The impact of China’s financial industry
The financial industry is an essential part of an 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, the three months China interbank repo rate rose to a record high of 13%. 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.
Cash crunch and the central bank
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, it’s in the central bank’s interest to let rates rise and let some companies fail from time to time, or else banks will irresponsibly issue bad loans (loans that may be uncollectible in the future) while companies 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% on June 24, 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. Given that the Chinese government is taking a more hands-off stance on economic policy and that housing prices remain high, a major boost to the economy via fiscal or monetary policy is unlikely.
Negative outlook for the Chinese economy, but there are opportunities
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, which can have a spill-over effect on the broader economy. As bills go unpaid and purchases are postponed, the economy will fall into a recession or weaker growth.
For dry bulk shipping companies that transport key raw materials such as iron ore, coal, and grain across oceans, this means lower or low shipping rates (visit Shipping Indexes for the latest data on shipping rates on outlook). As the majority of shipping expenses are fixed, gross margins, earnings and share prices will fall. Companies such as DryShips Inc. (DRYS), Diana Shipping Inc. (DSX), Safe Bulkers Inc. (SB) and Navios Maritime Partners LP (NMM) would be hurt in the short and perhaps medium terms. China’s cash crunch will also negatively affect the Guggenheim Shipping ETF (SEA).
But there are opportunities down the road. See Recommendation: Use credit default swap price to time entry for shipping companies for our advice.