"It's Coming To A Head In 2016" - Why Bank of America Thinks The Probability Of A Chinese Crisis Is 100%

Some sobering words about China's imminent crisis, not from your friendly neighborhood doom and gloom village drunk, but from BofA's China strategist David Cui.

Excerpted from "2016 Year-Ahead: what may trigger financial instability", a must-read report for anyone interested in learning how China's epic stock market experiment ends.

A case for financial instability

It’s widely accepted that the best leading indicator of financial instability is rapid debt to GDP growth over a period of several years as it’s a strong sign of significant malinvestment. Based on Bank of International Settlement’s (BIS) private debt data and the financial instability episodes identified in "This time is different", a book by Reinhart & Rogoff, we estimate that once a country grows its private debt to GDP ratio by over 40% within a period of four years, there is a 90% chance that it may run into financial system trouble (Table 1). The disturbance can be in the form of banking sector re-cap (with or without a credit crunch), sharp currency devaluation, high inflation, sovereign debt default or a combination of a few of these (Table 2).

As Chart 1 demonstrates, China’s private debt to GDP ratio rose by 75% between 2009 and 2014 (i.e., since the Rmb4tr stimulus), by far the highest in the world (we suspect a significant portion of the debt growth in HK went to China). At the peak speed, over four years from 2009 to 2012, the ratio in China rose by 49%.

Other than sovereign debt default, China has experienced all the other forms of financial instability since the open-door reform started in late 1970s, including a sharp currency devaluation in the early 1990s (Chart 3) and hyper-inflation in the late 1980s and early 1990s (Chart 4). China also needed to write-off bad debt and recap its banks every decade or so. Banking sector NPL reached some 40% in the late 1990s and early 2000s and the government had to strip off some 20% of GDP equivalent of bad debt from the banking system between 1999 and 2005.

When debt problem gets too severe, a country can only solve it by devaluation (via the export channel), inflation (to make local currency debt worth less in real terms), writeoff/re-cap or default. We judge that China’s debt situation has probably passed the point of no-return and it will be difficult to grow out of the problem, particularly if the growth continues to be driven by debt-fueled investment in a weak-demand environment. We consider the most likely forms of financial instability that China may experience will be  a combination of RMB devaluation, debt write-off and banking sector re-cap and possibly high inflation. Given the sizeable and unstable shadow banking sector in China and the potential of capital flight, we also think the risk of a credit crunch developing in China is high.

In our mind, the only uncertainty is timing and potential triggers of such instabilities.

Why 2016 can be a dangerous year

Since 2011, there had been a round of debate about the potential of hard landing and financial instability every year in the market. So far, the financial system has held up reasonably well, notwithstanding some periodic short term volatilities. Many view the absence of any severe disturbance as proof of the government’s ability to tame financial sector volatility and believe that the risk of this happening has diminished over time. We disagree. We believe that the government has maintained a superficial stability largely by debt-funded stimulus and an ever-greening of bad debts. These strengthened various implicit guarantees which have been generating destabilizing forces beneath the surface - a classic case of short term stability breeding long term instability. It’s our assessment that the longer this practice drags on, the higher the risk of financial system instability, and the more painful the ultimate fall-out will be.

Whether the government intended for it or not, we summarize that investors and other market participants have been counting on five government guarantees over the years: 1) the government will prevent a sharp slowdown in GDP growth by running pro-growth macro policies, including fiscal stimulus; 2) up until about two years ago, the government would always appreciate RMB vs. the USD, at least moderately a year; and since then, the government will not allow a sharp devaluation of RMB; 3) since about 2014, the government will always support the A-share market; 4) the government will not allow major debt default; and 5) the government will always hold up the property market because it’s so essential to the financial system and local government income.

In our view, so far these implicit guarantees have helped to maintain public confidence in the financial system or prevent investors from realizing the risks. However, as stated earlier, they are also creating powerful destabilizing forces. For example, the GDP growth guarantee means that the best strategy for many businesses over the past few years was to keep borrow and expand during any downturn, anticipating government stimulus; the RMB guarantee means that carry-trades designed to arbitrage interest rates and RMB appreciation became prevalent; the A-share market support prompted many investors to use leverage, counting on the government being the buyer of last resort; the no-default guarantee means many investors turned a blind eye to potential default risks (or simply not aware of them) and fund uneconomic projects; the property guarantee drove a significant portion of national savings into one of the most unproductive areas of the economy and the financial system has increasingly become a hostage to the property market via direct lending or through collaterals.

The problem with this stability-maintaining strategy is that many of the goals are conflicting so maintaining all of them are logically irreconcilable. For example, the government have tried to hold up growth by pumping money into the system – China’s M2 growth has been among the fastest in the world since the global financial crisis (so in our view, debating about whether China should QE or not is beside the point).

