Here’s a look at how USD bonds of Chinese developers are performing.

As the chart above illustrates, they aren’t doing well at all, and have resumed their free fall after managing to rally in November. The asset class is now down slightly more than 40% over the last 6 months or so. (as measured by the ETF and ICE index it tracks)

Considering that the Evergrande contagion has now reached Country Garden, it would be safe to say that the entire real estate sector has been engulfed. Should these problems lead to large write downs in the values of assets held by local banks, the contagion has a real chance at morphing into a domestic financial crisis. 

This in turn exposes the Chinese economy to a broader credit contraction while impairing its banks – a dangerous combination. Needless to say, the direct and second order consequences of both problems are much larger in breadth and scope than if the crisis were contained to real estate.

Of course, the Chinese government knows this, and has been taking steps to do just that.

Last year saw cuts in the reserve requirement ratio (RRR) and the RRR for foreign exchange.  They acted again yesterday with a 10 basis point reduction in the medium term lending facility, and a 10 basis point reduction in the reverse repo facility. 

The 10 point cut makes it cheaper for Chinese banks (those that have access to these facilities) to borrow bank reserves. While headlines in the media portray this as a “liquidity injection”, implying that more money is somehow being pushed into the economy, that’s not the case at all.

Increasing bank reserves only serves to ensure that banks have enough of them to settle their customers’ daily transfers. This is useful, and can help keep the system intact by preventing bank runs. That is, when customers rush to transfer or withdraw their funds en masse, leading to a bank not having enough bank reserves to fulfill its obligations.

While this is undoubtedly helpful, it does not actually increase the amount of money in the broader economy, simply because bank reserves do not get lent out.

The main way to increase the amount of money in the economy is for banks to make more loans, which Chinese banks are understandably cautious about doing given the current environment. Unfortunately, rate cuts and pumping the banking system with more bank reserves does little to remedy this.

Which makes it extremely important at this point to look for signs that the contagion is spreading to the banking sector.

Here’s how the broader Chinese fixed income market is doing.

As you can observe from the chart, prices have also fallen sharply since the turn of the year. Moreover, the largest holdings in this Chinese bond fund are long term debt issues of Chinese banks, which shows how unwilling investors are to hold on to them. 

Clearly, Chinese banks are starting to feel the effects of the contagion, at least in terms of long term funding costs. However, this does not yet imply that a domestic financial crisis is around the corner.

For that to happen, we need to observe short term bank funding costs rise as well.

Fortunately, this has yet to happen.

The chart above, of a fund investing in 6 month to 3 year onshore debt of Chinese policy banks, is still steadily climbing higher.

Until prices of such instruments begin to fall, markets remain somewhat confident in the real estate mess resolving itself without unduly affecting the banking system. Or, they remain confident in the Chinese government’s ability to keep it contained.

Either way, keep an eye on Chinese short term rates.

Last but not least, here’s the CNY, which is still trading firm vs the USD, even after Evergrande’s formal default and rate cuts on multiple fronts.

Clearly Chinese banks and businesses are not struggling to get hold of Dollars. Which means that the Evergrande contagion remains contained within China for now, and has yet to spread to the global Dollar funding markets.

This is important as the international USD funding markets are the main conduit through which the Evergrande contagion can spread to financial markets across the globe.

However, this works both ways.

Should global Dollar liquidity deteriorate independent of China’s real estate crisis, it could exacerbate already worsening conditions in China, sparking a negative feedback loop.

In such a scenario, rising Dollar financing costs drive other, non real estate Chinese companies into default, which creates more domestic economic stress. This increases the likelihood of Chinese banks having to write down asset values on top of their struggling real estate linked ones.

More credit contraction follows, then more economic weakness, and even more write downs. The end result being a domestic banking crisis not directly caused by the Evergrande contagion, but certainly not helped by it. 

Either way, USDCNY is a key variable in the ongoing saga. As long as economic conditions remain weak in China, the exchange rate must be closely monitored, regardless of Evergrande and Country Garden’s ultimate fate.