Conclusion: The Chinese economy has three major risks to it: property prices, the U.S. consumer, and U.S. Treasury holdings – all of which have major implications for the global economy. These TAIL risks should be kept front and center when contemplating the outlook for both the dollar and global growth.
As risk managers, it is our job first and foremost to protect capital – which is exactly what we’ve been doing when it comes to China. Despite our bullish long term bias on China’s economic growth, we are not invested. Sometimes the answer is to do nothing and wait. Everything has a time and a price, and with China backing off of its TREND line of 2,690 at the tail end of its recent rally, policy risks within the Chinese economy continue to weigh on investor sentiment. In our analysis below, however, we look beyond the equity market’s favorite question of, “when will they ease tightening measures?” We highlight some intermediate and long term risks to the Chinese economy that you should keep front and center when thinking about a) investing in China and b) future global growth.
Risk One: China’s “Hot” Property Market
The recent news about China’s latest stress test highlights risks that are not news at all (the Shanghai Composite is down 20% YTD – the 2nd worst performance of any major equity market globally). As we’ve been saying since January, China’s property market is an inflationary by-product of last year’s easy-money stimulus. Moreover, as a result of Chinese tightening policies, we have been expecting further marginal deflation in real estate prices from here – though perhaps not the 50-60% extent China’s banking regulator has asked lenders in the “hottest” cities to stress test for. Results from China’s previous stress tests show the ratio of non-performing real-estate loans within the Chinese banking system would rise by 220bps from the current 1.3% if housing prices dropped 30% and interest rates rose by 108bps. In sharp contrast to “stress” tests done by European and American banks, this latest risk management move by China’s may serve to scare away incremental yield-seeking capital, though few actually believe that prices could exhibit a 60% decline from here.
Like we’ve pointed out in a previous note titled Chinese Loans… A Crisis of Rumors (7/30), China’s $1.4 trillion in credit expansion last year and an additional target of $1.1 trillion in 2010 obviously brings about a great deal of credit risk to the Chinese economy. As a result, China’s banking industry has been replenishing capital in the form of $54 billion in total IPO’s and bond offerings this year. While we certainly need more data to accurately access the likelihood of a massive meltdown in China’s property market, we can rely on historical datasets provided by Reinhart and Rogoff’s 2008 paper titled: Banking Crises: An Equal Opportunity Measure to make a reasonable assessment of the risk. They conclude that banking crises are more common in countries that: a) have a sustained surge in capital inflows; b) rapid credit expansion in a shortened duration; and c) a boom in real housing prices, whereby the banking crisis occurs just after the bursting of the bubble. By all accounts, China meets all three conditions, though we must be careful to interpret the data property. The probability of a banking crisis is greater when these conditions are met, but that does not necessarily imply a banking crises would ensue. The tables below show both the probability of banking crises related to capital inflows, and historical housing bubbles which led to banking crises.
The takeaway here is that the risk of a banking crisis is should not be written off without due diligence. We contend, however, that China, more than any other country, has the ability to grow into the right level of demand to meet its bubbly housing market supply. While equilibrium is not likely to be found without the combination of time and further price declines, we do think equilibrium can be found point where real estate depreciation does not facilitate a major banking crisis. The success of that theory, however, hinges largely upon the China’s next major risk.
Risk Two: US Demand Rolling Over
China growth model is very export oriented, which makes its economy particularly vulnerable to external shifts in its demand curve, as manufacturing products for Western consumers accounts for a great deal of Chinese employment. If we are right in our call that the U.S. consumer (and subsequently U.S. growth) will continue to slow, the Chinese economy will slow incrementally as a result. The extent to which it slows will largely depend on its ability to shift its economy towards domestic consumption as a larger percentage of GDP.
We’ve been vocal recently highlighting wage growth and the prospects of a stronger yuan as bullish for the Chinese consumer. What cannot be overlooked, however, is that China’s transformation will not happen overnight. The process towards rebalancing its economy will be a long, arduous one filled with marginal improvements over time and bumps and bruises along the way. Without going into too much detail, China likely needs to expand its service sector to absorb any potential loss of labor from weakening Western demand. That will be hard to do without public investment in social services including health care, education, and pensions – though it must be done in a way that does not limit investment and consumption in the form of higher taxes. Moreover, based on current population demographics and its one-child policy, China’s dependency ratio is likely to climb over the next several decades – further stimulating the need for public spending on social services to lower China’s world-leading savings rate and stimulate household consumption.
