In light of concerns over China’s rising leverage, yuan stability, capital outflows and risks to emerging economies, Western Asset’s Portfolio Manager and Head of Investment Management, Asia (ex-Japan) Desmond Soon shares what we can expect from China’s financial markets in the next six months. He goes into detail about why we think a debt crisis in China is not likely, the safeguards in place to help ensure financial stability and the steps China is taking to encourage more foreign investments to conclude that China’s fixed-income market continues to be an attractive option for global bond investors. READ MORE.
A Debt Crisis in China Is Unlikely
Economic growth in China has exceeded analysts’ forecasts for the first half (1H) 2017. Inflation at both the consumer and producer levels has stabilized while indicators such as the Purchasing Managers’ Index (PMI), exports and housing starts have rebounded. Against a robust economic backdrop, China shares, credit spreads and the Chinese yuan (CNY) shrug off the Moody’s one-notch credit downgrade of China’s sovereign credit rating to A1 on 24 May. The credit rating agency cited an increase in contingent liabilities for the government due to a material rise in economy-wide debt.
China’s total debt has indeed risen rapidly to more than 260% of Gross Domestic Product (GDP) from 160% in 2008—alarming in the context of a developing economy. The growth of leverage has been mostly in debt issued by local governments, private enterprises and borrowings by state-owned enterprises (SOEs) especially those in industries with excess capacity (e.g., iron and steel, and coal production). On the other hand, the debt levels of the central Chinese government and households remain low and manageable.
However, China is no ordinary emerging country given its size, influence and the exceptional policy levers in the hands of its authorities. The Chinese government believes that if it reduces the pace of leverage growth, debt-to-GDP levels will drift lower over time as the economy grows (nominally) at about 8% per year (real GDP of 6.5% plus inflation of 1.5%). This gradualist approach is encapsulated by a Chinese expression “Using time to exchange for headroom 用时间换空间” often cited by Chinese policymakers, which, as global bond
investors, investors understand how time and robust economic growth can be applied to improve debt dynamics. Importantly, there is also the need to examine various mitigating factors and policy levers that make China different from the typical highly indebted emerging economy.
1) The increased debt levels in China are predominantly CNY-denominated and external borrowing (mostly in USD) remains modest. Holders of Chinese debt are primarily domestic players, and there is little dependence on external markets for financing. Until recently, Chinese capital markets have been mostly closed and foreign holdings of Chinese stocks and bonds were extremely low. Hence, foreign claims on China are limited and there is the policy option—when push comes to shove—for Chinese authorities to buy up bad debt in CNY, a policy response that is analogous to the US Troubled Asset Relief Program (TARP).
2) Most of the onshore debt is in the form of state-owned banks lending to SOEs or local governments. Hence, the possibility that Chinese interbank lending may freeze—in the way that it did post-Lehman in 2008—is extremely low as the entities are state directed. Third, Chinese authorities have engineered a massive debt relief program by swapping local government financing vehicles (LGFV) bonds into municipal debt. This CNY9.5 trillion (US$1.4 trillion) municipal bond swap program allowed short-term, high-interest-rate debt previously issued by local government funding vehicles to be swapped with longer-dated, concessionary interest rate debt, at 120% of Chinese Government Bond (CGB) yields. The “new municipal bonds” are purchased by Chinese banks as eligible repo collateral. The LGFV-to-Muni bond swap successfully lowered the debt-servicing burden of local governments, and a similar policy for excess-capacity SOEs may also be contemplated.
3) Most case studies of debt sustainability in highly indebted emerging economies have never dealt with a developing economy the size and with the influence of China. For instance, China has a large domestic savings base, sizable FX reserves, fiscal latitude, capital controls and flexibility in currency management along with a special drawing rights (SDR) currency status—which are policy levers not available to the typical emerging country. The point is, the rise of China challenges the very notion of what should be defined as an emerging market (EM) country, as China leapfrogged from nowhere to become the world’s second largest economy.
