Emerging markets: Big trouble from brittle China

In a crisis emerging markets tend to show their true colours – as an illiquid, high-beta bet on US rates, Chinese growth and commodity prices. So following a rise in US interest rates, as Beijing posted the slowest annual rate of expansion for 25 years and oil prices fell below $30 a barrel, EM currencies slumped to a record low in January. 

According to the Institute of International Finance, net capital outflows from emerging markets, led by China, hit a record $735 billion in 2015. Investor fears over a wave of debt defaults have increased. EM debt stands at an all-time high at $58 trillion, or 200% of emerging market GDP, according to BCA Research, with corporate leverage above 90%, at $25.5 trillion. 

Some $8 trillion was wiped off the value of global equities in the first three weeks of 2016. Spreads on developing-country government debt also hit 2009 crisis levels, as EM currencies hit lows not seen since the Asian crisis, even in investment-grade countries with current-account surpluses, such as Malaysia. 

Analysts fear that the attempt by EMs emerging-market policymakers to reflate their economies through a private sector-led debt expansion has sown the seeds for a new China-led global crisis. Standard & Poor’s data show EM companies were responsible for a fifth of the 112 corporate defaults last year, with this share expected to rise in 2016. The outlook for emerging markets is worrying as rising US interests rate and a strengthening dollar deflate EM assets and increase debt-servicing costs. At the same time, the fall in the renminbi and Chinese deflation raise the spectre of competitive currency devaluations. 

China holds the key. It accounts for a third of EM GDP, over half of their debt burden and drives liquidity and capital inflows for Asian exporters and global commodity producers. For the last two months China has been in the grip of a crisis as capital flows out and foreign-investor confidence in its exchange-rate regime collapses. In the first two weeks of January, $635 billion was wiped off the value of the Shanghai Composite Index, while the People’s Bank of China spent $120 billion in December alone to defend the renminbi. The PBoC has vowed to defeat “speculative forces” in the currency market and has suspended the FX operations of banks including Standard Chartered and DBS. At the heart of Beijing’s problems is its failed December switch from an effective dollar currency peg to a trade-weighted basket. Markets have seen this shift as a barely concealed bid to devalue the currency to boost exports – a move that could lead to a currency war in a period of weak global demand. The direct link between the equity market and the Chinese real economy is relatively weak, however. Few companies raise equity capital through public listings and a large proportion of shares are owned by state entities. However, markets fear policymakers have lost control of the levers of the economy while neglecting supply-side reforms, all setting the stage for a full-blown crisis. 

The immediate challenge for China is to control its monetary policy amid domestic outflows and an overvalued currency. It faces a policy bind that has trapped many EM economies – the impossible trinity of managing exchange rates, allowing the free movement of capital and maintaining an independent monetary policy, all at the same time. 

In December, Euromoney reported candid remarks from Chinese policymakers revealing their worries over the monetary trap. Wu Xiaoling, former PBoC vice-governor and vice-chair of the financial and economic affairs committee of China’s national legislature, said then: “The biggest conflict [for monetary stability] is relying on a single currency, and we now encounter the Triffin dilemma,” referring to the tension revealed by the Fed’s determination to set monetary policy according to domestic conditions, despite the dollar’s role as the world’s reserve currency. 

Karthik Sankaran, director of global strategy at Eurasia Group, explains the policy challenge: “China is confronting the exchange-rate implications of cyclical divergence between its economy and that of the US, which necessitates easier monetary policy there at the same time that the Fed is looking to raise rates. Changes in household sector and corporate exchange-rate expectations are driving renminbi weakness, to which Chinese authorities have responded with FX reserve drawdown and ad-hoc regulatory pressure to temper the pace of depreciation. The scale of reserve drawdown in recent months has led to fevered speculation about China undergoing an archetypal EM crisis along the lines of the 1997-98 Asian crisis.”

Domestic demand in China for liquid foreign assets could be as much as $3 trillion, according to some estimates, and if outflows continue, FX reserve depletion and a run on the renminbi are possible. Until market expectations for the exchange rate stabilize, China will be forced to continue deploying reserves to defend the renminbi, which will tighten monetary conditions and exacerbate the economic downturn. 

China could continue to cap interbank rates, but this would weaken the currency further, fuel capital flows and increase capital misallocation after a post-crisis spending binge that has helped to saddle the country with a total debt-to-GDP ratio of around 250%. A lack of monetary stimulus, however, combined with chronic domestic over-capacity and a weak service sector could precipitate a recession. 

