Uncommon Sense
August 2016
Will China Stage Another Midsummer
Night’s Nightmare?
by Michael Arone, CFA, Managing
Director and Chief Investment Strategist
for US Intermediary Business Group
If we shadows have offended,
Think but this, and all is mended —
That you have but slumbered here
While these visions did appear.
— A Midsummer Night’s Dream, Act V
Sometimes a media spotlight on a single issue or event creates
welcomed opportunities for others to operate in the shadows.
For instance, when the United Kingdom commanded center
stage after the Brexit decision shocked the world, the People’s
Bank of China (PBOC), mindful that its actions would attract
about as much attention as a stagehand’s, quietly depreciated
the yuan by 0.9 percent. The central bank’s biggest move since
its surprise devaluation last August set the yuan at December
2010 lows. Over the two weeks following the June 23rd UK vote
as the US dollar surged, the PBOC let the yuan weaken a total of
1.6 percent against the dollar.1
Yet, with attention focused elsewhere, the yuan’s devaluation
didn’t trigger the panic or capital outflows that occurred in
August 2015 or this January. Remember, last August US stock
prices plunged roughly 12 percent following the contagion
caused by China’s surprise move to devalue its currency.2 Then
in January, Chinese policymakers again roiled global markets
by introducing market-wide circuit breakers into their stock
markets. Both times contagion risks emanating from China
grabbed front page headlines in newspapers around the world.
However, even as many of those same risks have become more
concerning, coverage of the yuan’s devaluation now seems
relegated to page 10.
After reacting so severely to China’s two shocking policy moves
in six months, are the markets now immune to the ongoing
devaluation? Some capital market participants take comfort
in what they view as a more transparent yuan pricing system
and the central bank’s improved communication with global
markets. I appreciate that the PBOC maintains a difficult
balancing act — keeping the yuan at a rate low enough to
support exports, still the primary engine of Chinese economic
growth, but making sure it’s not so low that it results in massive
capital outflows. But the central bank’s current policy seems a
little fuzzy. That we find ourselves shaking our heads and
asking, “Did that really happen?” underscores the potential
for the PBOC’s policy decisions, once brought to light, to have
a nightmarish impact on the global economy.
The Plot Thickens
Trade-reliant economies like China have long used weakening
their currencies to make their exports cheaper and prop up
the domestic economy. But, today’s ongoing crafty yuan
devaluation presents a greater risk for the global economy
than Britain’s vote to exit the European Union.
First and foremost, the devaluation may signal further
deterioration in the world’s second largest economy. It may be
an attempt to uphold already slowing GDP growth by exporting
deflation to protect its exports. In fact, at a two-day meeting of
Group of 20 finance chiefs at the end of July, some expressed
concern over the yuan’s decline. In addition to putting
additional downward pressure on commodity prices, they
fear China’s export-driven trading rivals may devalue their
own currencies, resulting in a currency war where the biggest
casualty will be global growth.3
It’s also crucial to recognize that the currency devaluation
is not the only stress playing out. Accommodative monetary
policy, soft regulation and shoddy lending practices are
worsening an already shaky debt situation in China.
Will China Stage Another Midsummer Night’s Nightmare?
Figure 1: Total Assets of Chinese Banking Institutions
% Change YoY
has the highest corporate debt ratio at 160 percent of GDP.5 The
International Monetary Fund forecasts that China’s potential
losses from corporate loan defaults could exceed 7 percent of
the country’s GDP. McKinsey & Company claims this ratio
could reach an astonishing 15 percent in 2019 if China
continues on its current extraordinary lending course.
% Change Bank Assets YoY
17
16
15
14
13
12
Sep
2013
Mar
2014
Sep
2014
Mar
2015
Sep
2015
Mar
2016
Source: Bloomberg Finance LP as of 03/31/2016.
This concept tracks the aggregate assets and liabilities of banks within an economy
(including private or commercial banks, central banks or both).
China’s banking assets have risen dramatically in recent
years, topping $31 trillion through the first quarter of 2016
(see Figure 1).
Of that $31 trillion, net debt amounts to $25 trillion. At the
end of 2015, China’s total private and public debt stood at 250
percent of GDP, well above the level that can impede economic
growth (see Figure 2).
