Summary
With the combination of yuan devaluation and continuing capital outflows, China will be a source of volatility for financial markets in 2017.
Investors shouldn't underestimate China's ability to support its economy with massive fiscal stimulus measures over the medium term.
The recent rout in the onshore bond markets is being exacerbated by the unwinding of collateral agreements.
This article will use various freely available news sources and academic studies to present an unbiased view on issues facing the world's second-largest economy.
China is Kicking the Old Growth Model Back into Action
The Chinese onshore government bond markets have been selling off in tandem with global bond markets following the election of Donald Trump as US President. Investors are speculating that future fiscal spending in the US will lead to an increase in inflation, which will in turn make the US Fed to raise interest rates at a faster pace.
Commodity markets have been rallying since Q1 2016 after China's move to support its ailing economy with a massive credit burst into the state owned enterprises. The economics of a credit burst point towards the initial effects wearing off over time, but investors expect that the central government will follow up this stimulus with massive fiscal spending over the next five years under the One Belt One Road initiative and the 13th Five-Year Plan (Chinese).
China is the world's largest consumer of commodities, and although commodity prices have been traditionally priced in the US dollar, trading on the Chinese exchange has been increasing, driving global price movements in key commodities. On November 11th, copper futures on the Shanghai futures exchange jumped on the strongest surge in volume since trading began in 2004. At the open of trading on the LME in London, futures rose 7.6%, and at the open in New York, prices rose a similar percentage. Prices fell back later in the day in Asian trading to close 1.6% down. In the first two weeks of November 2016, the combined daily transactions on China's three commodity exchanges rose to an all-time high of $226 billion.
Much has been made about Trump's 10-year fiscal plan, but there has been relatively little commentary on the effect China's fiscal plans are having on global growth expectations. Under the 13th FYP, China has laid out massive infrastructure development plans which will dwarf the proposed US stimulus measures. There has long been a recognition among investors that China will have to spend at least $2tn per year to keep its economy growing at the minimum 6.5% GDP growth rate that it has set under the 13th FYP. China will likely exceed this figure in 2017 and 2018 in order to forge ahead these plans.
President Xi's Reform Agenda
Some China watchers take a dim view of President Xi's commitments to initiate deep reforms, and they see the credit burst in Q1 2016 as affirmation that the government hasn't found a way to maintain the old carrot-and-stick authoritarian governance model while allowing private enterprises to take a greater role. They take a negative view on commitments to allow market forces to take a more decisive role in China's future. Many see these efforts as being focused on allowing markets to absorb China's excesses rather than being measures designed to allow greater protection for private property rights and more support for private enterprises. Opening up the economy to market forces runs the risk of massive capital outflows as there is a relative scarcity in "sticky" investable assets inside China after years of excess fixed asset investment that has created massive pent-up capital liquidity that flows from the stock market, to real estate, to commodities. With depreciation expectations gathering pace, the PBOC will be intervening aggressively in 2017 to maintain a stable devaluation trend in the yuan.
Inbuilt Structural Issues
Although the economy has opened up significantly over the last decade, structural issues are still built into its economic model, and all of these issues lead back to what many say is the core motive of the CPC policies - maintaining its position of power over the country. The CPC has long relied on a trusty set of political tools to maintain control over local administrations and to implement its economic policies. The disparity between benefits obtained by rural citizens relative to urban citizens under China's social insurance system is designed to forcefully encourage rural-urban migration while also allowing for greater central control over far-flung regions. Many rural workers who are driven into the cities often struggle to afford basic services. The system has also long favoured workers in the old SOEs over workers at smaller private enterprises with superior benefits.
Local governments depend on their SOEs for revenues and for social stability and employment. Local authorities have monopolies over administrative decision making in their regions, and this created widespread corruption before Xi became president. While the anti-corruption campaign has publically punished thousands of corrupt officials, many key administrations remain unchanged. The CPC relies on the support of local administrations for its legitimacy.
Under the 13th FYP, the CPC has committed to allowing market forces to have a greater say while the CPC itself will maintain its position at the core of China's future. Policy analysts are taking this in a way to mean that new administrators will be installed at the badly mismanaged SOEs, but that the overall dominant policy of promoting large SOEs or quasi-public enterprises over smaller enterprises will continue. These policies that promote the achievement of scale over efficiency have been one of the main causes of the gross overcapacity issues in industries such as flat glass, steel, cement and real estate.
China watchers are concerned that Xi's administration will revert to the old growth model and rely on fiscal spending on government infrastructure projects to support growth going forward. China has overly relied on this avenue in the past and it has accumulated a debt pile that will be a burden on the economy in the future. China has a debt-to-GDP ratio similar to Western economies which are at a more developed stage in their growth patterns. In the future, China will face headwinds from shifting demographic patterns, where in the past, it has benefited from the tailwind of a rapidly expanding urban labour force.
There is much evidence of capital misallocation at a micro level in China where large SOEs benefit from more favourable lending terms relative to private enterprises, but from a macro perspective, there is a significant divergence between per capita income rates in rural regions and those seen in the coastal cities. China watchers worry that the central government will continue to "juicegrowth" to the maximum extent possible through fiscal spending on infrastructure projects, a significant portion of which will likely prove to be economically wasteful. The studies undertaken by Oxford University academics Atif Ansar and Bent Flyvbjerg showed that a large portion of sampled projects was poorly planned and produced negative economic outcomes after development. Although the results showed that project outcomes were no different to results in other economies with different political systems, China has over-relied on this avenue to generate growth, especially since 2008. These studies present strong evidence that the central bubble in China's economy is related to government's over-funding of infrastructure projects. The booms in the real estate markets in the cities along the coast are more related to excess capital liquidity and bad planning at a local authority level.
