World asleep as China tightens deflationary vice-Ambrose Evans-Pritchard
China’s
Xi Jinping has cast the die. After weighing up the unappetising choice
before him for a year, he has picked the lesser of two poisons.
The
balance of evidence is that most powerful Chinese leader since Mao
Zedong aims to prick China’s $24 trillion credit bubble early in his
10-year term, rather than putting off the day of reckoning for yet
another cycle.
This
may be well-advised for China, but the rest of the world seems
remarkably nonchalant over the implications. Brazil, Russia, South
Africa, and the commodity bloc are already in the cross-hairs.
“China
is getting serious about deleveraging,” says Patrick Legland and Wei
Yao from Societe Generale. “It is difficult to gently deflate a bubble.
There is a very real possibility that this slow deflation may get out of
control and lead to a hard landing.”
Zhang
Yichen from CITIC Capital said the denouement will be a ratchet effect
since China has capital controls and banks are an arm of the state, but
that does not make it benign. “They are trying to deleverage without
blowing the whole thing up. The US couldn’t contain Lehman contagion,
but in China all contracts can be renegotiated, so it is very hard to
have a domino effect. We’ll see a slow deflating of the bubble ,” he
said.
What
is clear is that we are dealing with a credit expansion of
unprecedented scale, equal in size to the US and Japanese banking
systems combined. The outcome may matter more for the world than
anything that the US Federal Reserve does over coming months under Janet
Yellen, well signalled in any case.
Societe
Generale has defined its hard landing as a fall in Chinese growth to a
trough of 2pc, with two quarters of contraction. This would cause a 30pc
slide in Chinese equities, a 50pc crash in copper prices, and a drop in
Brent crude to $75. “Investors are still underestimating the risk.
Chinese credit and, to a lesser extent, equity markets would be very
vulnerable,” said the bank.
Such
an outcome — not their base case — would send a deflationary impulse
through the global system. This would come on top of the delayed
fall-out from China’s $5 trillion investment in plant and fixed capital
last year, matching the US and Europe together, and far too much for the
world economy to absorb.
The
effects of this on large parts of Latin America, Africa, the Middle
East, and core Eurasia would hit before offsetting benefits accrued to
consumers in the West. Such commodity shocks are “asymmetric” at first.
Southern Europe would fall over the edge into deflation, pushing Italy,
Portugal, and Spain deeper into a debt compound trap.
China
did of course blink in January when the authorities stepped in to cover
the $500m liabilities of the trust fund, “Credit Equals Gold No. 1”. It
is the fifth trust rescue in opaque circumstances in recent weeks. Yet
it would be hasty to conclude that President Xi is backing away from his
Third Plenum vows to end to the bad old ways.
The
central bank (PBOC) is tightening methodically, allowing the benchmark
7-day repo rate to ratchet up by 200 basis points to 5.21pc over the
last year. It drained a further $50bn from the system this week.
Its
latest quarterly report has turned hawkish, even though producer prices
are in steep deflation, and the M2 money supply is slowing. It
complains that “reliance on debt is still rising” and that “hidden risks
in the financial sphere require attention”.
Zhiwei
Zhang from Nomura says China has entered a “prolonged period of policy
tightening” that will push up bank lending rates by as much as 90bp this
quarter, leading to a chain of defaults.
The
tell-tale signs are obvious in the central bank’s handling of reverse
repos and maturing bills. The yield on corporate AA 1-year bonds has
jumped 272 basis points to 7.15pc since June. “We think the PBOC intends
to raise the whole spectrum of interest rates to push deleveraging,” he
said.
This
will be a rough ride. JP Morgan’s Haibin Zhu says the shadow banking
system alone has jumped from $2.4 to $7.7 trillion since 2010, and is
now 84pc of GDP. To put this in perspective, the total US subprime
debacle was $1.2 trillion.
Haibin
Zhu says there is mounting risk of “systemic spillover”. Two thirds of
the $2 trillion of wealth products must be rolled over every three
months. A third of trust funds mature this year. “The liquidity stress
could evolve into a full-blown credit crisis,” he said.
Officials
from the International Monetary Fund say privately that total credit in
China has grown by almost 100pc of GDP to 230pc, once you include
exotic instruments and off-shore dollar lending. The comparable jump in
Japan over the five years before the Nikkei bubble burst was less than
50pc of GDP.
Source: People’s Bank of China, CEIC, BIS
The
transmission channel to the global banking system is through Hong Kong
and Macao. Bejing’s credit squeeze is causing a scramble for off-shore
dollar credit to plug the gap. It is this that keeps global regulators
awake at night, for foreign currency loans to Chinese companies have
jumped from $270bn to an estimated $1.1trillion since 2009.
The
Bank for International Settlements says dollar loans have been growing
“very rapidly and may give rise to substantial financial stability
risks”, enough to send tremors across the world.
The
BIS data shows that British-based banks — a broad-term, including
branches of US and Mid-East outfits — are up to their necks in this.
They hold a quarter of all cross-border bank exposure to China. By
contrast, German, Dutch, French and other European banks have cut their
share from 32pc to 14pc as they retrench to shore up capital ratios at
home.
Foreign claims on China by bank nationality
This
may be why the Bank of England’s Mark Carney warned before Christmas
that the “parallel banking sector in the big developing countries” now
poses the greatest risk to global finance. Officials at the Bank
recently showed him an unsettling report by the Hong Kong Monetary
Authority on China’s off-shore loan risks.
Charlene Chu, Fitch’s China veteran and now at Autonomous in Beijing, told The Telegraph last week that these dollar debts were large enough to set off a fresh global crisis if mishandled.
They
may be right, but bear in mind that the growth rate of America’s M2
money supply has halved over the last year. It might have contracted
since April without $85bn of bond purchases by the Fed each month.
The
European Central Bank is paralysed after the German constitutional
court read the riot act last Friday, strongly suggesting that its bond
rescue plan (OMT) is Ultra Vires and a violation of “monetary
financing”.
The
ECB cannot easily carry out quantitative easing to cushion a
deflationary shock in the teeth of such a judgment, even if QE is a
different tool. In German politics they are the same.
The
decision came disguised as a referral to the European Court, but was in
reality a warning shot, as former judge Udo di Fabio has more or less
said. The German court cannot stop the ECB buying bonds but it can stop
the Bundesbank from taking part, and must do so if actions are Ultra
Vires. That is enough.
So
we keep our fingers crossed as we glimpse the first foam of a
deflationary Ch’ient’ang’kian coming our way from China. The world’s
central banks have no margin for error.
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