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.