Crisis of Confidence
Doug Nolan
China’s Bubble deflation has entered the acceleration phase.
Going forward, Crisis Dynamics will be increasingly unpredictable and difficult to control.
August 17 – Bloomberg:
“Only a week ago, Zhongzhi Enterprise Group Co. attracted little notice within China and was almost unheard of everywhere else.
Now, the secretive shadow banking giant has become the latest symbol of financial fragility in an $18 trillion economy where confidence among investors, businesses and consumers is rapidly dwindling.
The privately owned manager of more than 1 trillion yuan ($137bn) and its trust-company affiliates are under intense scrutiny after halting payments to thousands of customers.”
Zhongzhi is a top-10 player in China’s shadowy $3.0 TN “trust” industry.
Operating as “shadow banks,” trust companies typically offer investment products with rates significantly higher than bank deposits.
Many are essentially subprime lenders.
The industry is said to have about $300 billion, or 10%, direct exposure to real estate development, though most analysts believe overall real estate exposure is significantly higher.
While the failure of so-called “wealth management products” is not that unusual, today’s situation is much more dire.
The unfolding collapse of Country Garden has unnerved already fragile confidence, with the entire developer industry likely to face a further collapse in sales, along with an acute liquidity crisis.
The trust industry faces the grim prospect of rapidly mounting bad loans and panicked investors desperate to get their money back.
As more data become available, a clearer picture emerges of why Country Garden and other developers faced such a rapid deterioration in their liquidity positions.
Already weak apartment sales fell off a cliff during July.
From Bloomberg:
“The value of residential sales nationwide tumbled 43% in July from June to 654.5 billion yuan ($90 billion), the weakest monthly sales in almost six years…”
And from the Wall Street Journal (Cao Li):
“Last month, the country’s 100 largest property developers sold new homes worth the equivalent of $49 billion—the lowest monthly sum in three years, according to China Real Estate Information, a private industry tracker.
The sales were down a third from June and from the same period a year ago.
They were also 59% less than the total in July 2021.”
There is now little doubt that government-generated housing data does not accurately reflect the intensity of apartment price deflation.
August 16 – Bloomberg:
“New-home prices have slipped just 2.4% from a high in August 2021, government figures show, while those for existing homes have dropped 6%.
But the picture emerging from property agents and private data providers is far more dire.
These figures show existing-home prices falling at least 15% in prime neighborhoods of major metropolitan areas like Shanghai and Shenzhen, as well as in more than half of China’s tier-2 and tier-3 cities.
Existing homes near Alibaba Group Holding Ltd.’s headquarters in Hangzhou have dropped about 25% from late 2021 highs, according to local agents.”
It's not hyperbole to warn that we are witnessing the collapse of perhaps history’s greatest Bubble.
To this point, confidence has held that Beijing has everything under control.
But as the Chinese people come to grips with unfolding apartment price deflation, this harsh reality will have them question their financial well-being, the soundness of China’s economy, future prospects, and the competency of their government.
This blow to confidence will unleash the destabilizing next crisis phase.
August 15 – Bloomberg (Jill Disis):
“President Xi Jinping has resisted pulling the trigger on a major stimulus to revive the world’s second-biggest economy.
The grim market reaction to a surprise rate cut shows investors want to see him take much bolder steps.
The People’s Bank of China on Tuesday lowered the rate on its one-year loans — or medium-term lending facility — by 15 bps to 2.5%, the steepest cut in three years.
The move came shortly before the release of July data that showed weak consumer spending growth, sliding investment and rising unemployment.”
Chinese markets immediately brushed off Tuesday’s surprise rate cut.
There was a similar reaction Wednesday, after the PBOC injected the most liquidity since February.
Thursday’s PBOC assurances of ample liquidity and “precise and forceful” support similarly fell on deaf ears.
Meanwhile, there was increasingly assertive currency intervention.
Monday Bloomberg headline:
“PBOC Maintains Yuan Support with Fix 668 Pips Stronger than Estimates.”
August 15 – Bloomberg (Tian Chen):
“China’s yuan is plumbing fresh lows for the year with the central bank’s favorite tool for guiding the managed currency quickly losing its effectiveness.
The onshore yuan on Monday closed at the largest discount since December to the People’s Bank of China’s daily reference rate, a sign Beijing is failing to bolster worsening confidence caused by weaker-than-expected economic data and heightening credit risks.”
Tuesday from Bloomberg:
“China Cuts Rates by Most Since 2020 as Economic Woes Deepen” and “PBOC Maintains Yuan Support with Fix 783 Pips Stronger than Estimates.”
Wednesday from Bloomberg:
“China Escalates Battle Against Yuan Bears with Fixing Guidance.”
