Marie Diron, Moody’s associate managing director, Sovereign Risk Group, commenting Wednesday on Moody’s Chinese downgrade (Bloomberg Television): “It is likely to be a very medium-term and gradual erosion of credit metrics and we are looking at the policies that the government is implementing. The authorities have recognized the risks that come with high leverage and have a very broad agenda of structural reforms and we take that into account to the point that we think leverage will increase more slowly than it has in the past. But still these measures will not be enough to really reverse the increase in leverage.”
I’ve always felt the rating agencies got somewhat of a bum rap after the mortgage finance Bubble collapse. Sure, their ratings methodologies were flawed. In hindsight, Trillions of so-called “AAA” MBS were anything but pristine Credits. And, again looking back, it does appear a case of incompetence – if not worse. Yet reality at the time was one of home prices that had been inflating for years with a corresponding long spell of low delinquencies and minimal loan losses, along with GDP and incomes seemingly on a steady upward trajectory. The GSEs had come to dominate mortgage finance, while the Fed had market yields well under control. Washington surely wouldn’t allow a housing crisis, which ensured that markets were absolutely enamored with anything mortgage related. So the mortgage market enjoyed bountiful liquidity conditions, and it was just difficult for anyone – including the ratings firms – to see what might upset the apple cart.
The ratings agencies were basically oblivious to the key issue of deepening structural maladjustment throughout the mortgage finance Bubble period. They were inattentive to what a major de-leveraging episode could unleash. But so were the Federal Reserve, Wall Street and the world. Analysis and models did not incorporate latent (financial and economic) fragilities that had compounded from years of rapid credit growth and asset inflation. These days there’s a similar inability to comprehend the myriad global risks associated with the runaway Chinese Bubble.
The Moody’s downgrade spurred a bevy of articles this week examining China’s debt issues (i.e. “Total outstanding credit climbed to about 260% of GDP by the end of 2016, up from 160% in 2008”; “$9 trillion local bond market”; “debt has been increasing lately by an amount equal to about 15% of the country’s output each year”). Interestingly, I saw no mention that Chinese debt growth this year will likely approach $3.5 TN. Not only will this exceed U.S. 2017 debt growth, it will significantly surpass even peak annual U.S. debt expansion from the mortgage finance Bubble period.
May 23 – New York Times (Keith Bradsher): “China has gone on a spending spree, borrowing money to build cities, create manufacturing giants and nurture financial markets — money that has helped drive the economic powerhouse in recent years. But the debt-fueled binge now threatens to sap the energy of the world’s second-largest economy. With its economy maturing, China has to pile on ever more debt to keep its growth going, at a pace that could prove unsustainable. And the money is increasingly flowing through opaque channels that operate outside the regulated banking system, leaving China vulnerable to blowups. A major credit agency sounded the alarm on Wednesday, saying the steady buildup of debt would erode China’s financial strength in the years ahead… China’s debt has been increasing lately by an amount equal to about 15% of the country’s output each year, to keep the economy growing from 6.5% to 7%.”
The world has never witnessed such a Credit expansion. Moody’s noted the Chinese economy’s ongoing dependency on stimulus measures. I would argue that the key issue has evolved into China’s systemic addiction to ever-increasing expansions of “money” and Credit. The almost singular focus on debt to GDP ratios understates Chinese fragilities. In short, they succumbed to the debt trap: massive ongoing expansion of Credit – or bust. How sound is this Credit? How stable is the Chinese financial sector? And, perhaps most pressing, how vulnerable is their currency?
May 24 – New York Times (Keith Bradsher): “Moody’s… downgraded its rating of China’s sovereign debt one notch on Wednesday, citing concerns over growing debt in the country, which has the world’s second-largest economy. In recent years, as China’s stunning economic performance of past decades has become difficult to sustain, the country has used debt to fuel growth… When it comes to pumping money into a financial system, China has made the Federal Reserve in the United States and the European Central Bank look almost lackadaisical. It has expanded its broadly measured money supply by more than the rest of the world combined since the global financial crisis. Now it has 70% more money sloshing around its economy than the United States does, even though the American economy is bigger… China has accumulated its towering debt remarkably quickly. Goldman Sachs looked last year at how fast debt had accumulated relative to the size of the economy in 55 countries since 1960. It found that by the end of 2015, China was already in the top 2% of all credit expansions — and its debt shot up even higher last year. All of the other large expansions occurred in very small economies, some of which essentially lost control of their finances.”
Moody’s report focused on the risk of further leveraging. This is clearly an issue. Corporate debt is at very high levels ($18 TN, or 170% of GDP) and corporations (many with earnings and cash-flow issues) continue to pile on additional borrowings. Much of this debt is “non-productive,” as companies borrow to meet rising debt service and to plug expanding cash-flow deficits. Even more alarming, the bloated financial sector continues to balloon, issuing risky loans while creating new deposit “money”. From the NYT (Keith Bradsher) article above, China “has 70% more money sloshing around its economy than the United States.” Even more than “leverage,” China’s Wild West Risk-Intermediation Mayhem has created momentous systemic risk. Much of the risky “Terminal Phase” debt growth – financing inflated apartment values, uneconomic enterprises, economic maladjustment and chicanery – is being transformed into perceived safe and liquid “money” and money-like financial instruments.
