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ANALYSIS

Dembik: Financial liberalization in China could spark
increased global risk

Should markets fear a new Chinese meltdown?

DUBAI, December 27, 2017

By Christopher Dembik

A few weeks ago, China’s stock markets led a global selloff on worries about the country’s growth. Concerns quickly faded, however, following the release of surprisingly good Chinese export data and major steps taken towards tax reform in the US.  Even so, some investors still consider it an early warning sign that a new shock is coming from Asia.

Over the past three years, China has given investors the cold sweats on more than one occasion as the country pursues deeper integration into the global financial system. It was China, after all, that triggered the last two global stock market corrections in 2015 and 2016.

In January 2016, the Shanghai Stock Exchange Composite index dropped by 19 per cent, causing a steep global selloff that lasted for almost two months. Should markets fear a new Chinese meltdown in 2018? The probability is high that it could happen again – and soon – but there are also several factors that could effectively mitigate risk.

The key macrofinancial risks associated with China

China’s economy is heading towards a sharper slowdown than the market expects, and the post-Congress tightening is nothing new.

Since September, China’s economic surprise index has been negative. China’s October activity data for the real estate market, industry, services, construction, and investment are all weaker due to calendar effects (the 19th Congress) and overcapacity reduction. What is more surprising is the number of infrastructure projects that have been stopped or cancelled in a move to focus on the quality over the quantity of growth (subway projects in Inner Mongolia, for instance).

This will have negative ripple effects on the private sector (as most projects in China use a public-private partnership approach) and ultimately on growth, since these infrastructure projects represent roughly 20 per cent of total fixed asset investment. The negative credit impulse, coupled with lower investment in infrastructure, clears the path for an inevitable slowdown that will be probably larger than is commonly anticipated.

In addition, signs of contagion from China’s slowdown are starting to materialise in Australia and Hong Kong, where the merchandise trade volume index – which serves as a good proxy for Chinese trade due to its intermediary port position – has pointed down since the beginning of the year.

It is not yet at worrying levels, but it represents an early sign that the global economy will face headwinds very soon.

Another thing to look at is that while the level of corporate debt in China is not that high (46.2 per cent of GDP in Q2'17) the private sector debt service ratio is rapidly increasing. This is something that is rarely mentioned when discussing China’s financial risks.

Based on data from the Bank for International Settlements, the private sector debt service ratio has reached a record level of 20 per cent of income (versus only 11.7 per cent in 2008). In spite of deleveraging, this trend is expected to continue, at least in the medium term. This is worrying because it implies that the private sector will devote an increasing share to repaying debt to the detriment of investment and wages in an unfavourable context of slower growth.

A lasting tension on borrowing rates could trigger bankruptcies that would first affect sectors experiencing overcapacity, ultimately requiring state intervention to prevent contagion to the four big banks.

In our view, financial liberalisation is the major long-term challenge for China and the global economy. The timeline still remains unclear, but substantial changes are expected in the coming years (for example, foreign investors will be allowed to own a majority share in the country’s financial institutions whereas they can currently own a maximum of 20 per cent).

This financial "big bang" will certainly have as many-long term positive consequences for the world as did Deng Xiaoping’s "open door" policy. However, it will also increase the global macrofinancial risk associated with China.

Until now, China’s economic slowdown has mainly been affecting the rest of the world through trade and currency. Once financial liberalisation comes to pass, it will do so through banks and financial intermediation, which will pose an important systemic risk in case of a much deeper than expected slowdown or when the next nonperforming loan cycle begins.

Historically, financial liberalisation has been a key catalyst in previous emerging market financial crises. While it is obvious that China has a number of strengths that other EM countries did not, there is a substantial risk that this process will lead to higher speculative financing, thereby increasing the probability for borrower default in a context of very high indebtedness.

The authorities fully understand this risk, as was proved by Xi Jinping’s three-hour speech at the 19th Party Congress... and this is why China needs to deleverage cautiously but quickly.

What could effectively mitigate risk?

In 2015 and 2016, global fears concerning China focused mainly on capital outflow and RMB devaluation. Those fears have since vanished, mostly as a result of better capital controls. The People's Bank of China's forex market interventions were curtailed significantly in 2017, and for the first month since the financial crisis, China's central bank did not intervene in the market at all in October.

Market intervention remained marginal in November when net purchases / net sales of foreign currency by the PBoC stood at just $10 billion. Another sign of rising financial stability is that the gap between the onshore and offshore yuan (which widened in 2014 and 2015, triggering a sharp devaluation) has been completely closed since Q1'16. Finally, the PBoC has also managed to rebuild its foreign currency reserves since the beginning of the year, reaching $3.12 trillion in November.

All of these elements indicate better financial stability and guidance by the central bank in the money market. The rising issue for China now is not so much capital flight but rather the repatriation of capital held by Chinese multinational corporations, which constitutes a long-term loss for Chinese investment capacity and growth.

Consumption remains a stable source of growth that can offset, at least to some extent, deceleration in investment and construction. Consumer sentiment is at the highest level since the end of 1996 due to better labour market conditions and strong wage growth. Since 1999, wage growth has increased substantially, both in real and nominal terms, and is well above levels observed in other major developing countries.

Over the same period, nominal wage growth has nearly always remained above 10 per cent (year-on-year). It recently decelerated slightly to reach 9.1 per cent in nominal terms and 6.9 per cent in real terms in 2016.

Coupled with low inflation, rising incomes provide some policymakers some comfort when facing China’s medium-term financial challenges.

At the same time, financial deleveraging is a work in progress. Since mid-2016, year-on-year loans to non-banking financial institutions have been contracting. In October 2017, this metric decreased by 33 per cent y/y.

This is a direct consequence of tighter monetary conditions and stricter regulation. The PBoC has hiked rates twice this year for medium-term lending facility and is expected to follow that path next year.

Alongside these measures, the Chinese regulator has also made convincing steps towards stricter rules on asset management products, including standard leverage ratio and guaranteed payments; these should be fully implemented by 2019.

 The risk associated with China’s debt, however, remains a central point of concern for investors – something that has led to higher bond yields over the past few months. It has pushed China’s 10-year government benchmark close to a three-year high around 4 per cent versus a 2016 low of 2.6 per cent... but again, there are factors mitigating risk.

China’s government is a key direct and indirect holder of private debt (through large banks and state-owned enterprises that represent roughly 2/3 of the country's total corporate debt) and, in the worst case scenario, the high level of gross savings rate (around 50 per cent of GDP versus 17 per cent in the US) offers a safety cushion which the government can draw on.

So far, only a marginal percentage of Chinese public debt is owned by foreign investors (around 1 per cent), limiting the risk of financial contagion.

High debt levels will start to represent a global risk once financial liberalisation has occurred. Even China bulls cannot rule out that liberalisation will probably cause more frequent global financial shocks due to China through banking, but primarily financial, intermediation.

Investors need to get used to China being an area of financial instability over the coming years. The pending question is to know how large these shocks will be and whether the global economy, which is already heavily indebted and faces sluggish growth, will be able to contain the negative wave.

About the author

Christopher Dembik is head of Macro Analysis at Saxo Bank, a Danish investment bank specializing in online trading and investment.

 




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