In January I made the case that China was slowing (https://wp.me/p9vaFZ-2w). By all accounts, this continues to play out and doesn’t seem to be changing course any time soon.
In this post I’ll discuss:
- China’s continued slowing demand of foreign goods and its correlation to debt
- Why the decline of Shadow Banking must lead to an increase of traditional lending
- Other indicators of importance
In previous posts I’ve stated that I expected growth to recover in the second half of 2018. However, it’s beginning to seem that I was potentially too optimistic with this outlook as China has yet to begin to restimulate their economy and instead has been managing the slowdown.
Note – this post will not thoroughly explain my thought process on specific topics that were discussed in the previous China post so please reference it as needed.
China’s Continued Slowing Demand of Foreign Goods and its Correlation to Debt
As shown previously, the Export Data of China’s largest trading partners correlates well to China’s 5yr yield. This continues to be the case, providing us a real-time market based indicator of China’s economy.
China’s 5yr yield (black), ISM (purple), Australia (blue), Brazil (green), South Korea (red) (note – country data Y/Y and 3 month average)
A well-known fact is that China’s economic growth has been driven by debt. From an article published by the WSJ in December 2017:
In the blueprint to be unveiled on Wednesday, past talk of bringing down debt, the priority for the past two years, is gone in favor of a pledge to just control the rise in borrowing, according to these people.
The softening of the goal, decided earlier this month by the Communist Party’s top leadership, is an official acknowledgment of how hard it is for Beijing to wean the economy off debt-driven growth.
“Let’s face it,” said an official involved in policy discussions, “it’s not realistic to reduce leverage when the whole economy relies on banks for financing.”
A broad form of analyzing credit in China is Total Social Financing (TSF). When comparing the next chart to the previous chart, we see that inflection points in TSF led changes in the trade data by ~6 months. However, this broke down as a leading indicator in 2017 as the trade data began to decline as TSF peaked.
China’s Total Social Financing (note – turning points in the growth rate circled)
Why the Decline of Shadow Banking Must Lead to an Increase of Traditional Lending
Historically, there has been a strong relationship between Shadow Banking and the Export Data of major trading partners. Similar to TSF, when Shadow Banking Y/Y peaked in the past, demand of foreign goods would peak 6-12 months later. This time, when Shadow Banking peaked, demand immediately rolled over.
China’s Shadow Banking Y/Y (black), Australia (blue), Brazil (green), South Korea (red) (note – country data Y/Y and 3 month average)
The change in the relationship of TSF and Shadow Banking with the Export Data might be due to the government’s plan to effectively ban Entrusted Loans. From the South China Morning Post (SCMP):
Entrusted loans often take the form of banks buying investment products from asset management plan providers, who in turn would lend the money to borrowers designated by the banks.
“Since the only channel for asset management plans to allocate funds to the end borrowers is via entrusted loans, the ban on using funds from the plans from brokers, fund management subsidiaries and private funds for entrusted loans will effectively put an end to the most popular structure for non-standardised credit assets”
He predicted that the new rule could reduce the amount of non-standard credit by 80 to 90 per cent over time, and push most credit back to regular channels such as loans and bonds.
“The message is very clear-cut, you just have to give up the non-standard credit business,” Xu said in a separate briefing on Monday.
In the past, Entrusted Loans accounted for ~15% of TSF. Therefore, the declining use of these loans will be a headwind for quite some time. Finally, we see that when Entrusted Loans Y/Y peaked in early 2017, the Export Data peaked like it has historically.
China’s Entrusted Loans: 12 month average, Y/Y (red), 12 month average (blue)
Understanding the relationship of growth and Shadow Banking is important for three reasons:
1) As shown by Moody’s, Shadow Banking has grown in importance over the years and is now as large as 80% of the Chinese economy. Keep in mind, Shadow Banking is only 25% of Total Bank Assets, which is why most investors are concerned about the debt levels in China (Debt to GDP in China is ~325% compared to the US at ~105%) and it’s ability to stimulate their economy effectively.
2) As examined by the Bank of International Settlements (BIS) in February 2018:
While growth of shadow credit to ultimate borrowers has slowed, the use of shadow saving instruments (eg wealth management products, trust products) has continued to expand at a fast pace. New and more complex “structured” shadow credit intermediation aimed at reducing banks’ regulatory burden has emerged and quickly reached a large scale. The bond market has become highly dependent on funding channelled through wealth management products.
In layman’s terms, Shadow Banking has not only grown in importance but is highly integrated into the Chinese financial industry.
3) As discussed by the SCMP on March 30, 2018:
“A massive clean-up is likely to take place in China’s 100 trillion yuan (US$15 trillion) asset management industry after new regulations targeting “shadow banking” were approved.
