World asleep as China tightens deflationary vice
We keep our fingers crossed as we glimpse the first foam of a deflationary Ch'ient'ang'kian coming our way from China. The world's central banks have no margin for error
By Ambrose Evans-Pritchard
8:00PM GMT 12 Feb 2014
China's Xi Jinping has cast the die. After weighing up the unappetising choice before him for a year, he has picked the lesser of two poisons.
The balance of evidence is that most powerful Chinese leader since Mao Zedong aims to prick China's $24 trillion credit bubble early in his 10-year term, rather than putting off the day of reckoning for yet another cycle.
This may be well-advised for China, but the rest of the world seems remarkably nonchalant over the implications. Brazil, Russia, South Africa, and the commodity bloc are already in the cross-hairs.
"China is getting serious about deleveraging," says Patrick Legland and Wei Yao from Societe Generale. "It is difficult to gently deflate a bubble. There is a very real possibility that this slow deflation may get out of control and lead to a hard landing."
Zhang Yichen from CITIC Capital said the denouement will be a ratchet effect since China has capital controls and banks are an arm of the state, but that does not make it benign. "They are trying to deleverage without blowing the whole thing up. The US couldn't contain Lehman contagion, but in China all contracts can be renegotiated, so it is very hard to have a domino effect. We'll see a slow deflating of the bubble ," he said.
What is clear is that we are dealing with a credit expansion of unprecedented scale, equal in size to the US and Japanese banking systems combined. The outcome may matter more for the world than anything that the US Federal Reserve does over coming months under Janet Yellen, well signalled in any case.
Societe Generale has defined its hard landing as a fall in Chinese growth to a trough of 2pc, with two quarters of contraction. This would cause a 30pc slide in Chinese equities, a 50pc crash in copper prices, and a drop in Brent crude to $75. "Investors are still underestimating the risk. Chinese credit and, to a lesser extent, equity markets would be very vulnerable," said the bank.
Such an outcome -- not their base case -- would send a deflationary impulse through the global system. This would come on top of the delayed fall-out from China's $5 trillion investment in plant and fixed capital last year, matching the US and Europe together, and far too much for the world economy to absorb.
What is clear is that we are dealing with a credit expansion of unprecedented scale, equal in size to the US and Japanese banking systems combined. The outcome may matter more for the world than anything that the US Federal Reserve does over coming months under Janet Yellen, well signalled in any case.
Societe Generale has defined its hard landing as a fall in Chinese growth to a trough of 2pc, with two quarters of contraction. This would cause a 30pc slide in Chinese equities, a 50pc crash in copper prices, and a drop in Brent crude to $75. "Investors are still underestimating the risk. Chinese credit and, to a lesser extent, equity markets would be very vulnerable," said the bank.
Such an outcome -- not their base case -- would send a deflationary impulse through the global system. This would come on top of the delayed fall-out from China's $5 trillion investment in plant and fixed capital last year, matching the US and Europe together, and far too much for the world economy to absorb.
The effects of this on large parts of Latin America, Africa, the Middle East, and core Eurasia would hit before offsetting benefits accrued to consumers in the West. Such commodity shocks are "asymmetric" at first. Southern Europe would fall over the edge into deflation, pushing Italy, Portugal, and Spain deeper into a debt compound trap.
China did of course blink in January when the authorities stepped in to cover the $500m liabilities of the trust fund, “Credit Equals Gold No. 1”. It is the fifth trust rescue in opaque circumstances in recent weeks. Yet it would be hasty to conclude that President Xi is backing away from his Third Plenum vows to end to the bad old ways.
The central bank (PBOC) is tightening methodically, allowing the benchmark 7-day repo rate to ratchet up by 200 basis points to 5.21pc over the last year. It drained a further $50bn from the system this week.
Its latest quarterly report has turned hawkish, even though producer prices are in steep deflation, and the M2 money supply is slowing. It complains that “reliance on debt is still rising” and that “hidden risks in the financial sphere require attention”.
