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China treads closer to a day of debt reckoning

Summary:
The People’s Bank of China (PBoC) lifted borrowing costs in step with the Fed overnight. But the real question is: can China’s economy handle this sort of tightening at this stage in its cycle?Diana Choyleva of Enodo Economics (one of the few economists to accurately forecast the yuan’s depreciation) believes it can’t.On one hand the PBoC is lifting rates, on the other, it’s been engaged in the injection of a record amount of liquidity over the last year to prevent market rates from rising organically.China’s version of the Ted spread, meanwhile (the difference between the yield of three-month PBoC bill and the three-month interbank swap rate) has also been widening, implying the only reason market rates haven’t spiked in tandem is probably due to the compensatory liquidity coming into the

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The People’s Bank of China (PBoC) lifted borrowing costs in step with the Fed overnight. But the real question is: can China’s economy handle this sort of tightening at this stage in its cycle?

Diana Choyleva of Enodo Economics (one of the few economists to accurately forecast the yuan’s depreciation) believes it can’t.

On one hand the PBoC is lifting rates, on the other, it’s been engaged in the injection of a record amount of liquidity over the last year to prevent market rates from rising organically.

China’s version of the Ted spread, meanwhile (the difference between the yield of three-month PBoC bill and the three-month interbank swap rate) has also been widening, implying the only reason market rates haven’t spiked in tandem is probably due to the compensatory liquidity coming into the market from the PBoC.

But there are other concerning omens out there too.

From Choyleva’s Thursday note:

A much bigger danger signal is the surge in interbank borrowing and lending and its dramatically changed composition. In the past two years, non-bank financial institutions (NBFIs) – such as trust and investment companies, leasing firms and asset managers – have increasingly had to fund themselves in the wholesale money markets.

China treads closer to a day of debt reckoning


NBFIs accounted for 54% of total borrowing in China’s repo market in 2016, up from just 14% three years earlier. They invest in assets that are much less liquid and often have much longer maturities.

It’s this reliance on wholesale funding that could prove to be China’s Achilles heel, argues Choyleva. For, as long as depreciating assets can be funded, insolvency can be staved off. If and when liabilities begin to evaporate, however, what lurks round the corner is a maturity mismatch that can only end in financial distress.

That said, as Choyleva notes, much of the risk emanating from mismatched maturities was transferred from SME lenders over to non-bank financial firms a while ago:

Even in a state-dominated financial system such as China’s, deteriorating NBFI asset quality will eventually prompt lenders to reduce risk and extend credit for ever shorter periods, heightening the danger of a mismatch of maturities. In fact, now that the authorities have managed to shift the shortage of liquidity from small and medium-sized lenders to non-bank financial firms, whose failure would carry much less systemic and reputational risk, Beijing is likely to allow more defaults. Indeed, the number of bond defaults is rising sharply, albeit from a low level.

Add to that surging coal prices which are pushing up energy costs (bad news for Chinese bitcoin miners) and industrial companies whose profits have been flatlining for a record period of time, and you end up with a scenario where Chinese companies will be incentivised to pass costs onto consumers sooner rather than later, igniting inflationary (if not stagflationary) pressures across the private sector.

All that without factoring in the effects of a potential China-US trade war or Fed-induced dollar shortages.

Worse things have, of course, been predicted about China for years with the country stalwartly defying the odds time and time again.

But if Choyleva is right, investors’ complacency about China risk will this time be tested in the domestic interbank market first.

If that test fails, 2017 will be the year of China’s debt reckoning, says Choyleva. And, as we all know, China has a lot of private-sector debt to reckon with:

China’s total debt has soared since the 2008 crisis as the government has poured money into unproductive investments to sustain growth. The result is that China’s non-government, non-financial debt has ballooned to an estimated 209% of GDP, almost as great as Japan’s was at its peak.

China treads closer to a day of debt reckoning

Related links:
On the overvaluation of the yuan – FT Alphaville
What is the Trump reflation trade? Dan, FT
Have we crossed the inflation Rubicon? – FT Alphaville
On the return of Japanese inflation – FT Alphaville
Don’t blame central banks for upcoming inflation, blame command economies – FT Alphaville

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Izabella Kaminska
Izabella Kaminska joined FT Alphaville in October 2008, which was, perhaps, the best time in the world to become a financial blogger. Before that she worked as a producer at CNBC, a natural gas reporter at Platts and an associate editor of BP’s internal magazine. She has also worked as a reporter on English language business papers in Poland and Azerbaijan and was a Reuters graduate trainee in 2004.