BMI View: Concerns that a collapse in China's shadow banking system could lead to a region-wide Emerging Markets crisis are overblown, given the limited direct financial linkages and the healthy state of Asian balance sheets. We believe that developed markets within the region, such as Australia and Japan, face the greatest risks from the indirect impact of a slump in Chinese demand. Asian FX should hold up relatively well versus the Chinese yuan, while property markets in the region face significant downside potential.
With China's banking sector instability increasingly coming to the fore, the potential impact of a collapse of the shadow banking system on other emerging markets has been hotly debated. Given the fragile state of Emerging Markets (EM) globally, there is heightened concern that Chinese financial weakness could exacerbate this trend, triggering a full-blown EM crisis. Within Asia, we believe that concerns of a 1997-style Asian Financial Crisis are overblown, as regional balance sheets are in much better shape. That said, as the major source of export growth for most economies in the region, economic activity will suffer across the board. In general, rather than Emerging Asia facing crisis risks, we find that the region's developed economies are most at risk from a China-driven shock.
The China View
We have long held that China's unparalleled credit boom since the Global Financial Crisis (GFC) would ultimately need to be unwound, seriously undermining real GDP growth. With the shadow banking system now facing serious risks stemming from potential wealth management product defaults, these concerns are heightened, while the threat of a systemic financial crisis is on the rise. Although we believe that the authorities have the willingness and ability to prevent a full-blown crisis, bouts of instability are a near certainty, and will have a negative impact on the region.
| Slowdown Just Beginning |
|China - Real GDP Growth, % chg y-o-y|
The Two-Pronged Regional Threat
When looking at the potential risks facing the region from a collapse in China's shadow banking system, it is important to distinguish between the direct and the indirect risks. Given the relatively closed nature of China's financial account, and the huge level of reserve coverage that China has, the direct financial risks are relatively small (although certainly non-zero). On the other hand, indirect risks are huge, given that China has been a major driving force of growth across the region over the past five years.
Direct Financial Contagion Risks Low But External Debt A Concern
A look at China's external balance sheet reveals a picture of stability when compared to several other emerging, and indeed developed countries. Its net international investment surplus is roughly 22% of GDP, with over 60% of its liabilities in terms of relatively stable FDI. The US$3.8trn reserve buffer will allow any banking sector bailouts to be paid for fully with central government funds, and/or quantitative easing measures, without risking a currency collapse.
| Solid External Surplus |
|China - Net International Investment Surplus|
However, while the yuan's direction will remain largely beholden to Beijing, any banking sector turmoil could still result in currency weakness as the People's Bank of China (PBoC) looks to support export demand and prevent deflation. This poses a risk to the lenders of US dollar to Chinese corporates, banks, and non-banking financial corporations. According to China's State Administration of Foreign Exchange (SAFE), US dollar denominated borrowing has tripled in four years, rising from US$270 billion to over $800bn currently, with over half of this amount short term in nature. Furthermore, according to the Bank of International Settlements (BIS), the loan-to-deposit ratio for foreign currencies in China's banking system has doubled from a around 100% in 2005 to almost 200% today, with foreign exchange swaps and forms of credit largely out of the reporting framework responsible for much of the increase in funding. At the same time bond issuance by Chinese firms has increase tenfold to almost $80bn in just eight years.
| Reserve Position Will Allow PBoC To Maintain Control |
|China - International Reserves, US$|
Clearly, then, foreign banks, particularly Hong Kong lenders that have increased their exposure to the mainland aggressively in recent years, will be on the hook for any credit weakness. Although the PBoC has the ability to prevent a large-scale currency devaluation, any deflationary credit crunch would lead to defaults and banking sector losses even in the absence of a devaluation.
Economic Linkages Much More Of A Concern
The indirect macroeconomic impact of a Chinese banking crisis on the region would be far more widespread than the direct financial contagion impact. China has played a major role in driving export demand across the entire region, and is now the largest export market for most Asian countries. It is crucial to differentiate, however, between the risks to economic growth and the risks to financial stability across the region. We believe that the likes of Taiwan and Korea would be hit hard in terms of economic activity by a collapse in Chinese growth, but the risk of a financial crisis is relatively low. On the other hand, we believe that in the case of the likes of Australia and Japan, poor balance sheets mean that any external shock has the potential to trigger financial crisis. In the case of the former, its external balance sheet is among the weakest globally, with the latter has one of the most precarious fiscal positions in the world.
| Varying Degrees Of Exposure |
|Exports To China, % of Total Exports And % of GDP|
Taiwan, Hong Kong Are Heavily Exposed But Face Limited Crisis Risks
The accompanying chart summarises the extent to which Asian economies are leveraged to Chinese import demand. Hong Kong, Taiwan, Malaysia and Korea stand out as being the most exposed to any banking-driven macroeconomic shock in China. However, it is our view that weakness in Chinese domestic demand, rather than a collapse China's exports, is the major risk stemming from the country's credit bubble, and so countries that export finished products and/or raw materials (both of which are at the mercy of domestic demand), such as Australia, will suffer disproportionately.
On the other hand, countries such as Hong Kong and Taiwan typically export semi-finished goods to the mainland, which are then re-exported out of the country. For example, over 70% of Taiwan's exports are intermediate goods, with a high proportion spending only a limited time in China before being shipped on, mainly to developed market consumers. With US real GDP growth likely to accelerate to 2.8% in 2014, Taiwan's crucial information and communications technology (ICT) sector should not suffer too greatly (at least directly) from a Chinese slump. Hong Kong's direct export exposure to China is also not as large as the headline figures suggest, with the vast majority of trade representing the re-export industry, and domestically produced exports making up just a fraction of total exports. To be sure, any slump in final demand in China would surely have a negative impact on trade volumes, hurting Honk Kong's major trade services export industry, but we do not believe that the economy is as susceptible as the headline figures suggest.
