NIKKEI ASIAN REVIEW

Yuan flashes warning signs amid slowing economy and widening trade war

William Pesek

August 03, 2018

The 2008 “Lehman shock” is finally catching up with China.

Beijing beat the odds for a decade, with the Chinese economy growing at above 6.5% year after year. It managed that feat with an epic explosion of credit and debt at government and corporate levels. The latter, for example, surged toward 170% of gross domestic product, from 101% in 2008. Corporate America’s ratio, by comparison, is about 73%.

That bill is now coming due. This year marks one of the busiest redemption periods for yuan and offshore debt since the post-Lehman Brothers collapse. Between now and Dec. 31, companies face $365 billion of bond payments. The strains show with at least 20 defaults in the first seven months, almost as many as in all of 2017.

There are two reasons to think things will get worse — a sliding Chinese currency and Donald Trump’s escalating trade war. Thickening the plot is how these might exacerbate one another.

The yuan is down 5.2% versus the dollar this year, with the deepest declines coming in the past six weeks. These coincided with signs Asia’s biggest economy is losing momentum, prompting capital outflows. Normally, traders might conclude Beijing is manipulating exchange rates for competitive gain. But the yuan’s fall does not seem intentional.

The reason: the weaker the yuan, the greater the risk of defaults on overseas debt. The market for dollar debt for Chinese companies barely existed in 2008. Today, it stands at about $500 billion. Not an amount that fuels panic about systemic risk, with Beijing sitting on more than $3 trillion of foreign-exchange reserves. Defaults on overseas loans, though, have a way of shocking even the strongest of political systems.

Beijing did not even let companies renege on debt until March 2014. Before that, government bailouts were the norm. The dubious honor of first offender went to Shanghai Chaori Solar Energy Science & Technology. Yet global markets paid far more attention 13 months later when Kaisa Group defaulted on dollar bonds, the first Chinese property developer to do so.

Tolerating such shocks is part of President Xi Jinping’s pledge to let market forces play a “decisive role.” Question is, how tolerant will Xi be? The more headline-grabbing defaults China racks up, particularly those denominated in dollars, the more investors might sell the yuan, creating a domino effect.

A stepped-up pace of defaults threatens Xi’s reform push. Until now, China’s peak for the number of annual defaults was in 2016, not surprisingly the year Xi began clamping down on financial risks, leverage and shadow financing. Beijing tightened rules on asset management and off-balance-sheet investment vehicles. Two years on, executives are having trouble raising new funds to repay existing debt.

Wintime Energy, the biggest 2018 defaulter so far, tells the story. Last month, when the coal-mining giant crashed, investors were right to react with canary quips. This idiom indeed fits, considering how the little-known outfit from northern Shanxi province ran up a roughly $11 billion tab, a quadrupling of liabilities in less than five years. It rode China’s post-Lehman credit wave until Xi’s team changed the game.

That makes for a fascinating microcosm. Its debt boom coincided with a near-doubling of China’s domestic bond market. At about $12 trillion, all in, it is now the world’s third biggest. Beijing, particularly on Xi’s watch, championed the use of debt to wean state-owned enterprises off shadow financing.

But few local punters were skilled enough in credit research — or doubtful Xi would ever allow defaults – to adequately hedge bets. Looked at through this prism, it is a wonder the yuan is not falling harder. One reason: People’s Bank of China may be lending support for fear of losing control. Another: avoiding Trump’s wrath.

Trump rarely misses an opportunity to complain the yuan is “killing us.” As he told CNBC last month: “China, their currency is dropping like a rock. Our currency is going up. I have to tell you, it puts us at a disadvantage.” Clearly, we may be approaching the limits of Washington’s tolerance.

Trump’s tariff arms race is already stress-testing China’s lopsided economy. First came a 25% levy on steel imports and 10% on aluminum imports. Then a 25% tax on $34 billion worth of mainland goods. Action on another $200 billion may be coming – on the way to as much as $505 billion. The fallout makes it even harder to raise capital. Any slowdown in growth will ricochet back at China’s weaker credits.

It is important, though, that Xi stay the reform course. We are just two years into efforts to create a balanced economy anchored by a vibrant private sector. Now, reducing excesses is again taking a backseat to stimulus. In recent days, Xi Jinping’s government unveiled measures to reassure investors: tax cuts, new business loans and increased infrastructure spending. The PBOC is lending the equivalent of at least $75 billion to banks to spark business activity.

Regulators, too, are throttling back, making for quite a balancing act. Fewer curbs might encourage banks to step up lending small-businesses, a chronically underfinanced sector. Risks abound, though. A generalized increase in lending might cheer markets and reduce default risks now, but at the cost of bigger debt troubles later.

Part of this balancing act relates to China’s ambitions. As Beijing spreads its tentacles via the “Belt and Road” initiative, bankers expect a bigger upswing in Chinese dollar issuance. Quite the irony, considering the enterprise is partly a challenge to American hegemony, of which the dollar is a key element. A spate of defaults could prompt Xi to check his global aspirations.

Yet Xi’s domestic reform ambitions must remain high. As Chen Long of Gavekal Research puts it: “An increase in defaults is actually a good thing since it reminds investors to pay attention to credit risk.” So long as Xi’s team works simultaneously to strengthen the financial system, defaults need not derail the journey toward a more productive economy.

In the meantime, Trump needs to be careful about how he trolls China Inc. Destabilizing the No. 2 economy and the biggest holder of U.S. Treasuries could boomerang in unpredictable ways. Washington also must recognize why the yuan is sliding. The dollar is underpinned by a U.S. economy growing 4.1%; unemployment is just 4%. That has the Federal Reserve hiking interest rates, giving the dollar a logical lift.

The danger is that Trump concludes it is Xi who is trolling him and exacerbates default risks as Washington escalates its trade war. It is wise for the two leaders to discuss differences on trade and exchange rates. But using blunt political tools to poke China, and raise the odds of a reckoning that would make the Lehman crash seem tame, is in no one’s interest.

William Pesek is an award-winning Tokyo-based journalist and author of “Japanization: What the World Can Learn from Japan’s Lost Decades.” He was given the 2018 prize for excellence in opinion writing by the Society of Publishers in Asia, for his work for the Nikkei Asian Review.

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