SocGen On A Chinese Slowdown: Buy China CDS, Sell Hard Commodities
Following last week's news that as we suggested US stagflation is starting to shift to China, SocGen's Patrick Legland looks at the consequences of what a Chinese slowdown in H2 would look like for the country, and the world. Cutting to the chase: buy Chinese CDS, and sell hard commodities. That said, the risks to the global economy, should China implode, are far vaster, and we fail to conceive how the central planning cartel would ever allow this to happen, or the PBoC for that matter, considering today's earlier news of not one but two failed Chinese auctions.
Chinese financial sector begins to reflect concerns of an economic slowdown. Following the US-China strategic meeting, cooperation between the two countries is again under the spotlight. But let’s try to analyse the current situation in China from a market viewpoint. The latest figures released for the housing market in April showed that sales in Beijing were down 40% in Q1 11. If we obtain confirmation of the property slowdown, bank balance sheets will be damaged. Markets now view this scenario as possible. Therefore, the Chinese financial sector is now exhibiting worrisome signals. Thus, the Chinese equity financial sector has clearly been underperforming US and European peers over the last six months. Next event: New Yuan loans 10-15 June 2011.
Consequence 1: Chinese CDS will be on the rise in H2 if China starts to slow. For now, the 5-year CDS is not pricing this scenario. Current market pricing suggests that either a hard or soft landing for China is merely seen as a potential scenario not very likely to happen. Conversely, SG economists (link) believe that China may soon face unusual turbulence and have adopted a bumpy landing as a definite possibility. Indeed, recent inflation figures and warnings of a potential property slowdown are not discouraging investors from investing in China. But, with further rate hikes, there is a risk of a property crash or equity market collapse. If we compare the Chinese situation with the economic situation before 2009 in the US, we get an idea of what could happen to Chinese CDS as US CDS jumped to nearly 100 from 6.5 in only 10 months at that time (May08-March09) Next event: Chinese CPI for May, 13 June.
Consequence 2: Hard commodities will fall apart if China starts to slow in H2 11. For example, early in 2011, we already saw a dramatic fall-off in Chinese appetite for copper although prices remained high due to continued production issues. Contrastingly, agricultural demand from China is likely to protect soft commodities better from a fall in prices as demand is still trending higher. For example, soybean imports from China doubled over the past five years which means demand was up by nearly 5Mt/year. The recent tightening in monetary policy had a limited impact on soybean prices and even the deceleration in economic growth could fail to curtail agricultural demand. Shortly, China will become a net corn importer and then a wheat importer. Next event: End of US QE2 30 June.
So what are the main risks:
Risk 1: Revaluation on the horizon. The economic situation, with high inflation, may push China to revalue its currency. It seems that the option of a one-off or smaller revaluation may be back on the agenda. The effect of a revaluation will of course depend on the amplitude of the move. But, excluding the US dollar, if we assume a 20% currency revaluation, this would only bring the yuan back to where it was when China joined the WTO in late 2001. As the Chinese currency is pegged to the USD, the yuan has mirrored the USD’s decline against €, Japanese ¥ and AUD since China joined the WTO. Meanwhile, the yuan was revalued by 20% against USD during the last 10 years.
Risk 2: Hard landing (vs bumpy landing) could be a major risk for the world economy China’s April data release was quite mixed with inflation still above the target 4% ( at 5.3%) and disappointing retail sales figures meaning Chinese consumption didn’t growth fast enough. Once again, this is pushing the People’s Bank of China to raise rates for the fifth time since the start of the year. The key issue for the Chinese central bank seem to be the slowdown in demand for credit and capital inflows. Our economists expect two more interest rate hikes, but the risk attached to this policy is that we could end up with a hard landing. If this were to materialise, it would be a major threat for world economies.
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