Australia, Japan Very Vulnerable To External Shocks
It is a different story for the likes of Australia, New Zealand and Indonesia, which largely export commodities to China, used in final demand. In the case of Australia, while Chinese demand represents only 6% of GDP, the export mix is very sensitive to Chinese investment trends. A collapse in China's shadow banking system would knock a major pillar of support away from investment, undermining iron ore, and to a lesser extent, coal demand. Additionally, while Hong Kong and Taiwan, for instance, are otherwise relatively insulated economies, given their huge external surpluses, Australia is heavily reliant on exports to China (and the associated foreign investment) to keep its current account shortfall stable and preventing a currency collapse.
| Unsustainable Export Boom |
|Australian Iron Ore Exports To China, AUDmn|
The current fragility of the Japanese economy also means that the direct economic and financial market linkages do not reflect the true risk that the economy faces. Japan is a relatively closed economy in terms of exports as a share of GDP, so despite China representing almost one quarter of total exports, this makes up just 4% of GDP. That said, Japan's economy is in desperate need of profit generation in order for the private sector to be able to carry the weight of the country's huge fiscal burden. Japan's export sector is a major source of this profit, and any negative shock poses a major risk to Japan. Indeed, as we saw during the GFC, corporate Japan's high operational leverage resulted in a major collapse in GDP growth. Should another external shock hit the country, the plunge in tax revenues could be enough to send bond investors fleeing the market due to fears of fiscal sustainability, leaving the Bank of Japan as the only buyer left in the market to prevent a full-blown fiscal crisis.
South Asia Relatively Unexposed
As the above chart clearly shows, South Asian economies do not have a great deal of exposure to Chinese export demand. Although China is a substantial investor in the likes of Bangladesh and Sri Lanka, it is not a major export destination, with these markets much more catered to US and European demand. In the case of India, while the economy faces a number of risks in 2014, a China slump is not one of them, with internal political and business environment struggles much more crucial to India's growth outlook. In fact, should we see a shift to more business friendly policies implemented in India, it is conceivable that the country could attract huge amounts of FDI as foreign investors increasingly look to diversify out of China.
Financial Market Implications
FX: Bearish CNY Versus Asia Basket
From a financial market perspective, it is tempting to conclude that a currency selloff in China will lead to weakness in Asian FX. However, we believe that Asian FX markets are relatively cheap right now, on the whole, and will be able to weather any Chinese depreciation relatively well. That is not to say that they would shrug it off all-together. However, they have weakened while the CNY strengthened over recent years, essentially 'getting their devaluations in early' so the contagion effect should be of a lesser impact. As the accompanying chart shows, in volatility adjusted terms, the CNY is trading at three standard deviations above where is should be based on the correlation with the Asia FX basket over the past five years.
| Major Divergence Suggests Yuan To Underperform |
|Chinese Yuan 1-Year NDF Versus Asian FX Basket|
Equities: Nikkei At Risk
Emerging Asia equity markets on the whole are trading at a sizeable historical discount, and while a China collapse would likely undermine all risk assets, the downside may be limited in general. South East Asian stocks look slightly vulnerable given their lofty valuations and the reliance on portfolio inflows, which could reverse in the event of a China driven growth shock. However, we believe that the Japanese Nikkei is the market most at risk, given the country's susceptibility to external shocks amid the deteriorating fiscal picture. Indian equities, meanwhile, should outperform the region owing to the lack of economic linkages between India and China.
| Falls Break Spells Trouble |
|Japanese Nikkei Equity Index|
Bonds: Bullish Developed Markets, Ex-Japan
We believe that bond markets represent attractive value at present, and developed market bonds such as Australia and New Zealand could benefit from renewed deflation fears. On the other hand, while not likely to pose a direct risk to the Japanese bond market, any hit to Japan's fiscal finances would further undermine the confidence of JGB investors. In the case of the more emerging markets such as Indonesia, Thailand and Malaysia, these countries could experience large external outflows, leading to a surge in yields, particularly on their external bonds as credit spreads widen.
| Still Value In Australian Bonds |
|Australian 15-Year Government Bond Yield, %|
Property: Major Downside Potential
Regional property markets face major risks from a banking crisis in China. Markets from Hong Kong to Australia have benefitted directly from Chinese demand, and have become extremely overvalued. As such, a period of intense export weakness could be enough to prick the bubbles we have seen in regional property markets. While it could be argued that wealthy Chinese citizens may increasingly look overseas in the event of a slump in Chinese property prices, we believe the greater risk comes from the reversal in optimism over property as a store of value as mainland Chinese investors experience sharply declining prices.
| Cracks Appearing In Hong Kong Real Estate Bubble |
|Hong Kong Property Price Index|
Commodities: Agriculture To Fare Better Than Industrial Metals
It is also tempting to hold a blanket bearish view on the commodities complex given how important China has been in generating marginal commodities demand. However, there are a number of caveat's here. Firstly, in a similar fashion to Asian FX markets, commodity prices have fallen a significant way from their peaks, and are by no means seen as one way bet on China's growth as they were in 2011. Secondly, while an implosion in China's banking system would certainly cause a deflationary shock across the world, we maintain that the official response to such a shock would be to expand monetary stimulus measures, which would support commodity prices. We believe that industrial metals, while down from their peaks, are not priced for the potential negative impact that a credit crunch could have on Chinese demand, and we favour agricultural commodities relative to industrial metals, particularly iron ore.
| Agricultural Commodities To Outperform Metals |
|Agricultural Commodity Index / Industrial Metal Index|