The bulls were quick to downplay the importance of Moody’s action, stating both that China has minimal dependence on external financing and that the country still enjoys $3.0 TN of international reserve assets. I would view the issue differently. Yes, China has an extraordinarily large international reserve cushion, though holdings have declined $1.0 TN from June 2014. Most importantly, this large hoard has allowed authorities to prolong the Bubble and delay the type of harsh measures required to rein in Credit, speculation and now deeply imbedded boom-time psychology. Chinese savers are accumulating wealth they’d never dreamed of, backed by an economy with serious deficiencies and a financial sector of dubious standing.
Moody’s and others – certainly including Wall Street generally – handle China with kid gloves. Chinese authorities have backed away from needed reforms. The late-2015/early-2016 scare forced Beijing to effectively impose capital controls. Rather than promoting open and effective market-based mechanisms, the game has turned to only more zealous interventions: stabilize financial markets and promote rapid Credit growth necessary to sustain 6-7% GDP expansion, while cajoling and controlling to limit the capacity of all this Chinese “money” to flow out of the country.
Chinese authorities have also been pressing Chinese corporations and financial institutions to borrow in overseas markets. This kills two birds… China can offload some high-risk, late-cycle Credit to international investors, while also attracting needed financial inflows. The problem is that foreign investors fear capital control measures and don’t trust the renminbi. So much of this borrowing is done in dollar-denominated debt. And this large issuance of dollar-denominated debt only exacerbates systemic vulnerability to an abrupt renminbi devaluation.
May 24 – Reuters (Adam Jourdan and Samuel Shen): “The decision by Moody’s… to downgrade China’s credit rating is ‘illogical’ and overstates the levels of government debt, a commerce ministry researcher said in an editorial in the official People’s Daily newspaper… Mei Xinyu, a researcher at China’s Ministry of Commerce, wrote in a front page editorial of the paper’s overseas edition the downgrade… overstated China’s reliance on stimulus and the country’s debt levels. Moody’s downgraded China’s credit ratings… for the first time in nearly 30 years, saying it expects the financial strength of the economy will erode in coming years as growth slows and debt continues to rise. China’s Finance Ministry said… the downgrade overestimated the risks to the economy and was based on ‘inappropriate methodology’. China’s state planner said debt risks were generally controllable.”
I’ve closely monitored China for years now. I recall reading some years back how Chinese officials had studied and learned from the Japanese Bubble experience. I’ve been waiting patiently for China to wrestle control of a precarious Credit Bubble. They have instead repeatedly taken tepid steps to curb various sectoral excesses – real estate, local government debt, stock market, corporate debt and, of late, shadow banking and insurance. Attempts to tamp down excess in one spot have only ensured it pops out elsewhere. The gravest policy misstep has been their failure to take a more systemic approach to Credit growth and asset inflation.
Basically, whenever tightening policies began to bite, Beijing would in short-order reverse course and stimulate. After a while, Chinese tightening measures lacked credibility. Moreover, the greater the inflation of Credit, financial institutions and perceived wealth, the more confident the Chinese population (including investors in real estate and financial assets, bankers, and corporate CEOs) became that Beijing would never tolerate a bust. Beijing these days essentially backs local government debt, the big state banks, corporate debt and apartment prices, not to mention $22 TN of “money” (M2) and trillions more of money-like “wealth management products” and such. The scope of Beijing’s contingent liabilities is unparalleled.
The Moody’s executive stated that “It is likely to be a very medium-term and gradual erosion of credit metrics.” The Credit “metric” that matters most is my hypothetical chart of systemic risk that turned parabolic with the rapid acceleration of Credit of rapidly deteriorating quality. This “Terminal Phase” Dynamic unfolds during a period of momentous structural maladjustment, with government policies invariably exacerbating already deep structural impairment. It’s worth recalling that the Japanese enjoyed incredible economic growth and restructuring for more than three decades before blowing up their Credit system during the final four years of the boom. The Chinese situation is much more precarious.
I found myself this week thinking back to Dallas Fed President Robert McTeer’s 2001 comment, “Let’s all hold hands and buy an SUV.” It was at the time a rather ridiculous central banker prescription for recovery from recession. Things, however, turned only more outrageous the following year, with the arrival of the Bernanke Doctrine at the Federal Reserve (and central banking more generally). Since then policy floodgates have been thrown wide open. What passes these days for reasonable policy would have been unimaginable fifteen years ago.