Opportunities and Risks for Fixed-Income Investors
Less than 2% of China’s US$9 trillion bond market (third-largest in the world) is currently owned by foreigners. The latest program aimed at enticing more foreign money into the local bond market is “bond-connect.” This is modeled on the existing “stock-connect” plan, and would allow foreign investors to buy onshore Chinese bonds via Hong Kong. Bond-connect should be a more flexible and convenient channel than the existing programs (e.g., QFII, RQFII and CIBM) because the Hong Kong Monetary Authority (HKMA) will act as a custodian via its Central Moneymarkets Unit (CMU), so foreign investors do not have to set up trading accounts with onshore Chinese market makers. In addition, the bond-connect program should ease some foreign investors’ concerns that in a crisis, China may impose capital controls to prevent them from repatriating funds. Hong Kong’s commitment to free capital mobility has a long track record, credibility and the free operation of the stock-connect program has set a strong precedent.
China’s onshore bond market has gone through a significant adjustment in yields—CGB bond yields have risen 50–60 bps YTD as the authorities’ tightened liquidity to combat excessive leverage. For the foreign investor, the combination of higher China bond yields, potential bond index inclusion, currency stability (including SDR status) and new innovative programs to easily invest in the huge onshore bond market could make the next six months an attractive time to invest in China bonds, starting with CGBs and policy financial bonds (PFBs), issued by policy banks.
For investors that remain cautious of China, we believe that macro trades betting on a replay of the “Lehman-style” meltdown in China are unlikely to be profitable. As we have explained earlier, Chinese authorities have sufficient policy tools to manage the magnitude and pace of deleveraging without sending the economy into a tailspin. That stated, President Xi is pursuing an aggressive and wide-ranging deleveraging program which may weed out weaker and more highly leveraged private companies and less strategic SOEs. Therefore, strategies focusing on the avoidance of micro idiosyncratic risk will be more fruitful than a bearish China macro overlay like shorting the CNY/CNH. To illustrate, Exhibit 6 shows that the balance sheet holdings of Wealth Management Products (WMP) vary widely among Chinese banks.
The major Chinese banks have 2%–3% of WMP on their balance sheets while for smaller and regional banks, WMP can be as high as 40%–50% of balance sheet. Therefore, it is not useful to generalize regarding Chinese banks’ exposure to WMPs and suggest a systemic risk. The emphasis in our credit strategies has been on judicious credit selection and hence, our core holdings are in bonds issued by China policy banks, the five major banks and their leasing subsidiaries, while avoiding the highly exposed regional banks.
USD-denominated bonds issued by Chinese Tier-1 SOEs (e.g., Sinopec and State Grid) offer a pickup of 30–60 bps over similarly rated global credits due to concerns by some global investors over the supply pipeline and transparency. However, bonds by these SOEs and strong investment-grade Chinese issuers are well supported by captive demand from Chinese bank treasury, exporters and high net worth individuals with large offshore USD holdings. Our credit preference has been for centrally owned, strategically important SOEs and strong investment-grade private companies while avoiding most high-yield private issuers. To underline the micro idiosyncratic risk of Chinese high-yield issuers, prices of bonds issued by companies such as Dalian Wanda, HNA Group and Fosun dropped by more than 10 points in mid-June after the news that they were singled out by CBRC for large offshore acquisitions.
Chinese investors have substantial USD holdings, well in excess of their liabilities due to widespread expectations of a stronger USD and capital flight. If this mindset changes (albeit slowly) over a period of CNY/CNH stability or appreciation, pent-up demand coupled with recent moves to include Chinese “A” shares and China bonds in mainstream indices could drive the CNY/CNH significantly stronger. With relatively attractive bond yields of 3.5% to 4.0%, we expect the Chinese yuan to be an outperformer (on a total return basis) relative to other developed Asia local currencies.
From a risk perspective, we are cognizant that the fixed-income investment opportunities that we have highlighted in China rest strongly on Western Asset’s central scenario of benign global interest rates, Fed balance sheet reduction and US President Donald Trump politics. As attention switches from the economy to politics as we approach the 19th Party Conference this fall, questions vary from how President Xi will manage the Standing Committee transitions, with five out of the seven members expected to retire this year, to his intentions after 2022 when his second term ends. Also, in the background remains the delicate issue of North Korea, which presents a “known-unknown” geopolitical risk of immense negative impact if a large-scale military conflict were to breakout in the Korean peninsula. While we do not expect any major unsettling outcomes from the Party Conference, we remain concerned about the North Korean situation and will watch warily, feeling confident only in that no one knows how this will play out.