Moreover, if we properly account for local government borrowing, the government as a whole has probably been running fiscal deficit close to 10% of GDP a year over the past few years. With this type of macro policies, it’s difficult to see how RMB can stay stable and how debt growth can be controlled. Another example is that to hold up the A-share market, the government has borrowed from the PBoC and commercial banks. This may crowd out private lending and hurt growth, or accelerate money growth and hurt the RMB.

It seems to us that the government’s policy options are rapidly narrowing – one only needs to look at how difficult it has been for the government to hold up GDP growth since mid-2014. A slow-down in economic growth is typically a prelude to financial sector instability. Putting it all together, it seems to us that many of these conflicts may come to a head in 2016.

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There is much more in the full report, but here is the reco summary:

We expect the key market theme in 2016 to be financial system instability as a few destabilizing forces seem to be coming to a head. We forecast HSCEI to decline by about 7% to around 9,000 (range for the year: 7,400-12,800), and SHCOMP, by about 27% to around 2,600 (range: 2,200-4,000), by 2016 YE. Our year-end targets had not factored in a credit crunch scenario because the timing of which is difficult to predict. Should it occur, we expect the indices to end below the low bounds, possibly substantially so.

Just remember: if the Chinese government catches you selling, arrest, or far worse, awaits.

Comments

[metanoic]

I don't really know so I will ask - Does this potential Chinese crisis set the stage for a move to SDR's ?

[polo007]

According to Macquarie Research:

https://app.box.com/s/ju6d0ren3gfg4m3dbr2o3qx09q9dp0tn

China’s savings dilemma

In our latest commentary, we ask whether China’s economy can be re-balanced.

China savings dilemma. It is a truism to state that China’s investment and debt fuelled economic formulae is ultimately unsustainable and could lead to severe consequences for China and the global economy. Indeed it has become one of the most consensus themes and hence mechanisms by which China can rebalance and the likely time-frame have emerged as the key points of debate.

In order to understand what is ailing China one needs to appreciate the underlying causes that drive overinvestment and rising debt levels. Whilst there is nothing new in China’s model of suppressing consumption and re-directing funds towards investment and trade (mercantilist model that over centuries has been used by countries as diverse as Germany, Russia, US, Japan and Korea), the global impact of China makes all other transitions pale into insignificance.

Arguably the best way to illustrate China’s challenges is to examine its sectoral balances (given that all sectors must ultimately balance to zero, it precludes arguments that do not take into account consequences of changes in one sector on others). The key problem is that all of China’s sectors (household, corporate and government) are significant gross savers. As a result, gross national saving rate (~48% of GDP) is the highest in the world and is responsible for ~30% of entire global flows. The high level of savings can be either utilized domestically in fixed asset investment or it can be exported to other countries (via current account surplus). Indeed, China has been doing both, with high investment rates (~45% of GDP) and CA surpluses. The challenge however is that China is starting to run into constraints in both domestic (high ICOR rate, declining ROE and debt addiction) and foreign utilizations (declining ability of other countries to absorb China’s surplus, in the global economy that lacks growth; trade and liquidity). Hence, an urgent need to unhook China from its investment and debt fuelled model and move towards lower savings and higher consumption.

Unfortunately, “iron logic” of sectoral balances precludes simple solutions. The ideal outcome would be: (a) spontaneous rise in household spending at a rate much faster than investment and concurrent (b) strong recovery in global trade, allowing China to further reduce investment via higher CA surplus (as other countries would have greater capacity to accommodate China when global trade expands). We view chances of either outcome coming to pass at almost zero.

Hence China has to settle for sub-optimum choices, such as: (a) relying on long (decades) demographic transition to lower savings; (b) attempting to accelerate consumption through higher fiscal spending (eroding precautionary savings); (c) transfer of surpluses from corporate sector to households (lower prices; higher dividend and capital distributions); and (d) lower currency (stealing growth from other countries). All of these choices have side-effects and do not yield quick results. The pace of China’s re-balancing is now too slow to make much ST difference and therefore it has no choice but to continue with investment growth fuelled by debt, until it is either exhausted (under weight of excessive debt) or global and local (reforms) factors converge to assist this transition. The jury is still out on which outcome is more likely. We continue to prefer quality private sector players that offer protection if reforms stall and benefit if they accelerate.

How did we do in 2015? “Quality & Stability” portfolio delivered ~8% relative performance; outperformance since Mar’13 is ~24%. “Sustainable Dividends” finished inaugural year with ~10% outperformance whilst “Thematic Leaders” is up by ~7-8% since launch in Sep’14.