Daiwa: China risks financial crisis

A Chinese investor monitors stock prices at a brokerage house in Beijing this week

While the world waits anxiously for the Fed to raise interest rates (or not) this week and the memory of China’s recent stock market crashes and yuan devaluation remains fresh, Daiwa predicts worse is to come for the world’s second largest economy.
“The debate right now is not between the soft landing or the hard landing; it is not relevant anymore. The debate should be between a hard landing or a possible financial crisis in China,” analyst Kevin Lai said.
Mr Lai, who has a bearish track record for accurate prediction, sees an ever-strengthening US dollar, over-leveraged China debt – as well the tapering off of the US’s quantitative easing and money outflows from the mainland – reasons to believe China must allow the yuan to come down significantly more. If not, there will be two grim “end game scenarios”. The first: staunchly defending the yuan “will be hugely deflationary”. The second, printing money to avoid a credit crunch, could bring the currency “down quite massively possibly 30 to 40% – a currency crisis.
Lai estimates the probability of the last two outcomes at around 30% each. He believes the possibility of the first scenario is 40%, where the yuan is allowed a lightly controlled float down. “I believe the government will try to manage an orderly downward adjustment. There will be some intervention from time to time. He added, “In that case there will some monetary easing, some further interest and reserve ratio cuts; the pace could not be too rapid but here won’t be any massive stimulus program because the PBOC cannot do that under that scenario.” Meanwhile, “the government quietly tightens capital controls.” The choice is very clear. If China wants to counteract inflation as well as recession it has to ignore the currency and start to be more aggressive on its monetary policy.
Lai warns that under the second end game scenario where “lines in the sand” are drawn, he argues, 6.40 yuan and 7.40 to the dollar, “of course if they try to defend it, it will be painful; it will be costly.” This because BOP surpluses indicate the quantity of US dollars converted into yuan over time between the inter currency rates of 6.40-7.20 and 7.40-8.30 to the dollar would lead to where the majority of long covering is found: “Most of the CNY (yuan) longs (USD1,740 billion and USD 1.293 billion)” respectively “are concentrated in these two ranges”.

Kevin Lai, analyst, Daiwa

If the first line of defense at 6.40 “is broken we would expect more aggressive CNY long covering and any FX intervention would be a lot more difficult and costly”. He added that the “PBOC will sell the US dollar; the treasury to defend it, leading to massive money or credit contraction… little currency depreciation but the effects will be severe, will be a domestic credit crisis”. If the second rate defending point at 7.40 is breached, “we would expect even more covering. By then FX reserves would have run down and any further intervention would be would be a lot more difficult and costly”. If however the 6.40 to the dollar is successfully defended, “the rest of the world should be OK because (they) will be happy to see the yuan staying at 6.40”.
Going back to the other end game scenario that Daiwa considers undesirable, “By printing money and taking interest rates down to zero to protect the monetary base” and thereby “save credit” China, along with “massive fiscal stimulus, a lot of bailouts a lot of bank recapitalization, will ignore the currency. But “it will not just be down by 5 to 10%, it will down quite massively possibly 30 to 40%, a currency crisis. In fact many emerging markets’ economies in the past have chosen this scenario.” In that case, the cost of fallout looks like “the rest of the world will be in a state of shock because the pressure will be on everybody else”.
According to Daiwa the Chinese economy has become vulnerable because of the stronger US dollar and the likelihood of Fed interest rate hikes. While the dollar had been allowed to fall to help American exporters and the economy recover from the global financial crisis of 2007-8 there have been many calls in the US to normalize interest rates from an unhealthy, prolonged – and artificial – historic rock bottom. Excessive liquidity and easy credit has spread around the globe in terms of unsustainable leveraged debt. That will be a “big problem” when rate hikes come said Lai.
“If somebody’s leverage is ten times 1%, increase in interest rates will be about 10%. The world outside the US has over USD9 trillion leverage up from 3 trillion ten years ago. China’s leveraged debt according to Lai is far more that usually estimated “close to $US3trillion, 3 trillion leverage compared to 3.5 trillion in foreign reserves, the balance is already quite tight”.
He added the underestimation stems from “hidden” debt being taken out in Hong Kong, Singapore and the Cayman Islands as well as in the EU on behalf of China and Chinese companies, not included in regular assessments. Robert Carroll, Hong Kong, MDT Correspondent