After discussing the risks for the world economy coming out of Japan (especially the level of Japanese public debt) last week, we turn our view to the risks emanating out of the other big Asian economy, China.
There are presently two main risks coming from China, and they have a complex interaction that should be understood.
The core problem is that much of China's industrial sector is plagued by overcapacity and falling prices. But not only that, it's also plagued by a large and increasing debt level.
The best solution for this would be a wholesale restructuring and rationalization to reduce capacity and write off bad debts.
But this process is politically difficult, as it would make millions of people redundant and would break the social contract from which the Chinese ruling class derives much of its legitimacy.
If handled badly, it could even lead to open protests and riots, some of this has happened already on a local level.
While the authorities have (several times in fact) announced such restructuring, such process is yet to start in earnest. In the meantime, authorities have two other options that pose risks, not only to China but to the world economy.
The first solution is a relatively sudden and sharp devaluation of the yuan. In fact, there has been strong market pressure for the yuan to go lower all of last year.
Despite a near 3% trade surplus, there is a strong downward pressure on the yuan, as capital is fleeing China.
The causes of that are complex. In its most benign form, it's mostly Chinese companies paying off dollar denominated debt. In that case, it will gradually disappear as a serious problem; in fact, it will fix itself.
However, many argue that the problem is more serious than this. Capital is fleeing as it is seeking more profitable investment opportunities abroad, as a result of a crackdown on corruption, the slowing economy, the crash in equities and stagnating real estate prices.
At worst, capital could be fleeing in anticipation of a devaluation, and we've learned at least since 1992 (when the pound and lira were unceremoniously kicked out of the ERM) that these expectations can easily become self-fulfilling prophecies.
Which is why the Chinese central bank (the PBOC) is defending the yuan with gusto, in order to crush these speculators. But the more the Chinese economy slows down and the more the PBOC depletes its forex reserves, the more this will become a one-way bet, the ones George Soros is so fond of.
Chinese forex reserves have already tumbled from $4 trillion to $3.2 trillion, and while the slowdown has slowed recently, this might be temporary, according to Yu Hongding, member of the Chinese Academy of Social Sciences and a former PBOC member. He warned (The Telegraph):
Reserves will continue to fall until we devalue. Once we get towards $2 trillion, the markets will start to panic. They won't believe that the government can control it any longer.
Yu argues that China needs to devalue 15% and the rot will stop, but that remains to be seen. He does put his finger on the problem, though, defending the yuan with heavy forex interventions automatically triggers monetary tightening.
This makes life even tougher for many producers faced with a whopping 49 consecutive months of PPI declines; March y/y decline was 4.3%. With Chinese interest rates above 4%, that makes for real rates of almost 9%, a whopping burden on an ever increasing debt load.
And then there is this. According to the IMF, money supply (M2) stands at a whopping 200% of GDP, roughly $20 trillion. If the currency situation is botched, it only takes a fraction of this money to run for the exit. It will overwhelm China's defenses and create a large devaluation for which the world is not ready.
So while we had something of a lull in the Chinese devaluation risk of late, this could very well be temporary, especially considering the fact that the Chinese are once again hitting on the monetary accelerator.
The second risk we highlight is the ever increasing Chinese corporate debt load, currently standing at $15 trillion or 145% of GDP.
Not only are debt loads increasing, they are giving less bang for the buck in terms of output growth and the quality of the credit is deteriorating fairly rapidly. Here is Standard & Poor's in January (from FT):
The rating agency has put 15 percent of its rated portfolio of 240 Chinese companies on watch - the most since the 2008 financial crisis and nearly double the 8 percent of a year ago, says Christopher Lee, S&P's chief ratings officer for Asia-Pacific. "Credit quality has deteriorated further in the past four weeks," he says. "I would say that the percentage of corporates with a negative ratings outlook would be trending towards 18 percent. We see further pressure on ratings and outlooks for the rest of the year."
The big problem is huge overcapacity and overleverage in whole swathes of the old largely state-owned industrial economy (steel, cement, etc.) geared towards the building boom that has moved down several gears. Again from the FT:
The 30 most leveraged of the top 200 corporations have debts equal to 21 times their gross annual incomes.
It is obvious to most that a significant restructuring of overcapacity and bad loans is required, but these are processes fraught with risk. It could trigger waves of bankruptcies and bank problems, stop the nascent bond market in its tracks, or produce large scale social unrest.
Funny enough, these risks can be softened with a significant devaluation (apart from companies with large dollar denominated debt), so we could trade one risk for another here.
Instead of announced restructuring, the credit tap is opening further (FTAlphaville):
In our view, the most obvious underlying factor behind this recovery is credit. In Q1, increases in total credit exploded to CNY7.5tn, up 58% yoy and equivalent to 46.5% of nominal GDP - one of the highest ratios ever. Credit growth accelerated to 15.8% yoy to end-March, the quickest pace in 20 months.
March credit data were much higher than expected. New yuan loans increased to CNY1,370bn (SG CNY1,200; cons. CNY1,100) and total social financing also delivered a solid print of CNY2,340bn (SG CNY1,500; cons. CNY1,400). Considering also the record swap amount of CNY776bn local government debt into local government bonds, total credit to the non-financial sector actually increased nearly CNY3tn last month. The strength in non-bank credit came first and foremost from the corporate bond market. Net issuance there was a record CNY695bn in March.
While postponing the day of reckoning, it is only making an already difficult situation more difficult. It isn't doing much good either (The Telegraph):
Fitch Ratings says the efficiency of credit - the extra yuan of GDP growth generated by each extra yuan of debt - has collapsed by two-thirds to a ratio of 0.2 since the lending spree began in 2009. The risks are rising exponentially for little gain.
Declining marginal returns have long set in, this is folly. Although one month data is a bit premature to use as a judgment, but at least industrial production and exports are picking up.
The problem is twofold, though:
- Monetary expansion is likely to accelerate capital flight.
- Adding more debt to an already very debt burdened industrial sector only increases the magnitude of the problem China will have to deal with sooner or later.
While China, given the capital controls, assets, and savings rate, might not implode under the debt level, the combined pressures of bad debts at financial institutions, overcapacity and very high debt burdens in the industrial sector could lead to a long drawn out stagnation.
So we think this isn't a wise avenue and could easily come back to haunt the authorities in the near future, and create increasing risks for the world economy.
China is plagued by industrial overcapacity and escalating debts (both in quantity and diminishing quality). There are basically three ways to deal with these problems.
By far the most rational would be to restructure and consolidate the overcapacity and bad debt. While initiatives have been announced, these policies have yet to start in earnest.
There is no doubt that a devaluation of the yuan would soften the situation, and despite the 3% trade surplus, capital flight has put significant pressure on authorities to yield to this.
It would export the Chinese overcapacity and deflationary forces to the rest of the world, so we could count ourselves lucky that the authorities haven't embarked on this, at least so far.
What they have done instead is embark on a renewed credit expansionary drive. It looks like it has stabilized the economy, but it is likely the yuan will come under renewed pressure, and dealing with an ever increasing debt mountain, even for a country with the assets and savings rate like China, becomes even more cumbersome.
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