Rising Systemic Risk In China?

by: Cam Hui, CFA

I got quite a few responses to my post when I speculated about the possible outcome of a Chinese hard landing (see What a Chinese hard-landing might look like). Many readers took offense at what I wrote and characterized it as fear-mongering.

They got me wrong. No one knows whether China will experience a hard landing, but I sketched out several scenarios IF China should hard land. I did, however, offer the opinion that the risks of a hard landing was rising. Last week, we saw further signs indicating that systemic risk is rising in China.

When does the credit bubble pop?
To set the stage, FT Alphaville highlighted research from Nomura indicating that the entire region is vulnerable as a major credit bubble seems to be forming:

Past financial crises in major economies are often preceded by the private credit-to-GDP ratio rising sharply by 30 percentage points (pp) in the five years before the crisis. We call this the "5-30" rule, and many Asian countries have either breached, or are close to, the 30pp since 2008 (Figure 24). Asia is also experiencing house price booms. If we overlay residential property prices in the US (indexed to 100 in January 2000) on residential property prices in several Asian countries, it is striking how many Asian property markets are tracking above the US price bubble.

The x-axis of the chart on the left shows how the private credit-to-GDP ratio has risen for the Asia Ex-Japan region. Note how China and Hong Kong are the outliers and literally off the chart compared to the other countries. In the right chart, Nomura overlaid the path of the property prices in the pre-Lehman U.S. to other countries in the region to highlight the rising level of systemic risk.

Click to enlarge

Riding around without a helmet

Just because a system is increasingly risky doesn't mean that a crash will happen. It just means that you have a risky system. The best analogy is a motorcyclist riding around at 100 mph without a helmet. It doesn't mean that he is going to get hurt, it just means that the results will be very ugly if he does get into an accident.

You need a catalyst for the accident to happen, or, to use the motorcyclist analogy, a pothole in the road. We may be seeing that pothole in the road ahead and the credit markets are starting to price in the risk of a meltdown, according to Bloomberg [emphasis added]:

Chinese companies' borrowing costs are climbing at a record pace relative to the government's, increasing the risk of defaults and prompting state newspapers to warn of a limited debt crisis.

The extra yield investors demand to hold three-year AAA corporate bonds instead of government notes surged 35 basis points last week to 182 basis points, the biggest increase since data became available in September 2007, Chinabond indexes show. That exceeds the similar spread in India of 120 basis points. The benchmark seven-day repurchase rate has averaged 4.47 percent in November, the highest since a record cash crunch in June and up from 3.21 percent a year earlier.

"Existing interest-rate levels and tighter credit conditions will pose downward pressure on growth," said Kewei Yang, head of Asia-Pacific interest-rate strategy at Morgan Stanley in Hong Kong. "Any potential defaults or bankruptcies in 2014 will trigger the market to reprice credit risk."

Markets are getting worried by the excessive leverage:

The nation's total debt, led by state-owned enterprises and local governments, may exceed 200 percent of gross domestic product, according to a Barclays Plc report yesterday. Implicit government guarantees and soft budget constraints have encouraged excessive borrowing and increased the potential for defaults, the analysts wrote.

These guarantees are now looking increasingly uncertain with China's Communist Party saying at the Nov. 9-12 plenum that it would encourage private investment in state-owned enterprises, which have enjoyed sheltered monopolies for years, and allow competition. The leadership pledged also to give markets a "decisive" role in the allocation of resources.

Could this be a tipping point? I wouldn't panic. My Chinese canaries, which measures the price performance of Mainland banks listed in Hong Kong, are still quite healthy and behaving well - for now.

Click to enlarge

Nevertheless, these signs of increasing anxiety in the credit markets need to be monitored - just in case these jitters turn out to be something more serious.

Disclaimer: Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). The opinions and any recommendations expressed in the blog are those of the author and do not reflect the opinions and recommendations of Qwest. Qwest reviews Mr. Hui's blog to ensure it is connected with Mr. Hui's obligation to deal fairly, honestly and in good faith with the blog's readers."

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this blog constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or I may hold or control long or short positions in the securities or instruments mentioned.