China not a financial crisis in the making
After the recent turmoil in Chinese equities and surprise depreciation of the yuan triggered a sell-off in global markets, unease is growing that China could be heading towards a financial crisis and not just a severe slowdown.
Holders of offshore Chinese high-yield debt need to watch events unfold carefully, as they are likely to be last in line in any debt blowout. But while China’s macro outlook has clearly deteriorated, there is little indication that we are on the verge of another financial crisis.
So far China’s bond markets have proved relatively resilient, although investors need to recognise that risks are rising.
Much of the strain today stems from a re-pricing of risk as the US Federal Reserve readies to normalise monetary policy after six years of holding interest rates at near zero. We are seeing a rerun of the “taper tantrums” of 2013 as capital flows reverse and Asian currencies weaken. But the difference this time around is that markets are also factoring in a China slowdown and fresh falls in commodities, in addition to the wider fear of instability in emerging markets.
Perhaps echoes of the Asian financial crisis are loudest with Indonesia
The surprise depreciation of the yuan was a key trigger for increased investor nervousness. While it adds a new layer of risk to offshore Chinese corporate debt, markets are not yet signalling wider solvency issues that would merit comparisons with earlier financial crises.
Although Beijing has felt the need to support markets, this is not similar to state intervention in 2007, when large financial institutions went bankrupt and interbank markets shut down. Nor do comparisons with the Asian financial crisis of 1998 bare close scrutiny when there was a toxic mixture of currency weakness and foreign capital flight. Economies were much less international back then, foreign debt exposure was significantly higher and fixed exchange-rate regimes were more common.
Perhaps echoes of the Asian financial crisis are loudest with Indonesia, where the rupiah is now trading at levels last seen 17 years ago. Although this is certainly inflicting pain on foreign debt holders, local corporates are much better placed to find relief due to the development of local currency financing markets.
China is the glaring exception to most of Asia in that it has been running a loose currency peg to the US dollar.
Much of the ferocity of the initial reaction to the yuan deprecation can be explained by poor communication: investors were caught wrong-footed and left guessing whether it signalled a new market-driven regime after 10 years of yuan appreciation, or was a further sign of macro distress.
Another factor at play was that many professional investors already felt markets were expensive and were just looking for a reason to sell.
The direct financial impact of the yuan depreciation on its own, however, does not raise alarms. Even if you take the recent falls at their most extreme, where the yuan lost 5 per cent, this is not going to trigger defaults and is manageable.
Chinese property developers have come under most scrutiny as they generally only have local currency revenues and have been the largest issuers of foreign currency bonds.
Most of the Chinese developers that we follow generally have foreign-currency-denominated debt at less than 50 per cent of total debt. Smaller players tend to have even less foreign debt. A critical factor that helps relieve funding stress is the emergence in China of a vibrant domestic bond market that helps developers reduce foreign debt obligations and interest expenses.
While the threat of wider systemic risk appears limited, there are clearly sectors of the Chinese economy that are experiencing disproportionate pain, such as commodities and mining.
The latest downturn in commodity prices adds to stress and means it is time to focus on the top industry players rather than the marginal ones. There is also a need to thoroughly understand each company’s cost curve and determine whether it will or will not survive market shocks.
Some may not be that far from closing shop.
In general, it is still possible for professional bond investors to hedge some of the risks. For instance China currency risk can be offset by shorting commodity-driven currencies such as the Australian dollar.
Unfortunately not all risks can be hedged away. Perhaps the biggest concern is the lack of transparency in China, or simply not knowing what you don’t know.
While we conduct rigorous financial analysis of corporates, this becomes less useful when there is fraud or manipulation of numbers. For example, movements in working capital need to be monitored closely and not just net profits, as this might be the only indication of a future cash flow problem and an inability to pay coupons.
Issues with transparency in China are also the biggest caveat to the consensus benign outlook - assuming authorities can successfully transition to “new normal” of slower growth. Most indicators suggest China is not a financial crisis in the making, but to maintain confidence, markets need to see more from Beijing in terms of a true long-term economic plan - and that each step is being followed and working.
Michel Lowy is co-founder and chief executive of SC Lowy
