Before China’s bursting equity bubble grabbed international headlines, and before the PBoC’s subsequent devaluation of the yuan served notice to the world that things had officially gotten serious in the global currency wars, all anyone wanted to talk about when it came to China was a “hard landing.” Indeed for what seems like forever, the bogeyman hiding in every economist’s closet was a sharper-than-expected deceleration in China’s economy which, as everyone is now acutely aware, is the engine for global growth and trade.
Of course no one knows where China’s official output numbers actually come from. They could be some amalgamation of real data and NBS tinkering (much like what you get from the BEA in the US) or they could come straight from the imagination of Xi Jinping. There’s also a strong possibility that a lack of robust statistical controls mean China routinely understates its deflator, leading to perpetually overstated GDP growth during times of plunging commodity prices - times like now.
But whatever the case, China’s “shock” devaluation effectively telegraphed the “real situation” (to quote the NBS). That is, policy rate cuts had failed to boost growth and the situation was in fact becoming so precarious that the PBoC was willing to loosen up on the dollar peg that had caused the yuan to appreciate by some 15% on a REER basis over the course of just 12 months, putting untold pressure on the export-driven economy.
The message was clear: China is landing and it’s landing hard.
Now, the task is to determine what the channels are for contagion and on that note, we go to RBS’ Alberto Gallo who has more.
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The contagion from China’s economic slowdown is deep and widespread, with profound implications for both emerging and developed markets.
There are five main channels of contagion for credit:
1. Exports and revenue exposure. Economies for which China is the largest trading partner will suffer from lower demand: Brazil, Chile, Australia, Peru, Thailand and Malaysia. Specific sectors in developed markets will also be affected, especially Germany and Italy. A number of sectors in DM credit with high dependence on Chinese revenue could be vulnerable, including German carmakers (VW, Daimler, BMW), luxury goods manufacturers (LVMH), and telecoms companies.
2. Banking system exposure. Among countries which report to the BIS, South Korea, Australia and the UK have the largest proportion of foreign claims in China. For the UK and Australia, exposure is concentrated among a few banks, specifically HSBC, Standard Chartered and ANZ. UK banks are more exposed than Australian banks, as their loans to China represent up to 30% of their total lending, whereas loans to Asia are generally less than 5% of Australian bank lending (except for ANZ at 14%).
3. Commodity dependence. With China consuming nearly half of the world’s industrial metal supply, slower growth may weigh on supply-demand dynamics and directly lower commodity prices. Countries that rely on commodity exports, and specifically China’s consumption of them, are especially vulnerable.
4. Petrodollar demand for $-denominated fixed income asset investment. Lower commodity prices also mean oil exporters will have lower revenues and less savings to invest in $-denominated fixed income assets. The yearly flow of Petrodollars may shrink to around $280bn/year this year from $700bn in 2014, according to our estimates based on average annual oil prices and lifting costs. If we assume that 30% of oil proceeds is invested in $ fixed income, then the decline is roughly equivalent to $100bn/year in lower demand for dollar assets. This is equivalent to the increase in net supply of Treasuries or $ IG corporates YoY.
5. Currency depreciation and a high proportion of hard currency debt increase solvency risks for EM corporates. While EM sovereigns generally do not rely on hard-currency debt much more than in the past, EM firms have boosted their share of hard-currency debt over the past decade. The portion of $-denominated bonds from foreign firms is now a quarter of the total US IG market. Many EM firms have a large proportion of their debt in hard currency. We have previously highlighted the vulnerability of some EM firms in particular, such as Chinese real estate developers.
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Bonus: The updated China contagion flowchart