注：本文发表于China Daily，2023年4月7日。转载请务必注明出处。

More turbulence ahead

On March 9, Silicon Valley Bank declared bankruptcy.

The direct reason was that specific shocks triggered by the Federal Reserve's rate hikes caused depositors to withdraw large amounts of deposits, and the bank had to sell its investment bonds to respond. Once Silicon Valley Bank began selling bonds, it had to disclose the book losses incurred on those bonds, triggering panic among depositors and ultimately causing a panic run.

In mid-March 2023, Credit Suisse reached a crisis point. The immediate cause was its own announcement on March 14 that there were significant defects in its annual financial reports for 2021 and 2022, which triggered short selling.

Considering that Credit Suisse is a systematically important global financial institution and Switzerland's second-largest commercial bank, the Swiss government chose to help it by putting pressure on the United Bank of Switzerland to acquire Credit Suisse at a price of 3 billion Swiss francs ($3.28 billion).In the mergers and acquisitions process, the Swiss government directly wrote down the $17.2 billion additional Tier 1 bond (AT1) issued by Credit Suisse to zero. AT1 securities are a form of "contingent-convertible" bonds created after the 2007-09 global financial crisis to prevent the need for government-funded bailouts of precarious banks. Cocos, as these instruments are known, are a hybrid of bank equity (the money invested by shareholders, which absorbs any losses in the first instance) and debt (which must be repaid unless a bank runs out of equity). Making the AT1 bondholders bear the bankruptcy losses of borrowers prior to shareholders has caused the European AT1 bond market, which was valued at $275 billion, to be volatile.

The short selling of AT1 bonds issued by Deutsche Bank is the direct reason why the bank is involved in this round of international banking turmoil. At the same time, there are two additional reasons for the Deutsche Bank crisis. On the one hand, the bank holds a portfolio of approximately $16.8 billion in US commercial real estate investments, and the US commercial real estate market is facing downward pressure. On the other hand, the bank has significant deficiencies in corporate governance. For example, in 2016, Deutsche Bank's US branch failed to pass the stress test organized by the Federal Reserve and was considered one of the most dangerous banks that could pose systemic risks to the global financial system.

One of the deep-seated reasons for the current round of global banking turmoil is that, under the pressure of high domestic inflation, the Federal Reserve's rapid interest rate hikes and quantitative tightening (QT) have pushed up long-term interest rates in the US and the dollar exchange rate, leading to a significant decline in the prices of various risk assets and safe haven assets, resulting in significant book losses for commercial banks that hold these assets.

The second deep-seated reason is that since the outbreak of the global financial crisis in 2008, the supervision of some commercial banks has not been strengthened substantively, or was tightened before being significantly relaxed, leading to obvious latent dangers in their operation and management, especially in risk control.

For example, in May 2018, then US president Donald Trump signed the Economic Growth, Regulatory Relief and Consumer Protection Act. Article 401 of the act basically cancels the stress testing of commercial banks with assets between $50 billion and $100 billion, and relaxes financial supervision of commercial banks with assets between $100 billion and $250 billion.

Is the banking turmoil in Europe and the US just the beginning or is it near an end? Based on the following three reasons, I am not particularly optimistic.

First, the Federal Reserve is likely to continue to raise interest rates. Even if it stops raising interest rates, the Federal Reserve will not bring them down soon. Currently, inflation in the US remains high and shows a strong stickiness (the main driving force for the increase is from costs of services, rents and wages). I believe that the Federal Reserve may still have one or two 25-basis-point interest rate hikes in store.

Second, the potential losses caused to financial institutions in developed countries by the US and European central banks' current interest rate hikes have not been fully exposed. For example, the European Central Bank used to implement negative interest rate policies for a long time. The asset size of negative interest rate bonds in Europe was close to $18 trillion at the peak, and most of these negative interest rate bonds are currently not yet due. This means that institutions that hold large amounts of these negative interest rate bonds, especially global insurance giants, are also facing huge book losses.

Third, financial turmoil may be intertwined and mutually reinforcing with economic recession and geopolitical conflicts, and ultimately the deterioration of the real economy and the international situation will do harm to the confidence in the financial market.

So far, the current global financial turmoil has had a relatively limited impact on China's economic growth and financial markets, but the following risks deserve attention:

First, in 2022, as the Federal Reserve began a new cycle of interest rate hikes and balance sheet tightening, the Chinese economy experienced challenges brought by a large-scale short-term capital outflow, a significant decline in asset prices and a substantial depreciation of the renminbi against the US dollar. If the recent turmoil in the international financial market becomes increasingly severe, we may again face a similar pinch as in 2022.

Second, the SVB bankruptcy, to a certain extent, has threatened Chinese science and technology innovation enterprises that had direct or indirect connections with it.

Third, the continuous outbreak of crises in small — and medium-sized banks in the US may also prompt domestic and foreign investors to pay more attention to the potential risks of Chinese small — and medium-sized commercial banks from the perspective of confidence channels, and even trigger short selling or withdrawal. In fact, some local urban and rural commercial banks have insufficient capital, low quality assets, and high financing costs for debtors, and they have invested heavily in bonds issued by local investment and financing platforms. The possibility of the intensive exposure of the above-mentioned banks' future risks cannot be ruled out.

Finally, as mentioned earlier, certain global insurance giants are likely to become embroiled in the crisis next if the global financial market continues to be in turmoil. Considering that many high-income individuals in China have previously purchased a large amount of life insurance and critical illness insurance outside the Chinese mainland (especially in Hong Kong), in the event of any accident of a global insurance giant, their insurance policies may face the risk of redemption failure in the future.

So, under the premise that the international financial market will continue to be in turmoil, how should the Chinese government and Chinese financial institutions respond?

First of all, the Chinese government should continue to implement expansionary fiscal and monetary policies to ensure the economic growth rate is over 5 percent in 2023. Against the backdrop of a global economic slowdown, the high growth rate of China's economy will not only stabilize the confidence and expectations of domestic entities, but also attract international capital flows to China.

Second, the People's Bank of China should tolerate wide fluctuations in the renminbi exchange rate while maintaining capital account control. An increase in the flexibility of the renminbi exchange rate can absorb adverse external shocks and avoid sustained overvaluation or undervaluation of the renminbi exchange rate. And capital account control can help curb the ups and downs of short-term capital flows.

In addition, the Chinese government should pay high attention to the potential upward financial risks of domestic financial institutions. In particular, the potential risks of small — and medium-sized commercial banks such as urban commercial banks and rural commercial banks in the context of high local government debt and the adjustment of the real estate market. Stress testing, risk planning and preparedness should be taken into consideration.