which fuelled fears about wobbly leverage underpinning China’s bond market rally.
Margin trading pumped up China’s stock market rally in 2015, and unwinding those leveraged bets amplified the crash. Now it looks like the $7 trillion bond market may be facing a similar, but perhaps bigger and murkier problem, stoked by shadow finance.
Mid-sized brokerage Sealand Securities threw a spotlight on those shadows when it aggravated a running bond market sell-off in late December. The broker prompted a panic when it said it would not honour contracts to buy back $2.4 billion of bonds from over 20 counterparties because the agreements were forged by two employees.
The agreements in question are similar to formal bond repurchase agreement contracts, commonly known as repos. They can be agreed directly between two parties or over-the-counter, and are often not backed by collateral. In some cases the agreements are only verbal. Worse still, nobody knows how many there are and how much net leverage is involved. During a rally, such contracts can prove profitable by allowing traders to amplify gains. They can also help window-dress balance sheets by quickly substituting cash for bonds for short periods of time. But they intensify losses when bond prices fall, as they have begun to do in China.
Under pressure from the China Securities Regulatory Commission, Sealand has now pledged to make investors whole. But regardless of whether the repurchase agreements were forged or not, the scandal points to more trouble brewing among the hundreds of other brokerages, trust companies and asset managers. Such non-bank financial institutions held $3.7 trillion in loans as of November, according to central bank data.
The non-bank financial sector is overseen by a host of financial regulators, which makes policy control challenging. But they also keep money flowing in the bond market and thus help the wider economy. Unfortunately banks are getting nervous about lending to them under tighter monetary conditions. Falling bond prices could prompt even more defaults on repurchase contracts, formal or otherwise. This round of bond turmoil won’t be the last.
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