Uncertainties surrounding China’s currency and broader economic transition continue to cloud the global economic outlook. In 2017, the feedback loop between rising U.S. interest rates and pressure on China’s exchange rate mechanism may well be a key determinant of returns across asset classes. The greatest risk in 2017 is that China is forced to choose in favour of financial system stability at the expense of exchange rate stability. If the Chinese yuan’s quasi-peg ends, we could expect a massive volatility spike in financial markets worldwide.
China’s sheer size means that a large yuan depreciation, a sharp slowdown in growth or some combination thereof would be highly disinflationary to the rest of the world. In this scenario, China’s current account surplus would again inflate as domestic demand slumps. Such a growth shock would be supportive of duration (interest rate risk) in sovereign bonds issued by the U.S., Europe and Japan.
Following a research visit to China last month, we came away confident that economic data should continue to look reasonably robust through the first quarter. This reflects the lag effect of past strength in real estate sales and belated infrastructure spending coming online. Recall that it was a combination of the botched yuan depreciation in August 2015 and hard landing fears that triggered the fallout in global markets. The unexpected strength of the property market in 2016 should also support industrial metals prices early in 2017; property sales volume generally leads China-related commodity prices (coal, copper, iron ore and steel) by nine months.
Into the second quarter, however, a slowdown in growth already looks baked into the cake. The extreme degree of fiscal stimulus and credit growth, along with tax incentives that brought forward demand for new cars in the second half of 2016, will fade.
Add to this the lagged effect of the recent property clampdown in many major cities, and we may see growth hindered.
Tighter capital controls have been insufficient to stop capital outflows and the associated bleed in foreign exchange (FX) reserves. Monetary policy is thus potentially constrained from reacting to weaker growth without exacerbating the capital outflow problem.
Key Uncertainties in China’s Outlook
Policymakers don’t appear hesitant to disrupt the financial status quo. Upending the consensus view that the leadership will be highly risk-averse ahead of the autumn 2017 National Party Congress, President Xi Jinping and the government have sanctioned moves to address key sources of financial stability risk earlier than expected. Access to mortgage and developer financing has been tightened, while the People’s Bank of China (or PBOC, the central bank) and the regulatory commission have cracked down on various forms of shadow bank leverage. The primacy of Xi as core leader is associated with primacy of the state in the economy. This domestic source of uncertainty tends to increase private sector demand for U.S. dollars.
A trio of external uncertainties – interest rates, trade and security policy – also increases demand for dollars. Just as exchange rate stability over the past 20 years has been used as a Chinese political tool to gain soft power, it could become a political weapon in reaction to potential aggression from the Trump administration.
Finally, we believe the quality of policy advice to the Chinese leadership has likely deteriorated. The Central Leading Group for Financial and Economic Affairs has replaced the much larger State Council as the primary body for economic policymaking. It mostly comprises bureaucrats with little market experience. Scope for policy mistakes in reaction to events has never been higher.
The conclusion is that while Chinese growth looks stable into early 2017, a more marked slowdown by the second quarter appears inevitable. Growth has been stabilized only after massive fiscal and credit stimulus. China’s total government and private sector debt will likely surpass 285% of GDP this year, a 90% increase since 2008.
Moreover, persistent balance-of-payment deficits and the continuation of strong credit growth have led to a structural rise in dependence on wholesale funding for broad credit growth. Abundant liquidity is increasingly an illusion in China: The effective private loan/deposit ratio is approaching 100%, while total augmented claims are 123% of system deposits as of November 2016, based on our calculations. The wholesale market has become a large and crucial source of credit funding.
The paradox of Chinese drift is that its success in maintaining the juggling act between multiple internal and external objectives only adds to the risk of a hard landing and greater global fallout in the future. This paradox stems from the fact that the balancing variable is ever-increasing debt.
Interest Rates, Flows and Trade: No Silver Lining?
The silver lining around rising U.S. interest rates is that they tend to be allied to cyclical upswings. Thus, there is typically a positive demand offset to an otherwise negative-for-EM rise in external borrowing costs and a reversal in portfolio flows. Unfortunately, history has repeatedly shown that capital flow movements stemming from changes in U.S. interest rates tend to dominate any positive trade-related effects from stronger U.S. demand. The current cycle looks more consistent with the 1990s than the mid-2000s, when the emergence of the Asian savings glut led to persistent FX reserve increases and recycling back into Treasuries. Thus, long-term U.S. yields were stable through most of the Fed tightening cycle.
In contrast, there is little silver lining in the case of a Chinese economic shock. Weaker Chinese growth imposes a double whammy on commodity exporters through both price and volume effects. It risks reversing EM progress in adjusting external balances toward more sustainable levels. Where demand compression is exacerbated by a reversal in portfolio flows (either out of concerns about China or the U.S. rate backdrop), there is a greater probability of credit stress.
Credit stresses tend to be more pronounced where domestic credit growth has been robust. The standouts prior to the 2013 “taper tantrum” have generally remained standouts in the past three years as well, most notably China, Turkey and Singapore. The countries to the right in Figure 1 are more vulnerable to GDP growth slowdowns given the relative importance of credit growth in recent years.
A significant slowdown in China would likely upend equilibrium EM asset valuations via both a direct income shock to all of EM and a negative terms-of-trade shock (via FX to regional competitors, and via both FX and lower commodity prices globally). In other words, the fair value of a given country’s real effective exchange rate would fall in tandem with actual declines in the exchange rate.
Fair value in domestic interest rates, in turn, would need to be repriced as a change in the fair value of the external risk premium (via credit default swaps, for example) and any additional domestic inflation risk premium. This means a lot of moving parts that create substantial uncertainty around true fair values. The only certainty is that the “relative” cheapness of EM asset prices would be significantly reduced by a China shock.
EM may again be facing two exogenous shocks simultaneously: a repricing of U.S. interest rates based on a fundamental reassessment of the policy mix under Donald Trump and a potential shock from China, which would affect both Asia and Latin America in profound ways.
The endogenous risk to EM relates to its own credit deleveraging, which had been forestalled by China’s ongoing levering up, a very benign Fed backdrop and a related normalization in commodity prices.
It is possible China may muddle through for another year, and the U.S. rate environment may well be anchored by structurally low inflation and potential growth rates. But the conclusion from our recent trip is that there is a feedback loop between Chinese growth sustainability and U.S. interest rates, and the loop can turn vicious over the course of 2017.
For China, the exchange rate remains a tricky pressure release valve. It does little to buoy growth in absolute terms, but it reduces pressure via higher producer prices on sectors burdened by overcapacity. The cost of this policy stems from the drain on domestic liquidity from the balance-of-payments deficit and the excess of credit growth relative to deposit growth. The PBOC can push on a string to keep domestic liquidity flush, but at a cost of faster capital outflows. Or it can let system liquidity tighten naturally, as it seems to be doing at present, which creates risks to the housing market and debt sustainability more broadly. Domestic rates are more likely to rise as a function of exchange rate considerations before eventually falling to support the domestic financial system.
If, as expected, China’s growth continues to slow over the course of 2017, this should naturally translate to a more negative stance on the EM commodity complex (mainly Latin America FX and rates) and to a lesser extent on Asian FX. Indeed, given present valuations, this risk argues for being highly selective on country selection and biased in favour of external debt over EM FX and local rate exposure.
A forced free float of the Chinese exchange rate would be a massive volatility shock to the global economy. This remains one of the key unknowns we are monitoring over the cyclical horizon.