The prospect of financial sector deleveraging in China increases the risk of a hard landing - despite yesterday's goldilocks GDP print (and ugly miss in IP). Although the probability of the hard landing is still low, Morgan Stanley warns it’s not low enough to make hedging costs irrelevant: The new government's policy drive to deleverage the banking sector has become more apparent, and they think this deleveraging will likely continue to unfold in the next 6-12 months. In MS' Super-Bear scenario, they expect aggressive policy tightening to reduce 2H13 GDP growth to 5.5% YoY. In this scenario, policy-makers are also slow to respond to this deceleration, leading to more turmoil in the financial sector. Although a low probability event, this would have major implications for global markets. MS estimates that markets are pricing in a 1-in-10 chance of a Super-Bear scenario in China in the coming 12 months, more in equities, less in FX markets.
Via Morgan Stanley,
The new government's policy drive to deleverage the banking sector has become more apparent. In the three months preceding the spike in money market rates the CBRC/SAFE have announced measures to regulate interbank entrust payments, wealth- management products, leverage in bond investments, FX lending and interbank loan structures all with the aim of curtailing the widespread use of new financial channels to grow bank assets rapidly. We think this deleveraging will likely continue to unfold in the next 6-12 months.
The Cheapest China Hedges
- FX and credit hedges tend to be more cost-effective than equity hedges, although most hedges are still marginally more expensive than at the start of the year, due to the post-May sell-off as well as higher vol levels. Most markets are now down YTD, although with considerable dispersion.
- CNY (FX) puts have the highest reward/risk ratio, although we have some reservations about the actual effectiveness of the puts due to potential FX intervention and restrictions on capital flows. China sovereign CDS also looks attractive, although the possibility of an actual credit event looks extremely remote.
- The most attractive equity hedge are puts on the TWSE.
What's Priced In?
and How Bad could it get?
Source: Morgan Stanley