by Ambrose Evans-Pritchard
January 3, 2017
As the Dow flirts with Trumpian heights of 20,000 on Wall Street, the Shanghai Composite in China has been drifting down for seven consecutive weeks.
It is hard to construct a case that reconciles this split, given the tightly intertwined nature of the world’s financial system and the trans-Pacific symbiosis that we call Chimerica. One of these two markets must reverse.
If you are waiting for the next Chinese boom, you have already missed it. The latest 18-month mini-cycle has peaked. The authorities are being forced to tighten. China’s $9 trillion bond market is seizing up.
Forty companies have had to cancel or postpone bond issuance this month. Nomura says 24 large firms are in default negotiations, ranging from steel and construction to shipbuilding, chemicals, textiles, and solar.
Beijing let it rip earlier this year with a fiscal deficit of 4% of GDP – a one-off loosening of two to three percentage points that you would expect only in an emergency – and it deliberately stoked a housing bubble in the cities of the Eastern seaboard.
The stimulus was comparable in scale China’s post-Lehman blitz, but the effects have been far less because the efficiency of credit has collapsed. It now takes four yuan of loans to generate one yuan of growth. Since there has been almost no underlying reform, this has merely bought time at the cost of greater imbalances.
“The game is getting long in the tooth. Beijing’s reflationary tactics are subject to diminishing returns, and the risks are accumulating,” said Konstantinos Venetis from Lombard Street Research.
The Communist Party has now lost its room for maneuver. Net capital outflows accelerated last month to the highest level since the currency panic a year ago. That panic – nota bene – led to an 12% fall in the Dow.
Capital Economics estimates that outflows in the single month of November reached $80bn. The Institute of International Finance says it may have been as much $115bn, three times the level in October.
This occurred in spite of draconian capital controls. Foreign forays by Chinese companies have been put on hold. Corporate payments above $5m must be cleared (or rationed?). The French group Saint-Gobain complains that it is having trouble getting its money out of the country.
The November outflows also occurred before the US Federal Reserve raised interest rates (12/14) and signaled a hawkish path of monetary tightening in 2017, sending the dollar index to 14-year high.
Rocketing bond yields in the US have become a magnet for Chinese money. This is combining with devaluation fears as the yuan weakens almost daily against the dollar – the only peg that matters in the Chinese collective mind. The exchange rate is fast approaching the symbolic line of seven to the dollar.
The central bank has slowed the currency slide by burning through a trillion of dollars of foreign reserves. But within a month or two the reserves will drop below $3 trillion, another symbolic line.
Ha Jiming, former vice-chairman of Goldman Sachs, says the key “psychological threshold” is $2.8 trillion, the minimum safe level for a country like China with a managed exchange rate under the metric used by the International Monetary Fund.
He also warns that China is more deformed than it was during Mao Zedong’s Great Leap Forward or than Japan was at the end of the Nikkei bubble in the late 1980s. Beijing risks being “forced into a corner” if debt woes metastasize and lead to a vicious circle of capital flight and a sliding currency, each feeding on the other.
Professor Victor Shih from the University of Southern California says the Chinese central bank (PBOC) is in a bind. It cannot easily raise interest rates to slow capital outflows because this crystallizes stress in the banking system.
“Given the growth target and the enormous amount of debt that needs to be rolled over, I don’t see how the PBOC can tighten in any meaningful way,” he told Bloomberg.
This has become clear over the last ten days. A slight tap on the brakes by regulators led to a liquidity crunch, sending a shock wave through the bond market. The 12-month Hibor rate in the Hong Kong money markets – the gauge of funding stress – has doubled to almost 7% and is back to the danger levels seen last January.
Funds have been borrowing on short-term money markets to buy bonds, and then using these bonds as collateral to borrow more, buying further bonds, and on and on with escalating leverage – and all beyond the scope of regulators.
These bonds underpin much of the $3.6 trillion industry of wealth management products, the most frothy part of the shadow banking system. It is a nexus of counter-party exposure linking banks, brokers, and funds. As the PBOC has discovered, the chain-reactions are fissile.
“We see a clear risk that global markets have become too complacent about Chinese risks and that financial turmoil in China could resurface in 2017,” said Allan von Mehren from Danske Bank.
Professor Yu Yongding, a former rate-setter for the PBOC and now the country’s leading currency guru at the Chinese Academy of Social Sciences, says it is futile to keep defending the yuan. The reserve loss is too damaging. “Once we get towards $2 trillion the markets will start to panic,” he said.
His view – gaining credence in the Politiburo – is that it would be better to lance the boil and let the exchange rate find its natural level. The initial slide could be as much as 25% but the yuan would soon recover. “Have you ever in history heard of a country with a current account surplus of 3% of GDP suffering a currency collapse? It is unthinkable,” he said.
Prof Yu told me earlier this year that he learned a valuable lesson observing Britain’s exchange rate crisis while studying at Oxford in 1992, and vividly remembers the two desperate rate rises in one day by the Bank of England. You cannot buck the market.
As for Britain then, the issue for China is not the exchange rate as such but rather the danger that defending it against the dollar – when the monetary cycle is out alignment with the US – will squeeze the money supply and trigger defaults.
“Corporate debt in China is $14 trillion – larger than in the US – and they have not even begun to deleverage. This is a dangerous situation for the banking system. A lot of debt is being rolled over and non-performing loans are much worse than they look,” he said.
Indeed they are. Fitch Ratings estimates that bad debts are ten times the official figure, and that the denouement could cost 30% of GDP. It is much more serious than the banking crisis of 1998 when debt ratios were far lower and China was still in its booming catch-up phase, about to enjoy the one-off windfall from joining the World Trade Organization.
This time it is grappling with the onset of demographic decline. The work force is shrinking by three million a year.
China must now pick its poison. For President Xi Jinping sitting in Beijing, devaluation may appear the less toxic option.
Whether the world could absorb the deflationary shock of a sudden yuan devaluation is an open question. It would undoubtedly set off mayhem in the East Asian currency system – a 1998 crisis writ large – and would enrage Donald Trump in Washington. He has already vowed to label China a currency manipulator “from day one”.
The official news agency Xinhua mocked the “scary prophecies” of perennial China critics in a prominent end of year comment, reminding George Soros and an army of foreign hedge funds that China’s long-foretold debt reckoning had yet to materialize.
“It is an easy game, and these China bears have been selling imaginary fears for their own fame and fortune for a long time,” it said.
Xinhua has a point. The speculators misread the boom-bust stimulus cycle and launched their short positions at least fifteen months too early.
But then Xinhua – the voice of the Standing Committee – gives its own hostage to fortune.
“The odds of a Chinese economic hard landing are so tiny that China economy skeptics would do well to rethink their betting,” it said.
Hubris always ends badly.