CNH Tracker-Hong Kong must heed risks as China toughens up on credit
By Saikat Chatterjee HONG KONG, June 27 (Reuters) - The liquidity crunch in China's financial system last week spooked global markets and led to a downgrade in the outlook of Hong Kong banks that has raised alarm bells about contagion. The widespread panic from the dizzying spike in onshore interbank rates offers a valuable lesson in risk management for the gatekeepers of Hong Kong's growing yuan markets as the territory's banks have deep ties to state-run mainland banks. China's central bank has balked at injecting funds into the money markets as it cracked down on funds flowing into the country's vast informal loans market known as "shadow banking". While offshore markets saw only moderate volatility from the credit squeeze and plunging stock prices, the spillover effects are hard to ignore even for the most ardent cheerleaders of China's yuan internationalisation project. "As the cross border channels strengthen between the onshore and the offshore markets, it is not going to be easy for Hong Kong's regulators to avert a contagion effect and they need to be prepared to stem any impact," said Becky Liu, a strategist at Standard Chartered Bank. The shortage of funds in China has spilled over into Hong Kong, pushing up the cost of funds in the growing offshore yuan market amid speculation that subsidiaries of Chinese banks were remitting money to the mainland. The clearing bank for yuan-related transactions in Hong Kong and Taiwan had to raise yuan interest rates this week to attract more yuan deposits. Some Chinese banks reportedly jacked up deposit rates for short-dated yuan funds, and the Chinese government narrowly sold out a jumbo bond sale on Wednesday. Indeed, Fitch Ratings said this week that sustained stress in the Chinese interbank market would raise counterparty risks for Hong Kong banks' exposure to mainland banks arising mainly from interbank placements and from guarantees on trade finance. Fear of a banking crisis are surfacing as the world's second-largest economy is already showing signs of slowdown. Confidence in Hong Kong's banking system is also critical at a time when the yuan becomes more popularly used in business and trade, making new inroads into markets outside Asia. ALLAY FEARS One way to prepare for any funding crisis is to let Hong Kong banks have unlimited use of short-term yuan funds via a 400 billion yuan ($65.07 billion) swap line the Hong Kong Monetary Authority (HKMA) has with the People's Bank of China. While on paper, the swap line is in place to avoid any short-term funding mismatches arising mainly due to trade, the HKMA can soothe concerns by making it clear that banks in the city can tap this funding channel to get emergency yuan funds. It was precisely Beijing's refusal to release short-dated funds to desperate Chinese lenders in the last couple of weeks that exacerbated the crisis. Moreover, Hong Kong would be reluctant to trigger any fresh shortages after the previous two episodes in October 2010 and September 2011. Offshore markets went into a tailspin after the trade settlement quotas were exhausted in both instances, which choked off the supply of offshore yuan and forced regulators to undertake major damage control. The HKMA can also shorten its settlement cycle for releasing yuan funds to banks, which currently, takes place one day later. The HKMA can pass on to banks the cost of swapping Hong Kong dollars to yuan and procuring yuan at higher interest rates in the mainland. A secondary concern arising out of such a backstop funding facility is that some banks may use this emergency access to funds to channel money back into its cash-strapped branches onshore via the growing channels of trade and commerce. But that concern can be easily addressed by demanding collateral in Chinese yuan or even Hong Kong dollar assets. Analysts have also warned Hong Kong banks against exploiting opportunities to expand lending to Chinese companies as their mainland counterparts struggle for funds, as it could have an adverse impact on their asset quality. "Hong Kong banks have substantially increased their mainland China exposures to 16.5 percent of consolidated total assets at end-2012, up from 9.8 percent at end-2009," said Sonny Hsu, vice president - senior analyst at the Financial Institutions Group at Moodys' Investor Services. WEEK IN REVIEW: China's Ministry of Finance managed to sell $2.1 billion of yuan-denominated bonds in choppy market conditions in Hong Kong on Wednesday as fears of a credit crunch eased. There were two interesting facets to this bond sale -- a 30-year tranche which was a novelty to the offshore yuan bond market, being the longest maturity to date. A tranche of the bond sale reserved for only central banks attracted good demand. The 3 billion yuan tranche received about 5.48 billion yuan of orders from about eight central banks in Asia, Africa and South America. The main clearing bank for yuan-related transactions in Hong Kong and Taiwan raised interest rates this week in a bid to offer more competitive rates to attract yuan deposits. Bank of China raised the interest rate it will pay for other banks' yuan deposits to 0.75-1.05 percent from a flat rate of 0.648 percent, effective next month in Hong Kong. In Taipei, Bank of China will raise overnight rates for yuan deposits in July in a bid to lure more yuan funds from Hong Kong, a source said. The hike in interest rates comes amid some reports that some Chinese banks were offering higher interest rates for short-dated yuan retail deposits and some companies were shipping their excess yuan funds across the border. Moody's Investors Service downgraded the outlook of the Hong Kong banking system to negative from stable reflecting its concerns over persistent negative real interest rates and banks' growing exposures to mainland China. In response, the city's de-facto central bank struck a confident stance with a spokeswoman at the Hong Kong Monetary Authority noting the ratings agency continued to recognise the Hong Kong banking system's strong financial metrics and high credit ratings relative to global peers. "We will continue our close dialogue with Moody's to ensure that the agency maintains a balanced view on the Hong Kong banking system's outlook," she said. CHART OF THE WEEK: China credit default swaps:As a near three-week cash squeeze in the mainland gripped the attention of global markets, the market for credit default swaps on Chinese assets became the microcosm for monitoring the ebb and flow of market jitters. Credit derivatives of the Chinese government and Bank of China particularly were actively traded with spreads on these swaps spiking sharply higher in recent sessions. 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