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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 July 1, 2013, China’s interbank three months repo rate, expressed in annual terms, stood at 6.45%, after falling from a record of 13% on June 20. From the end of May to June 20, the rate increased more than 800 basis points (8%)—another record over the past four years. The rate reflects the interest 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.
This is likely what we’re seeing right now: rates have fallen from a record high, as China expressed openness to fine-tuning its monetary policy last week, but the fact that the rate remains above 6.0% is negative and suggests conditions within the financial sector are more stressful compared to a few months ago. It’s also questionable whether the financial system will stabilize right away. Historically, high repo rates (which were also volatile) have followed abrupt increases in repo rates.
Negative outlook for the Chinese economy
This liquidity issue is negative for the Chinese economy (green shade represents lower economic growth in the graph above). 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 cause of a liquidity issue is often tied to over-investment.)
Because China is one of the largest importers of oil, lower economic growth will hurt oil import and tanker rates. 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. But is a crisis coming? Read Why China can contain the financial crisis and support oil demand for tanker stocks to see why that’s unlikely.
Investors should read other articles to further understand what’s currently driving the tanker shipping industry. Some must-reads include Shipping capacity growth drops but outpaces demand, negative for tanker stocks, Research shows China’s soaring housing prices actually support tanker firms, and Oil rig activity stays high, negative for oil shipping.
© 2013 Market Realist, Inc.