If you listen carefully, you can hear air escaping the credit bubble in China. While the bubble is still expanding, rising non-performing loans (NPLs), rising inflation and interest rates, increasing capital flight, and speculation are all causing leaks that may burst the bubble.
The People’s Bank of China (PBOC) is juggling all three variables -the foreign exchange rate, free capital account and monetary policy- to varying degrees with signs of stress emerging. They are trying to manipulate all three to avoid a drastic situation: managing the exchange rate decline by selling reserves, restricting capital movements and managing interest rates to avoid sharp increases.
Many forecasters have been predicting, over that last several years if not a decade, an end to China’s massive bubble. What is different now is the combination of capital flight with rising NPLs and rising interest rates. When will the bubble burst we do not know. But there is no doubt that when China’s bubble bursts it will affect global markets on a massive proportion as China is adding more to global growth than the US, Europe and Japan combined. Let us have a look at the data:
Currency Outflows Even With Capital Controls
PBOC’s Foreign Exchange Reserves
Foreign exchange reserves peaked in late 2014. Reserves have declined more than one third in the last two years at an accelerating rate. The principal drivers have been declining growth outlook and a rising US dollar from rising US rates. But recognize that this transaction is mostly sales of US treasuries on the one side and purchases of domestic assets on the other. Even with accelerated purchases and domestic financing interest rates are increasing. They have reduced reserve requirements for small banks to ease liquidity problems.
With locals and foreigners having increasing problems taking funds out of the country it seems reasonable that few will want to put money into China. Now apparently the PBOC wants local companies to access foreign currency funding to reduce pressure on the exchange rate.
More Aggressive Quantitative Easing (USD 800 billion in 1 year) and Financing of Local Banks
PBOC’s Domestic Assets (Total less Foreign, in USD billions)
So while capital is fleeing the country, the banks and non-banks continue to lend aggressively creating funding difficulties and driving up interest rates. The growth of the PBOC’s domestic assets is increasing at an accelerating rate and this can only be seen as inflationary and creating less confidence in the currency.
Currency Devaluation is Ongoing
The currency peaked as US interest rate expectations increased and China’s declined in 2015. The currency has declined at an accelerating rate since late 2015 even with a massive reduction of FX reserves. This seems to be a main worry for the PBOC as they try to manage with a mix of reserves reduction, letting interest rates move higher lately and stiffening capital controls.
Yuan Hibor Shows Stress in FX Markets
Short-term Interest Rates
The 3-month interbank rates for Yuan in Hong Kong reached 10% in late December before declining. Lots of stress as the government tries to manage an orderly decline in the FX rate.
Rising Interest Rates Risk Bursting the Credit Bubble
Domestic Interest Rates
Interest rates have increased between 60 to 150 bps in the last several months as market rates increased and to ease pressure on FX rate. The problem with this is that eventually the highly leveraged economy will slow and/or burst the credit bubble as higher rates start to reduce consumption and investment. And one day soon the PBOC should increase its benchmark interest rate. Rising inflation leads to higher interest rates which burst the bubble.
Net Bond Issuance Has Turned Negative
Monthly Bond Issuance Net
Bond investors head for the hills.
Even as Bond Spreads Have Widened
AAA Corporate Bond Yields Less 5-Year Government Bond Yields
Problem Loans Accelerate Even with Strong Growth in Total Loans
As a % of Total Loans
And many believe that problem loans are sharply understated.
Credit Growth Far Outpaces Growth in Productive Investments
Should not credit growth mirror growth rates of investments in real estate and manufacturing like they did until 2014? Now credit growth seems to be used for flipping assets or more speculative activities:
Investment and Share Loans Are Increasing Rapidly
Share and Investment Loans to Total Loans
Sounds like riskier loans. Most rapid growths in lending by bankers have ended in tears… time will tell. From 7% of total loans to 21% in 2 years! With the PBOC starting to reign in growth of wealth management products it is likely that we will see at least a slowing of growth. How many banks will fail when this ends? Generally the size of the boom corresponds with the size of the bust.
All This Lending and Domestic Liquidity is Building Price Pressures
Producer Prices and Consumer Prices YOY
With accelerating Producer Prices can Consumer Prices be far behind?
Lower Tax Revenues Imply a Weakening Economy
Fiscal Revenue: 6-Month Moving Average YOY
Lower tax revenues imply a weakening economy. Well below the 6% GDP growth rate.
Government Expenditure Growth is Waning
12-Month Change of 6-Month Moving Average
So declining growth in government expenditure combined with the end of Housing Bubble 3 (below) paint a difficult outlook.
Property Price Acceleration 3 is Ending with Limited Impact on Construction
Square Meters (m2) Under Construction YOY
Each increase in property prices has led to a smaller increase in growth. Property Price Acceleration 3 seems to be mostly about passing existing properties from one to another at higher prices. Ireland tried that and it did not end well.
So juggling several tools to manage the complex problem with a little tightening, a little depreciation and more capital controls to muddle through. The worst scenario would be several rate hikes by the US Federal Reserve in 2017 and a continuation of a strong US dollar.
The Bottom Line:
China is hugely important to global growth. With signs of a renewed slowdown in the cards, the biggest concern is that higher rates will prick the bubble of overly aggressive credit growth. Essentially, rising inflation leads to higher interest rates which bursts the bubble. Most expansions have ended with this classical pattern. It is especially worrying if you combine it with the weaker government spending and the apparent ending of Housing Bubble 3. Additional pressures are also building… capital flight, speculative investment share loans/wealth management products, rising NPLs and central bank funding needed to finance the balance sheets of the banks. Maybe global growth pickup will save the day (doubtful given the existing leverage), maybe they will buy some time with a new equity bubble or increased government spending or some other lever. In any event, there are plenty of reasons to be cautious for when this bubble bursts the deflation of recent years will look like a warmup act for the real show. Keep an eye on commodity prices, inflation, interest rates and the currency. We expect the second half of 2017 to look a lot different than the optimism that prevails today.