There is little evidence China is willing to bite the monetary bullet, as credit growth moves ever higher. Jonathan Anderson at Emerging Advisors Group in Shanghai has been bullish on the country for many years. He is now changing his outlook. 

“For years, we have been waiting for China to make the tough choice and sacrifice near-term growth in order to stabilize macro balance sheets and stop its exploding debt cycle,” he says. “We are not waiting any more. Even the new ‘prudential’ financial policies are merely aimed at plugging holes in the system while doing nothing to address the ongoing debt spiral. Our base case is no longer focused on how and when China will tighten. Instead, we are now treating China as we would Japan, where one simply ignores the festering debt problems in the background when making near to medium-term investment decisions. Right now we put the initial potential crisis threshold at around five years.” Edward Al-Hussainy, macro strategist at Columbia Threadneedle, says Chinese policymakers are stuck in a vicious cycle. “Low growth, falling productivity, capital flight and credit misallocation are reinforcing each other and weakening the efficacy of the policy response on the domestic front through monetary stimulus and directed credit, and on the external front through managing the renminbi depreciation through capital controls and by drawing down FX reserves. China’s current account is still in surplus and the FX reserve stockpile is large enough to comfortably service both sovereign and private-sector external debt, so we are unlikely to see a classic EM liquidity crunch or sudden stop of capital this year. That said, I expect bank recapitalization needs to rise and a significant stock of local government, quasi-sovereign and private-sector corporate debt to migrate to the government’s balance sheet over the next several years, which will continue to whittle away at the efficacy of China’s reserves in stemming a sharp depreciation.”

Al-Hussainy argues: “A significant deceleration in China’s growth – say to the 4% or 5% range, which a number of activity indicators are currently tracking – will accelerate capital outflows and onshore demand for dollar assets. Under these circumstances, I would expect PBoC to widen the renminbi’s trading band against both the dollar and the trade-weighted currency basket.”

Going against the market belief that China holds ample currency reserves, Worth Wray, chief economist at asset managers Evergreen GaveKal, says Beijing’s gradual depreciation policy is on trial. 

“While China’s $3.3 trillion in stated FX reserves (as of end-2015) sounds unchallengeable, it’s quite inadequate when compared to the country’s $21 trillion M2 money supply,” Wray says. “That’s assuming that $3.3 trillion in reserves are even available. The truth is that something like $500 billion to $1 trillion of the PBoC’s reserves are illiquid and another $1 trillion or so is essentially earmarked for Xi Jinping’s ‘One Belt, One Road’ strategy. By my best estimates, that leaves only about $1 trillion to $1.5 trillion of liquid reserves to defend the currency and lean against capital outflows.” 

Wray thinks that unless outflow pressures reverse, Beijing has three options: to close down the capital account and prevent outflows without draining FX reserves; to float the renminbi from a position of strength; or to float the renminbi from a position of weakness. Referring to the renminbi’s inclusion in the IMF currency basket late last year, Wray concludes: “It’s risky, but the best option at this juncture is to let the currency float under a narrative of bold IMF-endorsed reform.”

The counter argument point comes from a research report published by UBS in January. “It’s not helpful to lose 15% of a large reserves war-chest within six months, but let’s keep in mind that at the margin the increase in outflows has been driven by a reduction in liabilities, i.e. the paying down of external debt and an unwinding of the carry trade. One should not expect these capital outflows to persist at the same pace into the indefinite future. China’s outstanding external debt is roughly $1.5 trillion (compared to GDP of $10.5 trillion and reserves of $3.3 trillion) of which just under 50% is actually denominated in local currency. No run on the currency here.”

Sankaran at Eurasia draws attention to China’s size and liability structure, which he believes will protect the country from the problems that beset other EMs. China’s net foreign asset position of the public and private sector is positive, and a large portion of the FX reserve drawdown reflects the Chinese private sector covering large short dollar positions, he says. Also, China runs a trade surplus – $600 billion last year – which is likely to benefit from exchange-rate weakness. 

The key question for investors is how far have EM assets already priced-in the issues of commodities, tighter dollar liquidity and China? To some extent, wild swings in the EM deleveraging cycle can be smoothed through flexible exchange-rate regimes. Nevertheless, the currency and credit crises in Brazil and, to a lesser-extent, Russia highlight how gross external liabilities can be as important as current-account balances in creating financial problems. Analysts expect to see continued capital flight from emerging markets in aggregate, which will tighten domestic conditions, especially in markets such as Indonesia, South Africa and Turkey that rely on portfolio flows to finance current accounts. 

