China NPLs Risk To Tighten The US

by: Andres Allende, CFA

Summary

QE is a worry for the market.

If China needs liquidity they might take it from the US: see how.

In that case China NPLs would be adding to QE taper...Odds not good for the market.

Markets in the US and the West more generally are feeling rather awful of late. And that is because they are c. -4% off…their all time highs for the SP500! Who would have said it.

Anyway, headwinds keep blowing against the market one after the other, but one key worry for many is the end of QE. And understandably so given the rather convenient coincidence of QE and rising markets for the last 5 years. Correlation or causality…who knows? I know what I think though.

Because we now live in such a global World something else got me thinking a while ago, and it is related to all the above in a twisted way: China, but not for the usual reasons of slowing growth etc. China could be about to tighten on the US. Let me explain.

We all know about the crazy levels of debt that China has piled up for the last few years. Most would also know that much of that debt funded investment (and luckily so as consumption would have been an even worse dead end), which has remained at c. 45% of GDP for years. This is all understandable given China is trying to build a Western type of country/infrastructure in say 30 years as opposed to 100 as the US and Europe have done. However when things move so fast hiccups will occur, like in "misallocation-of-investment-from-time-to-time-at-the-very-least". This in turn will lead to low/negative returns on investment. And as a consequence NPLs should rear their ugly head sooner or later.

A typical level for NPLs after superfast credit growth is c. 8% (US savings and loans c. 6%, Japan bubble 8%, US GFC 8%, Spain 13% today, Ireland 19%, Asean in Asian crisis 25+%, Greece 30% as we speak...). You get the picture. However China NPLs still remain at 1%..Officially. In terms of odds I find it VERY UNLIKELY that NPLs will stay there. I think it is likely they will double, or treble or even more. Trust/Wealth Management products are beginning to default (link) and the practice of "evergreening" is getting really difficult as new sales volumes collapse ( link).

The problem is that when NPLs spike, lenders confidence is shaken and the whole system tends to seize up. And when that happens to China the US beware because its liquidity could suffer greatly as well. To wit, in a case such as the above it is reasonable to expect that PBOC will try to ease domestic liquidity to smooth the blow. One key tool used in the past was bank's RRR (reserve requirement ratios). Still today they remain among the highest globally at c. 20% (source for charts below: BIS working paper No 360, China's evolving reserve requirement, Guonan Ma/Yan Xiangdong/Liu Xi)

Click to enlarge

Click to enlarge

The US (and Ms. Yellen) needs to care about this because whatever moneys were "reserved" were used to buy US Treasuries (see chart below where RRR in purple grows to match growth of blue foreign assets) . This is how Current Account surpluses were sterilized and the weakness of the Rmb was defended while soaking up domestic liquidity. So if China eases RRR the reverse mechanism should play out, especially given that Current Account surpluses have ceased to grow. To put this in perspective if China were to cut RRR by 1% that would trigger a c. $50bn sale of US Treasuries all else equal. That's about one full month of QE gone, right? (link). I think odds look bad for the market here.

Click to enlarge

There you have it; China seizes up and needs more liquidity, PBOC takes it from the US and in doing so they add to QE taper, only this time "made in China". And as Forrest Gump would say, that's all I have to say about that.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.