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Must-read: Financial woe abroad drags tankers down, outlook negative

China Interbank Repo 3 Months 2013-06-25Enlarge GraphContinued from Why oil price is a key driver of tanker stocks

The impact of China’s financial industry

The financial industry is an essential part of any economy. Without a stable financial system—one that supplies liquidity to businesses and individuals and bridges the gap between savers and borrowers—an economy can’t function as efficiently and productively as it could. So, a collapse in the financial industry would grind an entire economy to a halt.

On June 20, 2013, China’s interbank three months repo rate rose to a record 13%, expressed in annual terms. From the end of May, the rate increased more than 800 basis points (8%)—another record over the past four years. The rate reflects the interest, expressed in annual terms, that banks charge each other for borrowing cash for three months in exchange for securities such as government bonds.

Central bank and cash crunch

A sharp increase in the repo rate reflects a cash crunch—a condition of high demand or low supply of cash, also known as “liquidity issue.” The central bank can intervene by purchasing securities from banks using cash, which increases the cash reserve and liquidity of banks while lowering the repo rate. However, central banks will sometimes let rates stay at high levels to punish banks that irresponsibly issue loans that may be uncollectible in the future, as well as companies that over-invest, anticipating that the central bank will bail them out in the end, creating a bubble along the way.

Although rates fell from a record high of 13% to 8.83% on June 25, as China expressed openness to fine-tuning its monetary policy, it’s questionable whether the financial system will stabilize right away. Historically, high repo rates (which were also volatile) have followed abrupt increases in repo rates. As the government is taking a more hands-off stance on economic policy and since housing prices remain high, a major boost to the economy via fiscal or monetary stimulus is unlikely.

China Real GDP Growth 2013-06-25Enlarge Graph

Negative outlook for the Chinese economy

This liquidity issue is negative for the Chinese economy. When liquidity dries up, companies that rely on banks to run their daily operations—such as paying suppliers and workers as well as purchasing new equipment—will not be able to use banks’ services as usual. As bills go unpaid and purchases are postponed, the economy will fall into a recession or weaker growth, which affects oil demand and price. The price of oil fell 374 basis points (3.74%) on June 20. The cause of a liquidity issue is often fundamental problems in the economy, such as the burst of a bubble. Regardless of the cause, current interbank repo rates spell a negative outlook.

Because China is one of the largest importers of oil, China’s significance in the global oil trade keeps growing as the U.S. winds down its imports. Lower economic growth will also reduce growth for China’s oil imports. This means lower or low tanker rates (visit Shipping Indexes for the latest data on tanker rates on outlook). As the majority of shipping expenses are fixed, gross margins, earnings and share prices will fall. Companies such as Teekay Corp. (TK), Tsakos Energy Navigation Ltd. (TNP), Ship Finance International Ltd. (SFL) and Teekay Tankers Ltd. (TNK), as well as the Guggenheim Shipping ETF (SEA), will be negatively affected over the next few months.

How bad will this slowdown be? Continue to Why China can contain the financial crisis and support oil demand for tanker stocks.

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