“The message is clear that China will proceed with strong financial regulations to defuse risks,” said Raymond Yeung, chief Greater China economist of ANZ Bank.
There will be little prospect of policy loosening “no matter how the regulatory regime is reshuffled or external tensions escalate,” Yeung added.”
Since we know that China’s Shadow Banking has grown in size and importance and the government wants to increase the regulation of Shadow Banking, this should result in less demand of foreign goods until China can replace this credit with more traditional means of financing, loan growth.
As seen in the next chart, when demand of foreign goods have slowed in the past, the growth of new Yuan denominated loans have increased. I would expect the Chinese to use this same playbook during the current slowdown but in a more meaningful way since it has to make up for the decline in Shadow Banking, Entrusted Loans, and restimulate their economy.
China’s CNY Monthly New Loans Y/Y, 12 month average (black, inversed), ISM (purple), Australia (blue), Brazil (green), South Korea (red) (note – country data Y/Y and 3 month average)
So far, the strategy of increasing new CNY loans and reducing interest rates has resulted in little to no financial stress compared to 2009-2010 and 2015, as shown in the bottom panel of the next chart.
Top Panel: 5yr Yield (blue), 1yr Yield (Black), SHIBOR (red), CNY (purple); Bottom Panel: 5yr – 1yr
However, it seems that it’s only a matter of time before this potentially changes as financial conditions in Asia ex-Japan have declined with ISM Manufacturing and the Option Adjusted Spread on Emerging Market debt has begun to increase from a very low level.
Barclays EM OAS (inversed, blue), Bloomberg Financial Conditions Asia ex-Japan (black), ISM Manufacturing (red)
Finally, despite little to no financial stress showing in the 5yr – 1yr spread, it’s important to note that defaults are already on the rise again in China, as discussed by the SCMP on May 14th:
China’s private sector firms are facing a debt crisis amid falling profits and rising financing costs, with the value of bond defaults in the sector rising by more than a third in the first four months of the year
“No matter what industry they are in, what these companies have in common is that they are finding it much harder than state-owned enterprises to get financing,” Qin Han, chief fixed income analyst at Guotai Junan Securities, wrote in a note.
“Deteriorating business could lead banks to withdraw loans and cause a cash shortage. Eventually, it will lead to more defaults. State-owned enterprises [in contrast] can rely on other sources of borrowing to sustain them, even if their businesses are feeling the strain,” he said.
Other Indicators of Importance
Since I tend to not trust the absolute value of the Chinese data, hence the reason why I look at the long term trend of the data, there are a few other indicators that I feel are important to keep an eye on that are outside of China’s control.
First, the currencies of Australia and Brazil, which tend to move fairly well with the Export Data shown previously.
AUD/USD (light blue), USD/BRL (black), Export Data Y/Y, 3ma: Australia (blue), Brazil (green), South Korea (red)
Next are the EUR/USD and US 30yr. The EUR has had a delayed move to the trade data the past few years, possibly because of its rising status as a funding currency alternative to the USD. With the US 30yr yield, it continues to stay around 3.1-3.2% for the time being. However, as global growth slows, I still believe that the 30yr will decline like it has previously.
EUR/USD (light blue), US 30yr Yield (black), Export Data Y/Y, 3ma: Australia (blue), Brazil (green), South Korea (red)
Turning to the lending surveys of US and European banks, both are still reporting loose lending conditions for large businesses. Based upon previous periods of stress, I would expect a tightening of lending standards to show up in the US first while Europe will probably wait until the last minute before tightening.
Source: St. Louis Federal Reserve
ECB Survey of Credit Standards for Businesses
The last indicators of importance are the shares outstanding for the iShares Emerging Markets ETF (EEM) and iShares Emerging Market Debt ETF (EMB). The reason why I’m focused on shares outstanding is because I’m looking for when investors change their thoughts on allocating money towards the Emerging Markets. Said a different way, how much pain are they willing to take before they want out.
EEM: Price (white), Shares Outstanding (red)
EMB: Price (white), Shares Outstanding (red)
While China continues to slow, there is no way to know whether this ends as another period of increased financial stress or a crisis, which so many have predicted in the past. What’s more important is knowing and understanding that asset allocation remains the same through this part of the cycle regardless of the end result in China.
- Overweight (or long) the USD
- Underweight (or short) Emerging Market currencies
- Overweight (or long) long dated maturing US debt
- Underweight (or short) Emerging Market debt
- Overweight (or long) S&P 500
- Underweight (or short) Emerging Markets
- Overweight (or long) US defensive sectors and industries
- Underweight (or short) US cyclical sectors and industries