In FIS Group’s latest insight piece, Tina Byles Williams, CEO and CIO of FIS Group, a manager of U.S. and global developed, emerging and frontier markets equity portfolio strategies with over $4.5B in AUM, shares her insights on China’s slowing growth and rising debt.
China’s growth reduction (to around 6.5%) and restructuring, as well as the gradual depreciation of the RMB, as it decouples from the dollar peg will be fraught with policy missteps. The Chinese financial system, however, remains fenced off from the rest of the world by capital controls and is highly liquid, so the risk of systemic financial crisis remains low. If the renminbi does decline by another several percent, the main losers will be other emerging markets, especially Asian exporters that compete with China. That is not great news, but presents a lesser risk to global growth than the rising probability of a U.S. recession.
The challenges facing China are that:
- Its policy makers face the difficult challenge of having to pirouette between two different Chinas: the booming consumer-oriented services sectors/regions and the capital goods and industrial sectors that are facing a “debt-deflation” cycle of falling cash flows and tumbling asset prices.
- It is caught in an “Impossible Trinity.” As Beijing lowers rates to combat slowing growth, it is hard pressed to resist downward market pressure on its currency. So it must either allow the RMB to decline further (spooking global markets) or regain its ability to control both the currency and interest rates by slowing the pace of capital-account opening.
On the first challenge, policymakers’ attempts at avoiding a disruptive debt deflation spiral through “old economy sectors” has led to increased infrastructure spending and preferential borrowing rates targeted at the (mostly state owned) capital goods sector. As a result of sliding growth, steadily rising bad debts and the need to earmark capital for “helping” big state firms, banks have also become cautious in their lending, particularly as full liberalization of interest rates has increased competition for deposits and raised funding costs. In response, banks appear to be favoring too-big-to-fail state-linked enterprises, whilst private sector borrowers are paying a hefty premium, and required to commit collateral and secure third party guarantees. As a result, China’s credit market has become even more bifurcated; with the share of borrowers who pay 50% or more above the benchmark interest rate rising to 18% by mid-2015, compared to 12% in 2014. In essence, despite central bank easing measures, this group is unlikely to benefit and will instead see a rising cost of debt finance. (See CHART 16).
Therefore, the risk in China is that private firms, especially small enterprises, bear the burden of the clean-up via much higher borrowing costs which reduces their appetite to invest. (See CHART 17 and CHART 18). Already, the bad-debt ratio in sectors with heavy private sector participation—manufacturing, wholesale and retail—has started to rise especially fast. Weaker growth is likely to drive more bankruptcies and higher non-performing loan ratios. This will leave the state with no option but to ease more aggressively in order to meet its GDP growth target of 6.5%.
Debt deflation can either be absorbed through increasing write-offs and deleveraging or it can be partially exported to the rest of the world via currency depreciation. This leads to the second challenge referenced above; i.e., the difficulty of trying to reduce interest rates whilst also attempting to stabilize the RMB.
The Renminbi’s December 1 inclusion as the 5th currency among the IMF’s reserve basket was a major diplomatic and geopolitical accomplishment for Beijing. While the long-term impact will be bullish for the RMB, the market’s reaction was negative, particularly after the People’s Bank of China (“PBOC”) introduced the trade-weighted renminbi index against a basket of currencies. From a policy perspective, tracking a basket is justified since the RMB’s de facto peg against the dollar meant that it had appreciated rapidly in trade-weighted terms when the dollar started to strengthen in mid-2014. For example, although the renminbi fell by 4.7% against the dollar in 2015, its nominal effective exchange rate actually rose. But, as happened in August when the PBOC introduced a new fixing mechanism for the currency, this policy change was poorly communicated and fed speculation that the PBOC intends to devalue the currency. As shown in CHART 19, market speculation has driven the spread between the two exchange rates to a record high.
In order to stabilize the currency, the PBOC again had to buy over $100bn (twice the previous peak in foreign exchange reserve purchases last August) and, in the short term, will likely have to continue to intervene on a large scale in order to shift market perceptions that the renminbi is a one-way bet. (See CHART 20). With reserves estimated over $3 trillion, the PBOC does indeed have the firepower to defend the onshore rate should it choose to. The risk for the PBOC is that intervention into the currency market to support the yuan requires absorbing local currency from circulation in order to sell U.S. dollars. Without offsetting liquidity injection, narrow money growth will shrink and interest rates will tend to rise. If this occurs, it will be detrimental to China’s growth, as higher interest rates will suffocate the overleveraged economic system. To prevent interest rates from rising, the PBOC has to inject as much liquidity into the system as it has withdrawn during its currency intervention operations, i.e., it has to “print” a lot of money. Such money printing could heighten expectations for further currency depreciation and lead to even more capital outflows. Hence, the real test for the PBOC is not the lack of foreign reserves – it has more than enough. The true challenge is whether it can continue to “print” RMBs and while halting capital outflows. Faced with such a challenge, the odds are that the RMB will be allowed to depreciate by another 5% or so in the next six months. Such non-trivial yuan depreciation could trigger another down leg in Asian currencies versus the U.S. dollar.
INVESTMENT IMPLICATIONS
The most likely way for China to disrupt the global economy is therefore through financial contagion. With a deteriorating growth/earnings outlook, A-shares remain overvalued, so we expect domestic stocks will hit further air pockets. But most global investors have already written off the A share market after last year’s bubble, so lasting spillover effects should be limited. Domestic bond defaults also have limited relevance outside China. Additionally, A share volatility should not be extrapolated to be a barometer of the Chinese economy. Prices are driven by speculative forces rather than fundamental factors. Conversely, equity price moves don’t drive developments in the economy. Relatively few in China own equities and those that do are much wealthier than average with high rates of saving. This is why retail spending in China actually strengthened in the second half of last year in the aftermath of the equity market implosion. (See CHART 21).
The RMB could be another source of market disruption. We believe that it is likely that the market will force Beijing to sacrifice its long-standing goal of currency stability relative to the U.S. in order to enable monetary easing to be effective. As the Fed keeps hiking rates, narrowing the spread between U.S. and Chinese rates, a strong CNY will be ever harder to sustain. However, since the Chinese financial system remains fenced off from the rest of the world by capital controls and is highly liquid, the risk of systemic financial crisis remains low. If the renminbi does decline by another several percent, the main losers will be other emerging markets, especially Asian exporters that compete with China. With CNY/USD in steady decline, other EM countries will find it very hard to stabilize their own currencies. This in turn reduces their ability to deleverage and return to strong growth. That is not great news, but presents a lesser risk to global growth than the rising probability of a U.S. recession. Finally, policy mistakes and conflicting growth data will continue to (mistakenly) stir fears of a China hard landing. As we have written in the past, tap dancing between the disparate policy needs that arise from heavy industry sectors/regions that are in recession vs. robust service sectors; between ample room for both monetary and fiscal policy reflation while still trying to tamp down on credit excesses; between ambitions of liberalizing the financial and capital markets while trying to control speculative excesses and/or stem substantial capital outflows; is likely to generate conflicting growth data as well as policy missteps that will intermittently stirs fears of a China hard landing. We do not however subscribe to a hard landing worst-case scenario because of Beijing’s determination and ability to support growth with bigger fiscal deficits and further monetary easing.
