As Trump’s trade war with China takes a resurgence in the news cycle, this serves as an opportunity for us to take a closer look into the debt crisis within China, and its subsequent impact it has on the global economy.
China’s debt crisis began with the Global Financial Crisis in 2008. While the US, and Europe entered recessionary periods, China was able to avoid the economic downturns and maintain their levels of GDP growth through the rapid expansion of debt. From 2008 to 2017, China’s debt-to-GDP has increased from 160 percent to 260 percent. One of the debt products that was created during this period were the Asset Management Products (AMP). AMPs are high-yielding deposits, offered by banks and financial institutions, perceived to be fully guaranteed by the government. AMPs became an attractive way for companies and local governments to raise capital, as they circumvented regulatory capital requirements. As competition for capital increased, issuers tried to match the high-yields promised to depositors by investing into speculative areas such as infrastructure, real estate, and stocks.
In a culmination different various events, many of the underlying infrastructure investments were over-valued and non-cashflow generating. This was worsened as China experienced a stock market crash in 2015 resulting in the stock markets, losing 30% of its value. As these underlying investments experienced huge losses, ratings agencies downgraded issuers of AMPs. With lower credit ratings, the issuer to AMPs faced difficulted in rolling their debts and raising new capital, as investors looked elsewhere to invest their capital. The eventually led to AMPs defaulting on these high-yield products. But how about that government guarantee?
Over the course of the year, the PBOC has taken numerous initiatives to provide liquidity for the economy. This includes cash injections to banks, changes to the Chinese banking system and monetary policy, and liquidation of foreign assets. The cash injection exercises worked to allow banks to meet their debt obligations, however many small and mid-sized institutions have not been provided the same bailouts as the government has allowed these entities to default. To spur on investment, the PBOC has also cut their Reserve Ratio Requirements, the amount of cash banks need to hold against their deposits and has allowed non-cash assets to be posted as part of this capital requirement. This reduces the amount of cash that the banks need to hold against loans and aims to improve the liquidity within the economy. Lastly, there have been talks by the Chinese government to cut their benchmark rate. While the benchmark rate has not changed since 2015, if a cut were to be implemented, it will further narrow the interest rate difference between CNH and USD.
As the differential between USD and CNH, Generic Government bond yields shrink, is the 100bps of worth the risk? While this debt crisis will result in a slowdown of Chinese GDP and credit growth, there are a few points that make this more palatable. The majority of this debt is locally denominated, and China is still expected to grow at 6.2%.
The importance of having locally denominated debt is that the PBOC will have full control of their fiscal and monetary policies. Unlike the European Debt Crisis in 2009, members of the EU belonged to a fiscal union and did not have the same level of fiscal and monetary intervention. For China, they have the full arsenal of fiscal, and monetary tools and can implement any policy they see fit to ensure that China makes it through this crisis.
Lastly, while China’s growth expectations have been cut, they are still expected to grow at 6.2%, twice as high as many countries in the G20. In the case where the Chinese economy significantly worsens, we will see a slow-down in production, and a decrease in China’s demand for raw materials. Countries such as Australia, South Korea, and Japan whose exports heavily to China, will be negatively affected by China’s downturn as well. This situation is worsened as there are additional trade tariffs being discussed ahead of the start of the G20 summit at the end of the week. As the trade war continues, we expect the impacts to impact China much more negatively than the US. In addition to this, the current expectations of a rate hike at the next FOMC is currently 77%. With these expectations of narrowing interest rates, and a growing debt crisis in China, we expect to see an appreciation of the USD versus the CNH.
Author: Derek Ho