Wednesday, 17 December 2014

Guest post - A Chinese "Déjà-vu"?

"Right now I'm having amnesia and deja vu at the same time." - Steven Wright, American comedian
The situation we are seeing today with major depreciation in EM currencies is eerily similar to the situation of 1998, with both China and Japan at the center of the turmoil.

On that subject, we share our concerns with our good friends at Rcube Global Asset Management  which they discussed in their Global Macro Monthly Review in December. Please find below their take on the Chinese situation reminiscent of the 1998 Asian crisis:
"The current situation in China is similar to the Asian tigers in the late 1990s. We will first describe the chain of events that led to the crisis and then look at China today and explain why not only the domestic conditions of the country are strikingly close to what they were for the Asian economies back in 1997, but also how close the international environment looks when compared with the late 1990s.
The NY fed published a paper co‐authored by Giancarlo Corsetti, Paolo Pesenti and Nouriel Roubini
in 1999 called “What caused the Asian currency and financial crisis?” that we have used for comparison purposes with today’s situation in China.
It starts by stating “Central to a full understanding of the root of the Asian crisis is the multifaceted evidence on the structure of incentives under which the corporate and financial sectors operated in the region in the context of regulatory inadequacies and close links between public and private institutions… At the corporate level, political pressures to maintain high rates of economic growth had led to a long tradition of public guarantees to private projects, some of which were effectively undertaken under government control, directly subsidized or supported by policies of directed credit to favored firms and or industries. “
At the time, government intervention in favor of troubled firms gave investors the impression that return on investment was almost guaranteed and that corporate defaults were unlikely to happen.
As a result, capital flowed to the region. As investment spiked compared to savings, the current account of these economies dropped sharply. Capital was plentiful at the time. The sharp drop in developed countries’ interest rates (Japan in particular) explained the large financial flows into the region, which were offering more favorable rate of returns.
By borrowing extensively abroad to finance local project, banks channeled these flows into the domestic economies. At some point, because the investment boom was confined to nonproductive sectors (commercial and residential construction as well as inward-oriented services) the rate of return on these investments started to drop, which became evident as the share of nonperforming loans begin to rise swiftly.

The final nail in the coffin came from the Japanese yen, which lost 45% against the US dollar between May 1995 and August 1998. Not only the Tigers had lost a substantial export market for their products since Japan had turned from boom to bust, but they were also losing market share against Japanese firms due to the JPY debasement. China had devalued its currency by 50% in 1994,
grabbing, like Japanese firms, new export market share in the process. Since most of their currencies were pegged to the US dollar, their real effective exchange rate appreciated
substantially, further deteriorating their competitiveness.
As the average return on investment dropped further, and NPLs kept on rising, capital inflows turned into outflows. Currencies started to weaken. Banks were doubly hit by rising NPLs and by the currency effect, having amassed large amounts of foreign currency debt.
The negative feedback loop accelerated, resulting in crashes in real estate, stock markets and currencies.
We believe that China’s situation is comparable if not worse than that of the Asian Tigers in the mid-90s. Growth has been almost entirely driven by an investment boom which, as a share of GDP, is significantly higher than where the Tigers were back then.
Just like for these economies, the interconnection between the public and private sphere is large. The government has directly or indirectly subsidized specific industries, and has until this year almost guaranteed a zero default rate. Furthermore, the investment boom has been concentrated in n onproductive assets, namely real estate construction.
Most of the balance was directed at industries that were tied to the property boom: steel, cement, aluminium. These sectors are now facing severe overcapacity. Standard & Poor's estimates that between 30 and 40% of all corporate loans are backed by property and land as collateral, so falling real estate increases the risk of a credit crunch.
The Chinese capacity of utilization rate has dropped to 70%. The investment bubble, just like for the Tigers, has been financed with cheap - and until recently plentiful - credit. China now has the largest corporate debt pile in the world, having surpassed the US last year ($14.5 Trillion vs $13.1 for the US). 
The BIS December quarterly report released recently reports that the outstanding stock of cross border claims on China stood at the end of Q2 2014 at just over $1.1 trillion. The current annual growth rate of claims on China is 50%, and the stock of claims has been multiplied by 10 in less than 8 years. China is by far the largest EME borrower for BIS reporting banks. As recently as 2009, China was not even among the BIS reporting banks' top 5 foreign EME exposures. The last phase of the the investment boom (since 2010) has therefore been increasingly financed by capital flows. 
 Claims of BIS reporting banks on emerging market economies outstanding stock.

On that subject, the largest drop on record in capital flows in Q3 (change in FX reserves - Current Account + net FDIs) is particularly worrying. The current account has dropped by 8% points of GDP since 2008 (investment rising much faster than savings).