Zhiwei Zhang from Nomura says China has entered a "prolonged period of policy tightening" that will push up bank lending rates by as much as 90bp this quarter, leading to a chain of defaults.
The tell-tale signs are obvious in the central bank's handling of reverse repos and maturing bills. The yield on corporate AA 1-year bonds has jumped 272 basis points to 7.15pc since June. "We think the PBOC intends to raise the whole spectrum of interest rates to push deleveraging," he said.
This will be a rough ride. JP Morgan's Haibin Zhu says the shadow banking system alone has jumped from $2.4 to $7.7 trillion since 2010, and is now 84pc of GDP. To put this in perspective, the total US subprime debacle was $1.2 trillion.
Haibin Zhu says there is mounting risk of "systemic spillover". Two thirds of the $2 trillion of wealth products must be rolled over every three months. A third of trust funds mature this year. "The liquidity stress could evolve into a full-blown credit crisis," he said.
Officials from the International Monetary Fund say privately that total credit in China has grown by almost 100pc of GDP to 230pc, once you include exotic instruments and off-shore dollar lending. The comparable jump in Japan over the five years before the Nikkei bubble burst was less than 50pc of GDP.
Source: People's Bank of China, CEIC, BIS
The transmission channel to the global banking system is through Hong Kong and Macao. Bejing's credit squeeze is causing a scramble for off-shore dollar credit to plug the gap. It is this that keeps global regulators awake at night, for foreign currency loans to Chinese companies have jumped from $270bn to an estimated $1.1 trillion since 2009.
The Bank for International Settlements says dollar loans have been growing "very rapidly and may give rise to substantial financial stability risks", enough to send tremors across the world.
The BIS data shows that British-based banks -- a broad-term, including branches of US and Mid-East outfits -- are up to their necks in this. They hold a quarter of all cross-border bank exposure to China. By contrast, German, Dutch, French and other European banks have cut their share from 32pc to 14pc as they retrench to shore up capital ratios at home.
Foreign claims on China by bank nationality
This may be why the Bank of England's Mark Carney warned before Christmas that the "parallel banking sector in the big developing countries" now poses the greatest risk to global finance. Officials at the Bank recently showed him an unsettling report by the Hong Kong Monetary Authority on China's off-shore loan risks.
Charlene Chu, Fitch's China veteran and now at Autonomous in Beijing, told The Telegraph last week that these dollar debts were large enough to set off a fresh global crisis if mishandled.
Whether this unfolds depends entirely on how the world responds. One can hardly be sanguine. Raghuram Rajan, India's rock star central bank chief, says global co-ordination has "broken down". Turkey, Brazil, and South Africa, among others, are tightening into economic downturns to defend their currencies. Others are distracted by their own political struggles at home.
The Fed's Janet Yellen can hardly back away from bond tapering as her first order of business, even though US data has turned soggy. She has to shake off her (unmerited) reputation as a dove. Besides, most Fed governors are on the warpath against asset bubbles.
They may be right, but bear in mind that the growth rate of America's M2 money supply has halved over the last year. It might have contracted since April without $85bn of bond purchases by the Fed each month.
The European Central Bank is paralysed after the German constitutional court read the riot act last Friday, strongly suggesting that its bond rescue plan (OMT) is Ultra Vires and a violation of "monetary financing".
The ECB cannot easily carry out quantitative easing to cushion a deflationary shock in the teeth of such a judgment, even if QE is a different tool. In German politics they are the same.
The decision came disguised as a referral to the European Court, but was in reality a warning shot, as former judge Udo di Fabio has more or less said. The German court cannot stop the ECB buying bonds but it can stop the Bundesbank from taking part, and must do so if actions are Ultra Vires. That is enough.
So we keep our fingers crossed as we glimpse the first foam of a deflationary Ch'ient'ang'kian coming our way from China. The world's central banks have no margin for error.