In fact, China has reached the highest point of debt
inefficiency since 2009, requiring the input of four units of
credit to produce a single unit of GDP. The public and private
sectors are increasingly using new lending to finance existing
credit obligations. For example, nearly 98 percent of municipal
bonds go to paying outstanding debt obligations.4 Moreover,
44 percent of corporate bonds issued in 2015 went to repaying
existing debt, an incredible figure when you consider that China
Figure 2: China Total Debt to GDP
China certainly expanded its rate of credit creation in the first
quarter of 2016. The Chinese economy experienced the biggest
three-month surge in new borrowing on record, increasing
credit by 6.2 trillion yuan and pushing the rate of new lending
to more than 50 percent ahead of 2015’s pace.6 According to
McKinsey & Company, if China continues its current borrowing
trend, the cost of handling bad debt could appreciate from
1 trillion to 3 trillion yuan every year.
The Truth’s Behind the Curtains
On first review, despite persistent yuan weakening, China
has seemingly managed to slow the flight of capital. China’s
foreign-exchange reserves in June registered their biggest
monthly increase in more than a year.7 The consensus was
that reserves would fall. However, the rise was largely cosmetic.
China likely holds fewer British pounds and more Japanese yen
than expected post-Brexit. In addition, Chinese households
now face tougher restrictions on taking money offshore.
Simply, more money is flowing out of China than meets the eye.
According to Goldman Sachs, an estimated $170 billion of
yuan, 50 percent more than indicated by the central bank’s
data, has found its way to the offshore Hong Kong market
since last October.
And a report from Nomura Holdings, Inc. suggests China is
over-invoicing imports from tax haven islands to mask
capital outflows. How else do we account for the astronomical
import growth from Samoa? (See Figure 3). Do we really think
that China’s appetite for coconut oil has increased more than
700 percent?
Figure 3: China Import Growth YoY 2016
%
% Change YoY
250
800
230
723.3
600
210
354.1
400
190
150
160.5
200
170
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
Source: Bloomberg Finance LP as of 06/30/2016.
State Street Global Advisors
0
Samoa
Bahamas
129.8
Seychelles Hong Kong
76
Cayman
Islands
33.5
Cook
Islands
Source: Nomura Holdings, Inc., 06/30/2016.
2
Will

China Stage Another Midsummer Night’s Nightmare?
As the US Presidential Elections and the Olympics join Brexit
on the daily front page, Chinese policymakers will remain all
too happy to accept the air cover. Policymakers will continue
their work to slowly but surely devalue the yuan, massively
increase credit and camouflage capital flight — all to support
vanishing economic growth.
China’s yuan has fallen about 3 percent against the US dollar
since the beginning of 2016 and nearly 6 percent against a
basket of 13 currencies for the same period.8 I’m concerned
that as we approach the one-year anniversary of the first
surprise devaluation, another policy surprise — or even a slow
news day! — may force China’s devaluations out of the shadows
and onto the front page. In that case, global markets surely will
suffer a third round of Chinese policy-induced volatility.
Because, at 16 percent of world GDP, China matters much
more to the global economy than the UK at less than 3 percent
of world GDP, contagion is not only likely but certain.9
Wei, Lingling. “As China Lets Yuan Depreciate, Other Nations Take Note.”
Wall Street Journal, July 24, 2016.
2
Bloomberg Finance L.P.
3
Wei, Lingling. “As China Lets Yuan Depreciate, Other Nations Take Note.”
Wall Street Journal, July 24, 2016.
4
Carmichael, Chase. “China, Not Brexit, Is the Biggest Problem for the World.”
July 29, 2016.
5
Ibid.
6
Ibid.
7
Trivedi, Anjani. “China’s Outflows Aren’t Over.” Wall Street Journal, July 7, 2016.
8
Wei, Lingling. “As China Lets Yuan Depreciate, Other Nations Take Note.”
Wall Street Journal, July 24, 2016.
9
World Bank as of 12/31/2015.
1
Glossary
Brexit An abbreviation of the term “British Exit,” which refers to the UK referendum
on June 23, 2016, that resulted in the country’s decision to withdraw from the
European Union (EU). Under Article 50 of the EU’s Lisbon Treaty, a country that votes
to leave the common market has 24 months to do so.
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