China Faces An Impossible Trinity As Debt To GDP To Hit Over 300% In 2-3 Years

Chinese financial engineers are currently in the process of testing what it calls the 'Impossible Trinity' of market feats, a Deutsche Bank report says. The level of difficulty is high as China walks a debt tightrope with rising interest rates potentially creating a tricky headwind as China’s debt servicing costs reach levels hard to manage.

Can capital controls mix with an independent monetary policy in China?

The past few weeks have seen Chinese interest rates start to rise, the April 7 Deutsche Bank report noted. Titled “China Debt: Testing the ‘Impossible Trinity,’” it focused on three core issues: 1) A fixed/stable exchange rate 2) Independent monetary policy 3) Free movement of capital.

Deutsche Bank Research Analysts Stephen Andrews and Hans Fan, citing economic theory, note that a government can only pursue two of the three of these policies at the same time. “We believe that events in China over the past 3-6 months are increasingly testing this hypothesis and asking the questions which of the three gives?”

Freedom of capital flows, for instance, has been an issue that has bedeviled the communist nation recently, as well-publicized capital controls the country instituted to stem a growing tide of individual and corporate wealth leaving the nation has been an issue.

If US interest rates continue to rise, China may be required to further tighten its capital controls to limit the pace of currency reserve depletion. One consequence of this action could be increased loan growth in Hong Kong and Singapore as more Chinese corporates seek offshore capital to fund their expansion, the report noted.

 

The “Trilemma,” as Deutsche Bank terms the move, is also an issue of managing China’s debt servicing cost via lower rates and debt restructurings.

The past two to three years witnessed China engage in a strategy of lower interest rates and significant debt restructuring to create manageable debt servicing costs, a fact evident in falling bank interest income and lower debt servicing costs expressed as a percentage of GDP.

Calling China’s growing debt load in the face of rising interest rates “the elephant in the room,” Andrews and Fan note that debt servicing costs rise dramatically. They model three interest rate scenarios that have potential to occur.

Deutsche Bank’s base case is the Chinese yield curve steadily converges with US over a 3-4 year time horizon. As US rates rise, China’s rates are expected to move higher “at a much slower pace.” This would soften the impact of debt servicing. Total debt to GDP is expected to move from just over 250% in March of 2017 to over 300% three years later, with a larger increase in debt payments coming with not only more nominal debt and higher interest rates.

“Even under this relatively benign base case scenario China’s debt servicing cost expressed as a % of GDP still starts to rise sharply from a current low of 10.8% of GDP up to a level of close to 16% of GDP in 2019/20,” the report observed. “This is well above the high of 12.9% seen in 2014 and would indeed be high by international standards.”

The second model notes that, to limit capital outflows, China raises interest rates more aggressively to defend its currency, which would result in the spread between US and Chinese yield curves remaining broadly constant but also raising debt servicing costs.

The third model assumes the overwhelming driver of policy is maintaining China’s debt servicing costs at affordable levels, which impinges on the trifecta of goals. “As such we set China rates so that total debt servicing cost as a % of GDP remains relatively constant,” meaning that Chinese rates have to fall further and end up with negative carry relative to US rates which could lead to building pressure from a capital outflow perspective.

Can China manage its Gordian knot? The world economy may depend on it.