China Systematic Risk: Probability Will Be Very Small For The Next 2 Years

by: Daniel Yoo


The potential 40% devaluation of the Chinese Renminbi is extremely exaggerated.

The fundamentals of the Chinese banking system look healthy based on the analysis.

The current attacks on the Renminbi can create volatility but will unlikely lead to systematic risk.

The Chinese systematic risk will be low for the next two years but could increase after 2018.

Nevertheless, as the attacks on the Renminbi continue, Chinese equity indices will continue to show volatility. One strategy of hedging would be investing long in the Korean stock market.

According to George Soros and Kyle Bass, there will be a 40% Chinese currency devaluation over the next three years. They base this belief on two assumptions: 1) the Chinese banking system has grown too fast and too much, and 2) it has an enormous amount of non-performing loans (see Kyle Bass article).

According to this scenario, Soros and Bass feel the Chinese government needs to inject liquidity which will result in high inflation and currency devaluation.

However, I expect there is very little chance of this scenario occurring. Here are the reasons why: 1) continued economic restructuring, 2) a strong banking system, 3) overstated corporate debts, and 4) strong foreign reserves and trade surpluses.

Continued economic restructuring

Since 2010, the Chinese government has adopted a systematic restructuring of the economy where it 1) reduced the fixed asset investment portion of economic growth, 2) increased the domestic consumption portion of economic growth, 3) raised the service sector portion of GDP vs. the manufacturing sector portion of GDP, 4) increased the private sector portion of the economy vs. the public sector portion, and 5) reduced the level of corruption in government and public corporations. (see China restructuring)

Strong banking system

Most importantly, Soros and Bass' assumption of a 40% Renminbi devaluation is flawed in that it does not take into account the capability to clean up non-performing loans (NPLs) of Chinese banks. The current Chinese economic system is made up of banks taking over 50% of the economic value created by the overall economy. Most listed Chinese companies make an average Return on Equity (ROE) of over 16% due to continued increases in efficiency with low labor costs. Moreover, the Chinese banks' lending rate is high vs. the deposit rate. In fact, China's savings ratio is over 50%, but the interest rate on these deposits is only 1.5% while the lending rate is well above 5%, which gives current Chinese banks an average net interest margin of over 3.8% (see table below). The average rate of NIM for Asian banks during the Asian Currency Crisis and U.S. banks during the Financial Crisis was only 2% or less.

According to the Bloomberg data, total loans of all the listed Chinese banks as a percentage of GDP is only 85.7%, and this number needs to be at least 105% for the Chinese economy to fall into a financial crisis or systematic risk. Also, the loans to deposit ratio (LTD ratio) of all listed Chinese banks is only at 69.5%. At the time of the 2008 US Financial Crisis, U.S. banks' LTD ratio was around 105%, and for Korean banks in the 1997 crisis, it was at 120%. Also, the LTD ratio of European banks in 2008 was around 118%. Since the LTD ratio for Chinese banks is less than 70%, the chance of China's systematic risk is very small now. The Chinese government has been successfully reducing the market share of secondary financial institutions in lending businesses while increasing the market share of the primary banking system for better control of the financial system (see China banks).

Also, Chinese banks' Tier 1 capital ratio is 10.15% while the overall capital adequacy ratio is 12.5% level with an annual ROE of over 17.2%. Also, the average dividend yield of these banks is 4.7% for Chinese investors, which is extremely high compared to the local deposit rate of banks at 1.5%. Unless we completely disregard these numbers and do not trust any of the figures from China, the probability of the Chinese economy being at systematic risk any time soon seems to be tiny.

Chinese banks valuations and situations

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(Source: Bloomberg, Self calculations)

China corporate debts overstated

The debt ratio of Chinese corporations is 125% of GDP, and the debt ratio of consumer loans is around 40% of GDP at the end of the second quarter of 2015 (consumer debts). If all the corporate debts and consumer debts are added, the total should be around 165% of GDP level. However, the Bloomberg numbers show that the ratio of total corporate and consumer debts as the percentage of GDP amounts to 207% which is much higher than the official number for the same period. Many hedge funds consider this number, 207%, as being too high.

Because of the ratio of Chinese consumer debts is 40%, which is very small, consumer debt is not the question here. If consumer debts are taken out of the total debts of 207%, then the ratio of total corporate debts as a percentage of GDP is 167%. If this number is correct, then systematic risk will happen as it did in Korea. At the time of the Asian Financial Crisis in Korea, corporate debts were the problem and they hit 130% of GDP when the crisis triggered.