May 21 – Bloomberg (Alfred Liu, Moxy Ying, and Enda Curran): “In 1997, the Asian financial crisis touched off a six-year property bust in Hong Kong that shaved more than two-thirds off prices and saddled the city with a stagnant economy and deflation. As Hong Kong gets ready to celebrate the 20th anniversary of its handover to China, which happened just as Asia’s crisis began to unfold, that pain seems all but forgotten. Prices are at all-time highs. Mortgage borrowing is booming. Developers are bidding up the cost of land to records. People young and old are lining up to buy newly built apartments. In short, the kind of fervor that preceded the last bust is back. That’s got experts fretting about the potential fallout should the city of about 7.4 million people experience another crash. By several measures, Hong Kong looks more vulnerable this time around.”
The global government finance Bubble has “gone to unimaginable extremes – and then doubled.” And there are various elements of previous Bubbles that have coalesced into something that somehow masks inherent fragilities and the risk of devastating collapse. I think back to the commercial real estate Bubbles, junk bonds and LBOs from the late-eighties. Bond market leverage (“government carry trade”) and derivatives (mortgage IOs and POs) from the early-nineties. There was Mexico, SE Asia and EM from the mid-nineties. Russia and LTCM fiascos later in the decade. The “tech” and corporate debt Bubbles, followed by the great mortgage finance Bubble. Individually, we’ve seen these kinds of things before, and we know they end badly. But as one gigantic, comprehensive, almost all-inclusive Bubble garnering the attention and support from policymakers around the world, it’s different enough this time that risks are dismissed or downplayed. Greed trumps fear.
I look around the world and see an unprecedented Bubble in Chinese Credit and investment. EM more generally has borrowed enormous amounts of debt, much of it in dollars and foreign currencies. European securities markets have inflated into historic Bubbles. Bond markets around the global are mispriced like never before. Almost everything providing a yield – from commercial real estate to corporate debt to dividend stocks – trades today at inflated values. Especially considering the Trillions that have been issued – and Trillions more in the offing – Treasury prices are detached from market pricing mechanisms.
The Trillions of central bank “money” that has spurred a historic Bubble in “risk free” securities has worked similar magic on risk assets, notably corporate Credit, equities and EM debt. The reckless abandon that took derivatives markets by storm during the mortgage finance Bubble period has gone to even greater extremes, this time on a global basis. Everywhere, it seems market perceptions are more detached than ever from reality. I continue to see confirmation that China is a major global Bubble weak link.
May 26 – Bloomberg (Chris Anstey and Enda Curran): “Chalk up another win for the visible hand in China’s markets over the principle of the private sector determining prices. A move by authorities to smooth out daily changes in the yuan’s fixing versus the dollar, taken on its own, suggests a shift away from any eventual float of the currency. The news comes in a week when officials were suspected of having intervened in the stock market to limit damage to sentiment after Moody’s… downgraded China’s sovereign credit rating. Both developments underscore the importance the Communist Party leadership places on specific outcomes, rather than the embrace of free markets that Western nations once pressed on China. President Xi Jinping has every interest in avoiding turmoil in the currency and equity markets this year as he oversees a critical reshuffle of top officials. While relatively minor, the change ‘is surely a negative step for financial openness,’ said George Magnus, an associate at Oxford University’s China Centre and former adviser at UBS Group AG. It’s ‘another step by Xi Jinping and the leadership to exert control where the deference to market forces was making at least limited headway.’”
May 25 – Wall Street Journal (Lingling Wei and Saumya Vaishampayan): “China’s central bank is effectively anchoring the yuan to the dollar, a policy twist that has helped stabilize the currency in a year of political transition and market jitters about China’s economic management. The yuan weakened more than 6% against the dollar in 2016; this year, it is up roughly 1%, and the expectation that the currency will fluctuate—a gauge known as implied volatility—is around its lowest in nearly two years.”
After a brief bout of selling in Chinese and Asian equities, there was little market reaction to the Moody’s downgrade. Perhaps telling, Chinese authorities revalued the renminbi higher both Thursday and Friday, with the Chinese currency gaining a notable 0.43% for the week. With my belief that China’s currency may prove their system’s weak link, I find it intriguing that officials would be compelled to move immediately to manipulate its value higher. I believe Beijing prefers a weaker currency to support its massive export sector and to stoke moderately higher inflation. And while their currency policy may be somewhat posturing to the new U.S. administration, I suspect they are more fearful of an unwind of foreign-financed leveraged “carry trades” that have accumulated in higher-yielding Chinese Credit. In the past I’ve referred to the Chinese renminbi as a “currency peg on steroids.” There’s never been an EM currency with the potential for such massive outflows from domestic savers and international speculators alike.
May 26 – Bloomberg: “For ever yuan that the People’s Bank of China injects into the nation’s financial system, it’s up to the banks to decide how far they stretch it in the form of loans to the economy. Right now, they’re working overtime. China’s money multiplier — the ratio between the broadest measure of money in use, M2, and base money created by the central bank — has climbed to the highest on records that date to 1997, data compiled by Bloomberg show. Each yuan of base money is being turned into more than 5 in the real economy. The turbocharged multiplier is helping compensate for the drainage of cash caused by Chinese savers and companies venturing abroad. It’s also helping economic growth…”
Categories: Doug Noland, Perspectives