We would suggest this is the correct way of thinking about China. The true level of GDP growth is gonna always be an especially fuzzy metric so it’s the right hand side of that chart — the effects of the slowdown — which matter and allow you to track backwards.
Long form, that looks like this:
1. Commodity dependence hurts. Growth in China has a strong impact on commodity prices: it consumes nearly half of the global supply of industrial metals given its past investment led-growth model. A slowdown in China therefore leaves commodity dependent LATAM economies and Australia vulnerable.
2. Petrodollars become petropennies: With lower oil prices, the annual flow of petrodollars may have halved to around $200-300bn, by our estimates. This may reduce the demand for fixed income assets, which was a significant portion of major oil exporting sovereign wealth funds’ growing investments over the past decade.
3. Banking system contagion. South Korea, the UK and Australia are the countries with the largest proportion of their foreign claims to China (BIS). In the UK, this exposure is concentrated between HSBC and Standard Chartered. Loan exposure to China represents around 30% of their loan books. In Australia, each bank’s exposure to Asia is small at generally less than 5% of lending (with the exception of ANZ at 15%). Similarly, foreign claims to China are not a direct risk to South Korean banks; these claims only comprise around 1.5% of total lending from South Korean banks.
4. Lower export revenue. China is the largest trading partner for a number of economies in both LATAM and Asia. DM corporates which derive a significant proportion of their revenue from China are also exposed to China’s slowdown. If China successfully transforms itself into to a consumption-based economy, these corporates could stand to benefit from the spending power of China’s growing middle class. However, we think this transition could take many years and will not be smooth.
5. Currency devaluation and rising asset-liability mismatches for EM hard currency borrowers. Unlike the Asian financial crisis in 1997, the original sin of emerging economies has shifted from sovereigns to corporates. EM non-financial corporate debt has tripled since 2008, to $2.6tn in June 2015, with a higher proportion in foreign currency. According to the IIF, 40% of EM bond issuance was in USD in the first five months of 2015 vs 10-15% in 2008, and only a third of hard currency EM corporate debt has natural revenue hedges. As local currencies depreciate, these EM corporates will see further rises in their leverage, leading to higher insolvency risks.
We’ve written about just about all of this before — and will pop some stuff in RL at the bottom — but it’s worth maybe concentrating on the devaluation risk once again, particularly in light of the recent IMF SDR inclusion decision.
To be clear, a serious devaluation is not in many people’s base case. But as CreditSights said, the ” suggestion is that any devaluation would wait until after the renminbi has been adopted by the IMF as one of the currencies backing its special drawing rights.” Which is about done.
And CreditSights add that:
… we believe that it is enough of a risk that the implications need to be considered, given that Chinese ‘stability’ does not necessarily equate to global financial stability.
A meaningful devaluation would:
See another wave of deflation in US and European imported prices.
Likely put pressure on any Chinese produced commodities such as steel without doing much to help the price of other commodities such as oil
And drive EM (and commodity focused developed economies’) exchange rates weaker as they fight to maintain competitiveness and potentially face capital flight.
Weaker risk appetite weakness could spread to developed markets as well. In the week that China allowed even a small devaluation in August those US HY sectors that have the greatest China exposure dropped by most, as the chart below shows. With more US focused sectors posting only small negative returns or in some cases positive.
It would thus boost Chinese exports at the expense of the rest of the world in classic currency war paranoia, beggar thy neighbour, style while putting those Chinese firms which borrowed in dollars under heaps of pressure.
Thing is though, as CreditSights refer to above, China cares more about its own stability than it does about global stability, even if those two things aren’t exactly mutually exclusive. If they have to sacrifice global financial stability (and some Chinese firms) to do things like support employment and keep the populace on the side of the Party generally… ? We know which we’re betting even if the long term risks will only build while they do the short term needful (from their point of view).
A final piece of CreditSights speculation to close:
Despite all the protestations of ‘rebalancing the economy’ away from exports and liberalizing the financial sector there are now worries that China could attempt to revert back to an export led, trade surplus model for growth if its primary goal of growth led stability is threatened…
As conspiracy theories go, the ‘big bang devaluation’ crowd can point to a record repayment of FX loans by Chinese residents in September and October. Coinciding with that repayment of loans there has also been a sharp slowdown in dollar HY bond borrowing in Asia in the third quarter. The Chinese property sector has seen a particularly sharp shift to onshore funding as the chart below from our October webinar on Asian HY shows. While dollar bond issuance from HY Chinese developers plunged by 48% YoY in 9M15, total bond supply (both offshore and onshore bond issuance) jumped by 65%. Domestic bond issuance from Chinese HY developers totalled RMB 90 bn ($14.2 bn) during 9M15.
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