Click to enlarge

(Source: Bloomberg)

However, the calculation above has a significant problem. Looking at all the non-financial corporations' debt-to-equity ratio, the average debt-to-equity ratio of Chinese corporations is only 80% on the average. If the ratio shown above of corporate debts to GDP (167%) is correct, the debt-to-equity ratio of all the non-financial corporations should be around 267%, not 80%.

It is very simple to derive such a number, using the following numbers. The current CSI 300 average PBR is 0.8 times while the total market capitalization/GDP ratio in China is less than 50%. If the CSI 300 debts are assumed to be corporate debts in China, the average debt-to-equity ratio of these companies should be around 267% for 167% of GDP to be the correct number. Even if these corporate debts are assumed to only account for 50% of total corporate debts in China, the average debt-to-equity ratio of these corporations in the Bloomberg chart should come out to be around 130-140%, which is far greater than the actual number of 80%.

In other words, a total corporate debt of 167% of GDP is only accurate if one counts the Chinese debt level as twice of what it actually is.

When debts from financial institutions are added to the total corporate debts, these debts are counted twice as banks lend to corporations, and corporations deposit in banks are counted as debts from financial institutions. Therefore, when the overall debts of corporations are being calculated, debts from the banking sector should be taken out.

In summary, total corporate debts of Chinese corporations should be around 100-110% of total GDP rather than 167%. This is true when the total debts from the baking sector, 65% of GDP, are taken out. If that is the correct number, then there is very little reason for the type of alarmist sentiment towards Chinese systematic risk as the one Kyle Bass is calling for (see IMF assessment of Chinese corporate sector).

China's strong foreign reserves and trade surpluses

The rapid decline of China's foreign reserves from $4 trillion to $3.3 trillion in the past year (see China foreign reserves), and the possibility of a quick evaporation of these foreign reserves, do suggest a threat of systematic risk. However, China is currently showing enormous trade surpluses and is adopting capital control measures. Since 1995, China has been recording consistent trade surpluses, which from 2004 to 2009 have increased tenfold. Since there is a $60 billion monthly surplus, China is generating $720 billion annual surpluses. Also, China attracted $126 billion in Foreign Direct Investments (FDI) in 2015. Therefore, the Chinese economy is attracting over $840 billion annually. Because of these kinds of surpluses, unless all Chinese corporations and individuals are selling Renminbi to buy USD denominated assets overseas, the worries about foreign reserves seem to be exaggerated.

Click to enlarge


In conclusion, if Chinese banks lend around 50% more than the current level to corporations, then there is a real threat of the bubble bursting for the Chinese economy, and a justification for systematic risk worries.

Preparing for a possible crisis in 2018 may be necessary, but even this has very little chance of occurring given the government's proper restructuring of the economy in the past five years, and this will continue in the future.

In other words, another 50% of GDP loans need to be added to the bubble before it is in danger of bursting over the next two years. If this scenario actually plays out over the next two years, the overall equity market will show a significant rise before the burst. Therefore, the Renminbi will stabilize over the next 12-24 months rather than depreciate as many hedge funds suggest.

If the Renminbi was to depreciate as a result of continuous attacks, and HSCEI index short, Hong Kong dollar short, as well as Shanghai Composite index short positions have been built, then these are directional bets with low potential for success given the analysis above. Nevertheless, if having such a belief is a strategy for the next 6 months, Chinese investment can be a very bumpy road over the next 6 months. One way to hedge this strategy would be investing in the Korean equity market which looks extremely attractive on all accounts, including 1) valuation, 2) earnings momentum, 3) liquidity, 4) sentiment, 5) economic leading indicators, and 6) government policy.

Some of Chinese market ETFs listed in USA are the ProShares Short FTSE China 50 ETF (NYSEARCA:YXI), the ProShares Ultra FTSE China 25 ETF (NYSEARCA:XPP), the Market Vectors ChinaAMC A-Share ETF (NYSEARCA:PEK), the Direxion Daily FTSE China Bear 3x Shares ETF (NYSEARCA:YANG), the Direxion Daily FTSE China Bull 3x Shares ETF (NYSEARCA:YINN), and the iShares MSCI China ETF (NYSEARCA:MCHI).

Some of Korean market ETFs listed in USA are the Horizons Korea KOSPI 200 ETF (NYSEARCA:HKOR), the iShares MSCI South Korea Capped Index Fund (NYSEARCA:EWY), the SPDR MSCI South Korea Quality Mix ETF (NYSEARCA:QKOR), and the Direxion Daily South Korea Bull 3x Share ETF (NYSEARCA:KORU).

Disclosure: I/we 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.