Furthermore, the BIS report also reveals that capital flows associated with non-financial corporations have increased markedly over the past few years through three different channels.
First transfer have surged within firms. Second, trade credit flows to EMEs have increased significantly. Finally, the amount of external loan and deposit financing to EMEs provided by non-banks has grown considerably. This simply means that EMEs non corporates have used their offshore subsidiaries to obtain funds from global investors through bond issuance and have repatriated the proceeds through one of the three channels mentioned above.
The reports states: "Chinese firms have primarily issued $ denominated bonds abroad, whereas non-Chinese companies account for a sizeable proportion of offshore Renminbi bond issuance. Very often, these non-Chinese entities will swap their CNH proceeds into US dollars. In doing so, they are taking advantage of the cross currency swap market to obtain dollar funding at lower costs...Similarly, cross currency swaps offer Chinese firms a channel to get around the tight liquidity conditions in China by swapping their US dollar proceeds from bond issuance into RMB and remitting to their headquarters."
International debt securities issuance in $bn
 Source BIS international statistics 
 China has been by far the main recipients of these types of capital flows. Part of these flows should be considered as foreign denominated debt since there is a currency risk. Even though classic measures of foreign external debt remain low, the currency mismatch is probably much higher - another similarity with the Asian Tigers.
 International issuance of EME based non-financial groups
 Source BIS international statistics 
For the first time, selective defaults happened this year. Shanghai Chaori Solar Energy Science & Technology Co was the first Chinese corporate bond default in March. In September, Anhui Wanjiang Logistics Group missed payments. The company cited banks' unwillingness to extend loans to the steel industry as the reason for the non-payments. Sinosteel, the state owned company, recently said that it was having difficulties paying back some lenders as a resuly of unpaid bills from customers. As local governments refuse to close down some steel mills for fears of fueling unemployment, China's steel production keeps rising, making the problem even worse (increasing overcapacity). This issue is similar in many over indebted industries (cement, construction, shipbuilding, etc.). 

The domestic economy is slowing down as a result of a weaker investment cycle. Additionally, two major export markets have also slowed down: Japan and Europe. Combined, they represent about 25% of Chinese exports. The Japanese Yen devaluation is making Chinese exports much less competitive, the nominal trade weighted Yuan has appreciated by 10% over the last 6mth only, 25% since 2011 and by 45% since 2005.
As the rising share of non‐performing loans starts hitting banks, and the already strained credit channel tightens further, more defaults will become visible. Foreign commercial banks, which are always late in a credit boom, are seeing their share of non‐performing loans rise very quickly. Unlike domestic banks that can hide NPLs, or are subsidized by the government, foreign banks’ data seems to be a much more reliable source of information. Standard Chartered PLC has been severely hit by its exposure to the main Asian economies and China in particular.

Capital outflows will intensify. In the face of a crisis, governments always choose devaluation over reforms. We don’t think it will be different this time.
Just like in 1997 for the Asian economies, it is the combination of domestic weakness, weaker export markets (replace Japan then by Europe and Japan today) and a loss of competitiveness that reveals the crisis. Similarly to 1997, it is the JPY devaluation that could tip over the boat (the magnitude and the velocity of the JPY crash being equal). The Euro weakness is not helping either.
 Just like in 1997, the FED is about to raise interest rates, which is lifting the US dollar. But we believe that the sharp improvement in the US current account is shrinking rapidly the amount of dollar liquidity. The international liquidity environment is thus much tighter than in 1997 despite Japan QE and the coming European action. One US dollar of QE is not equal to 1 Euro or 1 Yen of QE.

When put into context, investors today are looking at the EUR and JPY debasement from a bullish perspective for world stock markets. We think the reality is different. Combined, these two economies, equaled about 125% of the US economy in dollar terms 4 years ago, they barely represent 100% of the US GDP today (in $ terms). That is not good for world exports outside these zones, and most particularly China.
 China, just like the Tigers at the time, is losing market share at a time when its economy is slowing down.

This will prove unbearable when unemployment starts rising, which looks inevitable given the link between the investment cycle and job creation over the last 15 years. If, as we expect, China’s investment share of GDP drops by the same magnitude as the Asian tigers witnessed (around 20 points in a few years) the damage on employment could be massive.

As the investment boom turns to bust, the most likely collateral consequences outside China will be a crash in commodity currencies and industrial commodities that have been so tightly correlated during the boom phase.

The recent spike on Chinese stocks is motivated by a plunge in interest rates and commodity prices, but macro momentum is weakening, which is visible by a flattening yield curve and widening corporate credit spreads. As a consequence, it is very likely that Chinese stocks will reverse course by early next year if not sooner.

From a longer term perspective, China is likely to eventually become the world's dominant economy (even in nominal terms). This is simply because of the fact that its population is four times larger than the population of the US. However, we believe that this "Long March" will be a lot bumpier than most expect.
The issues plaguing China's economy (unproductive investments, corruption, cryonism etc.) are well known and documented. Given these structural problems, it is interesting to observe the degree of admiration exerted by China's system on many Western countries.
We can draw an interesting parallel with the views many economists held about the Soviet Union until the 1980s. In the successive edition of his textbook "Economics: An introductory Analysis", Paul Samuelson (Nobel prize winner in 1970) kept updating a chart showing that the USSR was poised to catch up with the US in terms of GDP due to the latter's higher growth rate (the convergence date was always 40 years later).

This anecdote does not only illustrate that even the most brilliant minds are subject to the "extrapolation bias", but also that planned economies can create the illusion of high growth rates for a very long time until reality bites..."

"The whole world is run on bluff." - Marcus Garvey, Jamaican publisher

Stay tuned!


  1. Unlike the Tigers, China starts out with massive reserves. It could keep its currency overvalued, hike domestic wages, and finance a current-account deterioration with reserves. The investment slump would be offset by higher consumption growth. China would need to run massive fiscal deficits to bail out (parts of) the banking system.

    The result: higher inflation, a sharp sectoral adjustment towards consumption, massive reserve disaccumulation, and perhaps a 3-4 year window to make the transition before reserves reach worrying levels.

    Flicking the wage switch would turn China into the source of wage inflation in the world. Corporate profits would deteriorate, even as some consumer goods exporters (and some commodities, including oil and gold) would benefit. Inequality would begin to fall as a result.

    A likely scenario? I'm not sure, but I do think they, unlike the Tigers, have the option to choose it.


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