According to Euromoney Country Risk, which polls 400 economists and risk analysts on sovereign risk, Brazil and Saudi Arabia suffered the biggest falls in their total risk score among the 186 countries in 2015. In total, 73 countries’ scores fell (implying they had become riskier) from 2014. 

Falling sovereign creditworthiness has had an impact on the debt capital markets for high-grade and high-yield issuers alike this year. According to Dealogic, dollar bond issuance from emerging markets up to January 20 was just $16 billion, compared with $39 billion in the same period last year, and barely ahead of the January volumes reached in 2009 and 2010.  EM currencies have fallen by 23% in trade-weighted terms and 52% against the dollar since 2011. In December, Lombard Street Research estimated EMs ex-China were only half-way through their currency adjustment process to regain competitiveness. The consensus view sees continued weakness in Asian currencies in countries with strong trade and financial links to China, particularly Taiwan and Singapore. 

Paul McNamara, investment director of emerging markets at GAM, believes that with the exceptions of Poland, India and Mexico, markets across South America, Turkey and South Africa will remain under pressure.

BCA Research, which is part of Euromoney Institutional Investor, is even more bearish, noting that credit growth in too many EMs has not adjusted accordingly as policymakers engage in a futile attempt to inject banking-system liquidity. 

BCA notes: “Some of the worst offenders in this regard are Indonesia, Malaysia, Turkey, South Africa, Mexico, Peru and Colombia. This is a very risky strategy and will likely backfire: continued currency depreciation will eventually lead foreign investors to flee these markets.” 

If BCA is correct, commercial banks will be forced to raise lending rates or cut loan growth. Either outcome will see a rise in non-performing loans in the financial sector, which accounts for 31% of the JPMorgan EM corporate index.

The global sell-off in FX, credit and commodity markets in January has left many analysts puzzled. After all, the IMF predicts the world will expand 3.4% this year, the EM GDP slowdown is a three-year-old trend, household spending in the US and eurozone is rising and corporate earnings outside the energy sector are still decent.  George Pearkes, analyst at Bespoke Investment Group, thinks valuations have overshot fundamentals as markets struggle to come to terms with a new era of China-driven volatility. “Chinese financial markets just aren’t that connected to the broad global financial markets, relative to the concern that markets are showing. It’s a confusing transmission of magnitude. I think ‘volatility where there was none’ is the factor that’s multiplying real and financial mini-shocks from China to the broader financial markets.” 

In 2016, investors are likely to lurch between the positives (recovering developed markets) and negatives (struggling emerging markets ) driving the global recovery, Pearkes concludes. 

At the heart of China’s fragility – and EMs’, more generally – is the messy and incomplete shift to a multi-polar world. As Stephen Jens, founder of SLJ Macro Partners, a London-based hedge fund, notes: “Trade globalization has made the world more multi-polar but financial globalization has thus far made the world even more uni-polar. Contrary to popular presumption, the international role of the dollar has been enhanced in the past decade as much of EM has continued to rely on the dollar and the Fed. China is a good example of the lop-sided developments in the real economy (over-developed, on some measures) relative to the financial markets (under-developed). EM economies, as a result, have had to rely more on the dollar, helping to boost the dollar’s international role.” 

According to a report from Morgan Stanley in January, emerging market yields are still dependent on the developed economies. “The often-heard argument suggesting that rising dollar credit costs do not matter much, as most leverage is denominated in local currency, is misleading. The fact is that, since Lehman, the impact of the slope and the level of the US yield curve on other FX rate markets has increased. US rates and yields explain 60% of rate and yield levels in Asia and the commodity bloc. Hence, we expect rising US interest rates to tighten local credit conditions and thus increase deleveraging.” 

Further, in this cycle, US energy efficiency is shrinking the global dollar supply for commodity producers. China’s political economy means it can force the rest of the world to adjust to renminbi weakness through lower rates. Sankaran at Eurasia concludes: “China has some ability to echo former US Treasury secretary John Connally and say: ‘Our currency, your problem (too)’. One of the lessons the world has learned since 2008 from the experience of the US, the eurozone and Japan is that large economies have the ability to externalize some portion of the adjustment costs of their past public policy mistakes. China is likely no different.”

There is, therefore, a case for the bulls. If China finally rebalances its economy, aided by a weaker currency, it would generate new sources of consumer demand and investment opportunities for the world. In the meantime, developed markets will re-adjust to China’s shifting external balance through monetary policy. 

So far, the markets do not seem to share this optimism.