Thursday:
“China Ramps Up Yuan Defense with Most Forceful Fixing on Record,” “China Told State Banks to Escalate Yuan Intervention” and “Dollar-Yuan Gets Super-Sized PBOC Pushback (1,041 Pips).”
Friday:
“China Targets Yuan Bears with Most Forceful Fixing Guidance”
Despite it all, the renminbi closed the week 0.6% lower versus the dollar – down 5.30% y-t-d and just below trading lows back to 2008.
Dynamics have changed, with evidence mounting that Beijing is losing control.
Most analysts are scratching their heads, pondering why it’s taking Beijing so long to bring out the stimulus “bazookas.”
For one, they likely question the effectiveness of the big $600 billion “GFC” response, believing instead that directed measures are more suitable to address current issues.
Sufficient stimulus to jolt the entire economy would today be in the Trillions.
They seem to want to avoid massive deficit spending.
But mostly, I think Beijing is terrified of a currency crisis.
Authoritarian Communist leadership has become the masters of control.
They aggressively censor the Internet for content they find objectionable.
They limit public protests and crush any dissent.
They limit kids’ video and screen time.
There are an estimated 600 million surveillance cameras keeping a watchful eye.
They tabulate individual “social credit scores” to keep their citizens in check.
They have cracked down on private-sector businesses, with the communist party taking more control over all fascets of the economy.
Beijing increasingly commands the banking system and entire financial sector.
The so-called “national team” still holds a semblance of control over the stock market.
And they have recently taken tighter control over news flow, even threatening repercussions for the dissemination of unfavorable economic views.
But they can’t control currency markets.
Let’s assume they’ve studied the catastrophic 1997 “Asian Tiger” crisis.
The domino collapse of Asian currencies (i.e., South Korea, Indonesia, Malaysia, Philippines…) triggered panicked capital flight, bond market meltdowns, banking system insolvency, economic depression and, in some cases (i.e., Indonesia), complete social breakdown.
China’s circumstances are different.
Most notably, the country runs big trade surpluses and has accumulated a huge international reserve position (at least partially squandered by lending to high-risk countries) - factors integral to such a protracted Bubble period.
Still, China’s unsound financial structure leaves its currency increasingly vulnerable to a Crisis of Confidence.
Aggregate financing inflated $20.3 TN, or 67%, over the past five years, in what has certainly been history’s greatest expansion of non-productive debt.
Total Bank Assets inflated $35.4 TN, or 181%, over the past decade.
The unfolding real estate collapse will leave a multi-trillion dollar hole in the Chinese financial system.
Bubbles are notorious for unequal distributions of wealth.
China’s Bubble has enriched a segment of society with wealth beyond anything previously imagined.
Wealthy Chinese today see what is unfolding in Beijing and their country - and will be working diligently to get as much money out of China as possible.
A further tightening of capital controls appears inevitable.
There is another key source of currency vulnerability that operates surreptitiously: speculative leverage.
How big is the China “carry trade”?
With China’s financial sector offering enticing yields, and the PBOC actively managing the renminbi (loose peg to the dollar), the backdrop has certainly been conducive to leveraged speculation.
Why not borrow for free in a weak Japanese currency for levered holdings of high-yielding instruments in an appreciating Chinese currency?
Could speculative leverage be in the Trillions?
While it is not the type of rigid currency peg whose breakdown led to the Asian Tiger debacle, China’s currency regime has been about the next worst thing.
China’s developers borrowed over $200 billion in U.S. dollar-denominated debt.
China’s banking system has been an aggressive borrower in foreign currencies, much of it in dollars.
This structure creates vulnerability to a disorderly currency devaluation.
Bloomberg’s Jonathan Ferro:
“Ben Lazar of eToro wrote a line yesterday, Mohamed, and he said something like '[China] is an economic giant and financial markets minnow'.
Is this an economic giant that we need to pay attention to, or a financial market minnow that we can ignore?
What I’m getting at, Mohamed, is this a contagion issue – is there a prospect that this bleeds out to broader markets worldwide or not?"
Mohamed El-Erian:
“It won’t bleed out through the financial channel, because financially they’re not as big as they are economically.”
I respect Mr. El-Erian and appreciate his experience and analytical framework.
He knows better.
Global markets remain highly synchronized.
The “financial channel” is key.
As we’ve witnessed repeatedly, de-risking/deleveraging doesn’t remain contained within a country’s borders.
In the event of a global crisis, U.S. markets will not be immune.
Chinese finance is a clear and present risk to global financial stability.
And there is evidence that Crisis Dynamics attained important momentum this week.
China sovereign CDS surged 23 this week to 85 bps, the biggest weekly gain since September 2022.
China today has the largest banking system in the world – rapidly approaching $60 TN.
