China, the devaluation possibility
A couple of points from Deutsche Bank’s GEM Equity strategy team on Friday to file under the “it’s China, not the Fed, that’s driving everything at the moment” meme:
…‘we believe that the improvement in the Chinese economic and corporate data, which has become evident since the end of August, is not sustainable’ and that ‘the Chinese growth story is starting to unravel’. As regular readers will know, our negative structural view derives from an examination of the relationship between the corporate sector and the state, especially at a local level, which we have documented in two longer research reports (China’s corporate sector; a messy transition’, 15 May 2012, and ‘China; no quick fix for the Beijing model’, 30 August 2012).
Third, ‘the dollar is likely to experience a sustained rally through most of 2013, sucking liquidity out of EM assets, especially local currency debt, though EM dollar debt is also vulnerable given the massive fund inflows since 2009’. This has also been the view of DB’s FX strategists Bilal Hafeez and James Malcolm.
The sharp falls in emerging market equities were precipitated by the chairman of the US Federal Reserve Ben Bernanke’s statement on 22 May concerning the potential timetable for the tapering of the Fed’s QE policies through the next couple of years. The effect was then compounded by the PBoC withholding liquidity from the Chinese interbank market, which pushed SHIBOR up to unprecedented levels. We have detailed the impact on individual emerging markets and sectors (Figure 1), which has been universally negative, but with some noteworthy differences by country. There has been relatively little dispersion between sector performances with the traditionally low beta consumer staples and utilities performing closely in line with materials and energy. By country, the dispersion is much wider – the effect of the actions of the Fed and PBoC has been aggravated in the case of the stand-out worst performer Turkey, by the reaction of the Erdogan-led administration to the demonstrations in Istanbul.
Deutsche’s John-Paul Smith and Priyal Mulji go on to state they, like most other commentators, have been puzzled by the recent actions of the Chinese central bank. The strategy, to be blunt, is strange:
We accept the broad brush conclusion that the authorities in Beijing are trying to bring some discipline back into the system following the conclusion of the leadership transition. The method which appears to have been chosen, namely to engineer a squeeze in the interbank system, does however strike us as an extremely blunt instrument, which runs the risks of unintended consequences.Given that the ultimate stated objective of the new leadership is to increase the role of the private sector in the economy using a more market-determined cost of capital, it seems strange to then put pressure on precisely those medium-sized banks which conduct a disproportionate amount of lending with the only significant component of the indigenous private sector in China, namely the SMEs. This episode reinforces our conviction that the authorities in China face an almost insurmountable task to restore historic rates of productivity growth, in terms of complexity and the vested interests involved.
The major structural problem is the very blurred boundaries which exist between the state and private sector which distort capital allocation at enterprises above the SME level. The only way to resolve this situation over the longer term is for a complete overhaul of the fiscal relationship between local and central government, which would also involve wholesale changes to the fundamentals of land ownership.
But also, they wonder, what actually happened to the liquidity that was distributed into the system during last summer’s well publicised cash flow difficulties?
Statements from both the PBoC and the State Council clearly indicate a belief that much of it has gone into ‘speculative’ investments, presumably property, but there are clear indications that a great deal of the non-bank finance has been used for servicing existing loans, primarily to LGFVs and industrial companies, which are closely affiliated to regional governments. If this assumption is correct, then the authorities in Beijing have a major problem of conflicting priorities, given that on the one hand they warn against adding more industrial capacity but on the other talk of the need for the banks to serve the interests of industry and to protect ‘labour intensive’ sectors of the economy. In the meantime, overcapacity is visibly growing in most sectors covered by DB analysts, while companies were complaining about difficulties in accessing credit, well before the PBoC action. We would expect to see clearer indications of more cash flow problems across different industrial sectors in China in the near future.
And it is the increased realisation that the authorities in Beijing are not in full control — despite great efforts to appear that they are — and more importantly, that there may not be a coherent master plan behind everything they do, which may now be shaking confidence in the durability in the Chinese growth model.
According to the analysts, the authorities are also increasingly being faced with very conflicting pressures with regard to the exchange rate:
…on the one hand they are trying to attract inflows of foreign capital, most notably via increased quotas for the ‘A’ share market, whilst they must also be aware that a weaker currency could help the corporate sector to overcome its liquidity problems and regain some of the competitiveness lost over recent years due to the steady rise in the REER. A weaker RMB would also be a mechanism to bring some inflation into the system and erode the real value of the potential NPL burden on the banking sector, although the authorities have been very wary of creating higher inflation, which would have potentially severe social and political repercussions.
Which leads them to conclude:
We continue to believe that whilst a full blown financial crisis may be unlikely over the short term, an eventual devaluation of the RMB remains a strong possibility, though in order to be effective, this would have to be accompanied by convincing measures to impose a hard budget constraint over the corporate sector and prevent the formation of potential new NPLs.