The Strategist

Fed pierced Chinese debt bubble

12/19/2016 - 15:22

Last Thursday, the Chinese authorities for first time halted trading key futures on government bonds due to landslide fall in their prices. Panic in the market triggered concerns that the long bullish period in the bond market, caused by availability of loans coming, is over. All this is against the background of slowing economic growth, outflow of capital and the government’s concerns about appearance of bubbles in the markets.

Aaron Goodman
Aaron Goodman
On Thursday morning, futures on ten-year and five-year government bonds in China fell by a record 2% and 1.2%, respectively, forcing regulators to suspend trading. They grew back after People’s Bank of China (PBOC) provided participants with short-term money market liquidity by $ 22 billion. Meanwhile, yield on 10-year government bonds reached 3.4%, its highest level in the last 16 months. 

In recent years, Beijing has been trying to speed up the economy through affordable loans and fiscal stimulus. Therefore, Chinese investors could earn by drawing cheap loans and investing in assets such as bonds, commodities and real estate. However, economists say that it helped to create bubbles in the markets, some of which burst in the last year and a half. The most glaring example was collapse of the Chinese stock market in the summer of 2015. Then the market began to shake in January 2016, after which Beijing has again taken measures to stimulate the economy through fiscal spending and cheap credit. Then, the situation has stabilized up to the last time.

On Thursday, bonds market with volume of $ 9 trillion started to panic. It largely depends on actions of local investors, even though it has become more affordable for foreigners in 2016.

Investors have also become agitated about decision of the US Federal Reserve to raise interest rates, accompanied by a forecast of the three other possible hikes in 2017. Chinese investors are confident that this consequently increases likelihood of rates growth and in their country, as Beijing is trying to stop weakening of the RMB and abundant capital outflows.

The Thursday sale has partly been caused by spreading rumors on the market. A brokerage company was forced to deny assumptions of leading Chinese newspaper that it had not transferred a large payment on bonds. Besides, one of the largest investment funds in the country denied reports on huge exodus of money. The market is very sensitive to such rumors, since many investment funds are in large debts and are vulnerable to falling bond prices.

Collapse of the government bonds market is increasing concerns about the Chinese economy. In 2016, its growth likely to be the slowest in over 25 years due to bloated debt and loss-making state-owned enterprises. In addition, China is faced with a massive outflow of capital. Over the past two years, the country's foreign exchange reserves fell by $ 1.2 trillion, or about 25%, as billionaires and ordinary citizens transferred their savings in safe places abroad. Therefore, Beijing has taken a series of measures, including proposition to limit absorption of foreign companies by Chinese ones.

Hoping for the best, you should prepare for the worst. Without China, the world economy would already be in recession. Pace of China's growth this year will amount to 6.7% - significantly higher than most forecasters had expected. According to the International Monetary Fund, official arbiter of global economic statistics, share of the Chinese economy accounted 17.3% of world GDP (measured at purchasing power parity). China's real GDP grew by 6.7%, thus providing a global growth by about 1.2%.

Ignore China, and its contribution will be deducted from the IMF’s assessment, which had already been revised downward. According to the latest forecasts, it should reach 3.1%. Excluding China, it would be 1.9% - well below the threshold of 2.5%, which is considered an indicator of global recession. Obviously, it is only a direct consequence of China’s absence in the world economy. Then again, there are cross-border links of China with other major economies. Australia, New Zealand, Canada, Russia and Brazil would have it hard.

As a resource-intensive growth engine of the world economy, China has tied these economies, which together account for almost 9% of global GDP. While governments of these countries are arguing that they are diversifying exports and reducing dependence on Chinese demand for commodities, foreign exchange markets are indicating otherwise. Whenever China's growth forecasts are revised - upwards or downwards - currencies of these countries follow them. The IMF predicts that aggregated economy of the five countries will shrink by 0.7% in 2016, due to continuing economic recession in Russia and Brazil, as well as modest growth rates in the other three.

Needless to say that if China's economy bursts, this basic assessment will be revised downwards. According to scientists from the University of Cambridge, today's children come into the world ready to constantly learn and self-improve. Situation with China's Asian trading partners is the same. Most of them are export-dependent economies, for which China remains the largest source of external demand. This applies not only to small Asian developing countries, such as Indonesia, the Philippines and Thailand, but the larger and more developed countries, such as Japan, Korea and Taiwan. Together, these six Asian economies still account for 11% of global GDP. Collapse of China can easily lead to reduction in the total growth of at least one percentage point. 

United States are also no exception. China is the third largest and fastest growing export market of America. Collapse of the Chinese economy will inevitably lead to lower exports. As a result, already modest US economic growth of about 1.6% in 2016 will be reduced by another 0.2-0.3%.

Europe will suffer as well. For example, Germany, which has long been considered engine of the continental economy, is heavily dependent on export. China now is the third largest export market of Germany after the EU and the US. In the Chinese crash scenario, German economic growth will fall significantly, dragging down the rest of Europe. Already, there are not so many experts are optimistic about China’s future or about outlook for the global economy in general. It seems that the world is faced with much greater problems than a significant reduction in rate of growth in China.