Ominously, China’s “big four” bank CDS spiked higher this week.
Bank of China CDS surged 22 (biggest move since November) to 86 bps.
China Construction Bank jumped 21 (biggest since October) to 98 bps, Industrial and Commercial Bank 21 (October) to 98 bps, and China Development Bank 17 to 90 bps.
Not surprisingly, the developer bond collapse continues in earnest.
It’s worth noting that “last man standing” Vanke CDS spiked 404 to 884 bps, while the company’s bond yields surged 336 bps to 12.04%.
Remember the “AMCs” – the “bad bank” asset management companies created back in 1999 to clean up a troubled banking system?
Huarong CDS spiked 161 this week to 652 bps – the biggest move since March.
China Orient surged 45 to a near record high 372 bps, and China Cinda rose 38 to 282 bps.
China’s CSI 300 equities index dropped 2.6%, with a two-week fall of 5.9%.
Hong Kong’s Hang Seng Index was clobbered 5.9% - and was down 8.1% in two weeks to trade at lows since November.
The Hang Seng China Financials Index slumped 5.6% (down 9.3% y-t-d), also to lows since November.
This index is now basically unchanged from a decade ago.
Japan’s Nikkei 225 Index dropped 3.2%, Australia’s ASX 200 2.6%, and Singapore’s Straits Times index 3.7%.
Major indices were down 3.7% in South Korea, 4.4% in Vietnam, 1.8% in the Philippines, 1.5% in Thailand and 1.3% in Taiwan.
Contagion was forceful.
Emerging Market (EM) CDS jumped 19 to 222 bps, the largest weekly decline since the banking crisis week of March 17th.
Vietnam CDS rose 13 to 128 bps, Philippines 12 to 114 bps, and Indonesia 12 to 93 bps.
Outside of Asia, Panama CDS surged 21 (largest gain since September 2022) to 118 bps, Colombia 21 (largest since March) to 229 bps, Brazil 18 (March) to 192 bps, Peru 16 (March) to 87 bps, and Mexico 10 (March) to 115 bps.
EM local currency yields spiked 132 bps in Brazil to a two-month high 11.24%.
Mexico yields jumped 27 bps to 9.33%, and Colombia surged 46 bps to 10.89%.
De-risking/deleveraging had EM dollar bonds under notable pressure.
Dollar yields in Peru jumped 27 bps to a five-month high 5.67%; Philippines 31 bps to a five-month high 5.26%; Indonesia 29 bps to a nine-month high 5.27%; Brazil 23 bps to a near 10-month high 6.59%; Mexico 19 bps to a nine-month high 5.95%; and Chile 22 to a nine-month high 5.42%.
With China’s Bubble deflating and Crisis Dynamics having placed an iron grip, there’s a long unanswered question that again becomes germane: Is China “developed” or “developing”?
Does it have sound and battle tested institutions?
Is the country governed by seasoned, professional, and adept policymakers?
Has its Credit system and financial institutions been managed effectively and prudently?
I will continue to argue that China remains king of emerging markets despite its incredible growth and now massive financial system and powerful economy.
Gross mismanagement has created acute financial and economic fragilities.
It poses a huge risk to global stability – financial, economic, and geopolitical.
The bursting of the Chinese Bubble is likely to be a catalyst for bursting global bubbles.
The Atlanta Fed GDPnow model forecasts 5.8% 3rd quarter U.S. GDP growth.
Economic resilience has economists downplaying the impact of a Chinese slowdown.
I would not extrapolate current growth dynamics.
The economic upsurge is the upshot of a dramatic post-banking crisis loosening of financial conditions.
It started with over $700 billion of liquidity injections (Fed and FHLB), followed by a short squeeze and unwind of hedges, and then huge FOMO flows and derivatives-related “melt-up” dynamics.
Financial conditions will now tighten.
“Risk on” has begun the transition to “risk off,” with the system now vulnerable to an abrupt change to the liquidity backdrop.
That EM and U.S. markets (in particular) succumbed to “melt-up” dynamics in the face of festering Chinese issues only exacerbated vulnerabilities.
Importantly, the liquidity-induced market and economic upsurges underpinned inflation dynamics.
And it was remarkable again this week to see Crisis Dynamics unfold in China (with intensifying global contagion) – and yet U.S. yields marched higher.
MBS yields surged another 17 bps to a 16-year high of 6.14%.
Ten-year Treasury yields rose nine bps to 4.25%.
It has me contemplating the possibility that de-risking/deleveraging has begun a problematic tightening of global market liquidity.
Meanwhile, U.S. banks (BKX) were slammed 5.6% this week.
To be sure, developments out of China are more serious than what U.S.-based analysts are saying.
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