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Missing the Chinese Forest for the Canadian Trees

Sean Coakley May 19, 2017

With non-bank lenders taking a knock and talk of housing bubbles reaching a fever pitch here in Canada, it’s easy for investors to be caught missing the forest for the trees.

Missed in the news has been the fact that across the globe valuations for real estate, stocks and even antique cars having been hitting all-time highs. With the world awash in capital in the wake of the financial crisis investors, have been drawn into risky assets by the search for decent yields and easily available credit.

Nowhere is this more apparent than the world’s second largest economy, China. Despite decades of price inflation there, only now are regulatory changes emerging that could spell impending pain for credit markets and global growth alike.

Given China’s role as a key driver of growth in the global economy and a critical factor in the pricing of commodities, troubles there will rapidly spill over into global asset markets.  Currency markets in particular, as they frequently feel the impact of financial and economic disruption before other asset classes.

A Growing Concern

Traditionally, the consensus has been that the Communist Party of China would do nothing to imperil the economic growth that underpins its legitimacy.  Against this backdrop, a rapid and unsustainable growth in lending has taken place, pushing debt in the non-financial sector to 258% of GDP, with the bulk of that figure added in the last five years alone.

The consequences of this binge have been profound. The stratospheric increases in home prices in Beijing and Shanghai are well known. Perhaps more troubling has been overcapacity in state owned industries that has pushed steel prices lower while costing millions of jobs as businesses struggle to repair their balance sheets.

Shaken by the potential for calamity and the social unrest that would entail, it now looks as if the Chinese leadership is willing to toss aside its traditional emphasis on credit market harmony.

This shift is evident in the appointment of Guo Shuqing to the chairmanship of China Banking Regulatory Commission in February of this year.

Known as a reformer, his brief tenure has already resulted in significant changes in the regulatory landscape. Pledging to clean up the ‘chaos’ within the financial system, Guo has already issued a series of directives to curb leverage in the non-bank lending sector. This resulted in a significant jump in wholesale credit rates and fears of a liquidity crisis within the Chinese interbank market.

These challenges have been compounded by the fact that counterparty relationships in recent years have grown increasingly complex and opaque, meaning there is no certainty as to where the credit risk actually lays.

Painful Rate Spikes in China’s Funding Market

Clearly, the Communist Party is walking a tightrope – attempting to reduce risk in a financial sector that has run amok without triggering a full on panic. Party leaders’ efforts have been complicated by the leadership transition expect to occur during this autumn’s leadership conference.

With Xi Jin Ping’s credibility on the line, the CPC has every incentive to make this latest effort as smooth as possible.

That said, they face considerable headwinds. Outside of China financial conditions have also tightened, with this process accelerating in the wake of Donald Trump’s election.  While it is said that credit cycles rarely die of old age, this one looks to be getting fairly long in the tooth. If spreads and suppressed volatility are any guide, it is increasingly likely that unforeseen event could easily trigger a massive risk reversal.

Growing Credit Costs

So financial market nerditry aside, what does this really mean?

Unlike 2007-2009, the situation in China and in Canada does not look to be globally systemic. While we are unlikely to slide into a full scale financial crisis, an outbreak of panic in China would be sure to have significant impact on asset prices both in China and abroad.

If we look to past history the most likely losers would be commodity producers and the currencies of countries heavily exposed to commodity markets. i.e. Australia, New Zealand, Canada.

Outside of direct impacts on the real economy, given the rich valuations seen around the world it’s not a stretch to say that a reversal in sentiment in China could easily spark a sell off across all asset classes which would be painful for investors and corporates alike.


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