A loss of faith
Financial markets, like religions, are faith-based networks. The complex structures of assets and liabilities that comprise markets are held together by a set of underlying beliefs. Unlike religions, however, financial dogmas are occasionally shown to be false. We experienced such a moment last week, when the Chinese authorities chose to devalue their currency.
For years, the consensus view has been that as China’s economy outgrew the developed world, its currency would inevitably appreciate. True, the yuan’s value was pegged to the dollar, but Beijing in the past had allowed it to gradually rise. The decision by the People’s Bank of China to relax the peg and depreciate the currency thus took the market by surprise. The significance of this move is not that it will set off another round of currency wars or that it will exacerbate global deflation – although both these outcomes are possible. Rather, the true danger comes from the adverse impact this unexpected devaluation may have on China’s dysfunctional financial system.
The era of ultra-low U.S. dollar interest rates has lured global carry traders to China. It’s easy to see why. Chinese banks paid better deposit rates than their U.S. counterparts and yields were even higher in the country’s shadow banking system. In addition, carry traders could expect to earn a few percentage points from currency appreciation each year. To many foreigners, lending in China with an expected annual return of around 10 percent must have seemed a one-way bet.
The inclination of Chinese borrowers to avail themselves of foreign loans has been driven by need as much as greed. Of course, it has been cheaper to borrow abroad and the rising yuan shrunk the size of outstanding liabilities. More to the point, as the country’s credit boom continued, China’s financial system has strained to keep up with demand. Foreign lenders have filled the gap.
Furthermore, as China’s non-financial debt has climbed above 250 percent of GDP, the costs of servicing these obligations has become extremely burdensome. Two years ago, Fitch estimated that Chinese corporate interest payments were 11 percent of GDP and rising rapidly. Foreign loans reduced this burden.
The result has been a surge in Chinese overseas borrowing, much of it from foreign banks. The Bank for International Settlements records that global banks’ net U.S. dollar lending to China rose from around $100 billion in late 2012 to nearly $650 billion by mid-2014. The BIS also notes that Chinese corporations have increasingly taken to borrowing abroad through their overseas affiliates – a type of borrowing misleadingly recorded in the national accounts as foreign direct investment.
Trade credit has provided yet another source of foreign currency borrowing. Chinese corporations betting on the continued appreciation of the renminbi have got around the country’s capital controls by faking export invoices, which enabled them to bring dollars into the mainland. The practice, which is known as export preconversion, has been mainly conducted with Hong Kong counterparties. In recent years, the value of exports to Hong Kong as reported by Beijing has regularly exceeded Hong Kong’s own record of imports from the mainland by a wide margin. In the late 1980s, Japanese companies likewise boosted their profits with complex financial transactions known as zaitech.
The result is that China now has vast foreign debts. Although the country is still a net foreign creditor, its gross foreign liabilities have climbed to nearly $5 trillion, according to Macro Strategy Partnership, an independent research company – a figure that even exceeds China’s $3.7 trillion pile of foreign exchange reserves.
In recent months, China has experienced large capital outflows, estimated by Goldman Sachs to have reached some $224 billion in the second quarter. As the global carry trade retreats, foreign bank lending to China has collapsed – it’s down by around $250 billion over the last year, according to the BIS. While Beijing was maintaining its currency peg, these outflows forced the PBOC to sell foreign exchange reserves and buy renminbi.
The trouble is that when a central bank swaps foreign exchange for its own currency domestic liquidity tightens, something that China’s cash-strapped corporates can ill afford. The PBOC has reduced the reserve ratio requirement – the money that banks must hold at the central bank – to 18.5 percent of deposits and could lower it further. But it’s not clear whether this would be sufficient to offset tightening liquidity conditions. Historically, there has been a strong correlation between growth in capital inflows and growth in Chinese bank deposits.
The alternative was to let the currency depreciate, thus upsetting the calculations of all those who were relying on the renminbi’s continued appreciation, or at least stability, relative to the U.S. dollar. Chinese foreign borrowers – particularly real estate companies, many of which have large dollar debts – now face the consequences of having mismatched their assets and liabilities. Thai finance companies found themselves in a similar predicament in 1996.
Great financial disasters often result from what the investment writer Vitaliy Katsenelson has called “false axioms”. For instance, Japan’s bubble economy of the 1980s was founded on the notion that the country’s property prices could only go up. When that belief turned out to be wrong, Japan’s banking system collapsed taking down the economy with it. Likewise, Ben Bernanke and others argued that U.S. home prices would never decline. That false axiom delivered us the subprime mortgage crisis. The belief that China’s currency could only appreciate is another such mistaken belief. We cannot predict the consequences. Yet history suggests that bad things happen when the market’s deepest faith is shaken.