Crisis Comparisons
Commentators who try to compare the current situation to that seen in the US before the financial crisis are trying to compare two completely different economic models. The underlying question that investors should focus on is, has the growth in credit become unsustainable, and as a result, has the system found new ways to sustain that growth with more credit.
Commentators who point to the fact that China's debt is predominately held by domestic institutions and that Chinese households have high savings rates overlook important aspects that have created both situations. Recent academic studies have attributed much of China's large household savings levels to its one child policy and the need for parents to maintain precautionary savings for their retirements. While these savings will be a boon for consumer spending, China has very high education, healthcare and accommodation costs relative to the per capita income levels. Savers have also been disadvantaged by poor deposit savings rates at Chinese banks for years while SOEs have been able to borrow at low rates to fund capacity expansion.
Before 2008, US households were heavily indebted with mortgages tied to real estate while today Chinese households carry very little mortgage-related debt and home buyers purchase property with significant down-payments. While Chinese banks get approximately 70% of their funding needs from deposits, those levels have been gradually falling, and some banks rely heavily on funding from short-term money market sources. What is worrying is that the financial firms in China have been finding new ways to provide credit to companies looking to roll over existing debts. The total amount of outstanding wealth management products at Chinese banks grew 57% in 2015 while off balance sheet amounts grew 73%. The legal documents backing these products don't outline what assets comprise the loans, and as a result, there is no way to determine what comprises the loan agreements and what monetary amounts can be lost in the event of a default.
To date, there have only been a handful of reported defaults, and local banks have covered all losses. It would be very unusual for loan agreements with these characteristics to be moved off balance sheet by a Western financial institution. The fact that these products are traded by retail investors looking for high returns is concerning. The greater competition among the old SOEs that is being encouraged under the 13TH FYP is showing up as competition for retail WMP investors among the large regional banks competing with each other by offering higher interest rates. Unlike credit default obligations traded on Western exchanges, there is no capital buffers on these agreements.
The comparison to the situation Japan faced in the late 1980s is not dissimilar to what China is facing today. Outside observers placed faith in the fact that Japan's debt was mainly held by domestic financial institutions. The IMF Working Paper study on the Japanese crisis found that among the main causes of the crisis was the liberalisation and deepening of the country's financial system without adequate development of financial regulations.
The PBOC is Caught Between a Rock and a Hard Place
The PBOC is facing a situation where a rising US dollar will pressure its exchange rate, capital outflows will increase in the face of growing depreciation expectations, domestic money market rates will rise pressuring domestic banks, while China's foreign currency reserves will continue to decline. A weakened yuan will support China's export economy, but the fact that the PBOC has to attempt a gradual devaluation means that investors will struggle to see where a line can be drawn in the sand and depreciation expectations can reverse. The recent introduction of capital controls on foreign companies looking to remit dividends shows the extremity of the situation. Goldman Sachs recently reported that approximately $1.1tn in foreign currency has left the country since the initial August 2015 depreciation. Corporations looking to unwind carry trades made to take advantage of interest rate spreads will be a significant force acting against the yuan as it devalues.
Recent Sell-Off in Onshore Government Bond Market
In recent weeks, the onshore government bond market has been selling off in tandem with global bond markets. Below is a chart from Bloomberg showing the spread between US and Chinese benchmark government bonds and the onshore yuan spot rate:
In the face of the sell-off, Interest rate swaps rose to a 20-week high, and analysts at various onshore brokers were reporting that the selling pressure in the market was the strongest they had witnessed. Western investors are well aware that traders in the interbank lending markets are using questionable collateral such as wealth management products to cover trades. Charlene Chu, China banking analyst at Autonomous Research, has questioned whether investors know if these products are backed by real assets or if they are backed by assets at all.
Commenting on the recent sell-off, Ping An Securities reported that domestic banks were commissioning funds collected from the sale of WMPs to third-party managers which were in turn using them for leverage to boost returns. As the PBOC has been steering domestic money rates higher, this trading trend started to break down and banks began calling in these borrowed funds. As a result, fund managers began selling down their holdings and hedging their losses with derivatives. It has also been reported that these traders have been using hush-agreements to entrust their holdings to other investors to circumvent holdings rules, and a lot of these transactions are also coming unstuck in the recent market environment. Significant amounts of the loans and bonds that are traded through the domestic interbank market are of low-quality WMP-related agreements. Ping An Securities estimates that no more than 10% of these commissioned WMPs have been redeemed, so this selloff could continue into the New Year.
Investment Advice
Investors with exposure to Chinese markets should look to diversify their holdings as the Chinese economy faces significant risks in the short to medium term. Businesses that depend on trade with China should look to other markets to diversity their trade risk. Investors should wait on the sidelines to see if the central government can initiate meaningful reforms that reduce the reliance on fixed asset investment to support economic growth. If debt levels continue to rise precipitously, then the risk of China experiencing an economic crisis will rise dramatically. A recent IMF Working Paper warned that China must deal with its excessive corporate debt problem before it results in an economic crisis. The paper found similar patterns in the lead up to the crises in other emerging market economies and what can be observed in China today. Another IMF study in 2012 showed that the probability of a credit crisis increases if a boom lasts longer than six years, starts at a higher level of financial depth, and develops faster. China meets all three criteria.
