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History shows high repo rates follow high repo rates, negative for dry bulk stocks

China Interbank Repo 3 Months 2013-07-08Enlarge GraphChina’s repo rates and dry bulk

Although China’s interbank repo rates have fallen from their peak, questions remain over whether interbank repo rates will continue to stabilize and stay low in the short to medium term. What, then, would the repo rates’ implication be on China’s economy and demand for dry bulk shipments, which depend heavily on China’s industrial output?

How repo rates moved

Interbank repo rates have fallen recently, as China expressed openness to fine-tune its monetary policy and injected some money into banks. But history says that a volatile increase in interbank repo rates precedes persistent or volatile rates. In late 2007, for example, the interbank three months repo rate spiked from ~3.0% to 6.0%. Although it came down to 3% for a few days, it went right back above 6.0% a few days later. This zig-zag action continued until the first quarter of 2008. Even as volatility fell, the repo rate continued to stay above 4.0%, which was negative.

Baltic Shipping Index by Ship Class 2013-07-09Enlarge Graph

Shipping rates for dry bulk shipments, for example, eventually collapsed.

iShares FTSEXinhua China 25 Index ETF (<a href='/quote-page/fxi/'>FXI</a>) 2013-07-09Enlarge Graph

The popular iShares FTSE/Xinhua China 25 ETF (FXI), which invests in several financial companies, topped out earlier, in late 2007.

The central bank

Often, the central bank can intervene by purchasing securities from banks, which increases the cash reserve and liquidity of banks while lowering the repo rate. However, central banks will sometimes let rates stay high 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 and create a bubble along the way. This is what we’re seeing now. As China prepares itself for an economy led more by private enterprises, it’s trying to discover and expose excessive lending so that it can correct this practice.

Many financial companies in China predict that rates will stay high, as Governor Zhou Xiaochuan (People’s Bank of China) calls for a correction to excessive lending. In addition, a high rate would increase the opportunity cost for these financial firms to move money back into the real estate sector, thereby reducing investments in the short term. This move may be negative for the economy in the short to possibly medium term, which will also negatively affect dry bulk shipping companies such as DryShips Inc. (DRYS), Diana Shipping Inc. (DSX), Eagle Bulk Shipping Inc. (EGLE), Navios Maritime Partners LP (NMM), Safe Bulkers Inc. (SB), and Knightsbridge Tankers Ltd. (VLCCF). But it will present an opportunity for long-term investors in the future. The situation isn’t all bad, since the central bank (People’s Bank of China) announced that it will give liquidity support to banks that lend to help the economy.

The sharp rise in interbank repo rates on June 9 (see Why China’s interbank rates have an impact on dry bulk shipping companies) suggests that rates will likely remain high in the short term and that risk has not gone away. But will this be the beginning of another crash? We’ll have to see if the central bank has the right tools.

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