Regarding China’s high savings rate (+50% of GDP), recent estimates from Michael Pettis of Peking University suggest that because of low interest rates on household deposits (60% of total), Chinese savers may actually be receiving a negative real return (0.65% est.). As a result, Chinese savers are forced to save more to make up from a lack of interest income. That, coupled with a limited range of investment opportunities, further exacerbates China’s shift to consumption. When it’s all said and done, China’s shift to a consumption-driven economy will not happen nearly as quickly as some investors anticipate.
All told, the main global risks to China rebalancing are twofold: 1) higher labor costs among exporters will likely create imported inflation in the economies of Chinese export markets and; 2) China no longer has the current account surplus to finance U.S. deficit spending by way of U.S. Treasury purchases. That leads us to our final major risk to the Chinese economy – its U.S. Treasury holdings.
Risk Three: Concentrated Foreign Exchange Risk
As of the most recent data, China is sitting on $867 billion worth of dollar-denominated U.S. Treasury debt, which is likely to continue to depreciate over time based on the current trajectory of debt supply and dollar demand. In a recent study done by the Congressional Budget Office, U.S. federal debt held by the public as a % of GDP is likely to eclipse 185% in just 25 years under scenarios that we consider aggressive based on assumptions of above-trend tax receipts and below-trend expenditures – which certainly hasn’t been the case of late (see Daryl Jones’ note from 7/13: The Deficit Still Looks Ugly, Normalize for TARP and It Looks Uglier). The results of the mid-term elections may prove to be a positive catalyst on the margin for reigning in the deficit, but a slowing U.S. economy may ultimately prove to trump any form of American Austerity.
On Tuesday, we put out an extensive presentation regarding the future of U.S. sovereign debt (email us if you need the replay), with the key takeaways being: 1) current demographic trends will likely beget further deficit spending; 2) a low U.S. savings rate will necessitate that an increasing amount of foreign buyers will be required to fund new debt issuance; and 3) at current and conservatively-projected near-term debt levels (+90% of GDP), U.S. economic growth will be below-trend for years to come – likely furthering the “need” for additional government spending and investment. All told, the U.S. is likely to issue a great deal more of U.S. Treasury supply in the coming decades and buyers of that supply will be increasingly foreign entities, which increasingly makes the U.S. vulnerable to external shifts in demand for U.S. sovereign debt – which is currently near all-time highs. If we’ve learned anything from Greece’s sovereign debt woes, it is that, ultimately, the market can and will re-price sovereign debt and reset the cost of government borrowing.
It is important to note that we aren’t suggesting that U.S. Treasuries are following in the footsteps of Greek sovereign bonds. What is likely to happen based on historical precedent set by Japan is that Treasury yields stay low as a result of prolonged near-zero interest rates. From a central bank action perspective, there hasn’t been a threat to Japanese Government Bonds in decades and the United States has already started on that path. What matters to China, however, is converting those debentures into cash upon maturity. The U.S. Dollar Index continues to make as series of lower-highs and lower-lows from a intermediate and long term perspective, meaning that as time elapses, China is likely to receive less and less purchasing power from converting U.S. Treasury debt into actual currency. The U.S. dollar is still the dominant currency as a percentage of world currency reserves, but, as we say, everything that matters in Macro happens on the margin. In the last ten years alone, the dollar has declined over one thousand basis points as a percentage of world FX reserves, falling from 71.9% in 1999 to 61.5% in 2009, according to the IMF. The outlook for the U.S.’s economic growth and debt build-up over the next 20-30 years suggests the dollar will not likely regain any of its lost value any time soon.
All told, China has become increasingly aware of this risk and has decreased its U.S. Treasury holdings by nearly 8% since its July ’09 peak holdings of $940 billion. De-pegging the yuan to the dollar will help China reduce the need for additional purchases, but any rapid selling to diversify its FX portfolio will be more harmful than good as the market will react negatively to large selling, further compounding China’s problem. Unfortunately for some, China can’t sell them fast enough: according to Yu Yongding, a former Chinese Central Bank adviser, “U.S. Treasuries are not safe from an intermediate-to-long-term perspective”. He continues by saying, “Only God knows how much value that China has stored in the U.S. government securities.” Unfortunately for China, by the time it finally does need to drain its excessive FX reserves, the whole world will have found out the true value of those securities, which is likely to be a great deal less than anticipated upon purchase.
In summary, the Chinese economy has three major risks to it: property prices, the U.S. consumer, and U.S. Treasury holdings – all of which have major implications for the global economy. These TAIL risks should be kept front and center when contemplating the outlook for both the dollar and global growth.