UBS Raises Flag on China’s $1 Trillion Overseas Debt Pile

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The Renminbi
The renminbi is heading for a 2.8 percent loss in 2014 as the dollar gains on Federal Reserve plans to raise interest rates and the People’s Bank of China cuts borrowing costs to support a flagging economy. Photographer: Brent Lewin/Bloomberg

UBS Group AG is flagging risks from China’s $1 trillion worth of unhedged foreign debt as forecasters see bets against the greenback unwinding in 2015.

The world’s second-largest economy is exposed to shifts in currency and interest rates as never before because of expanding international trade and easing foreign-exchange regulations, said Stephen Andrews, head of Asia banks research in Hong Kong at UBS. Daiwa Capital Markets has a $1 trillion estimate for carry-trade inflows since 2008, bets on the difference between yields in China and overseas. It sees a 5.7 percent drop in the yuan next year.

The renminbi is heading for a 2.8 percent loss in 2014 as the dollar gains on Federal Reserve plans to raise interest rates and the People’s Bank of China cuts borrowing costs to support a flagging economy. Capital controls and record foreign-exchange reserves will help the PBOC cope with any similar situation to 1997’s Asian financial crisis, when firms struggled to repay debt as currencies slumped, Andrews said.

“This could get very uncomfortable very quickly,” he said in a Dec. 12 interview. “I boil it down to its basics. You’ve borrowed unhedged and leveraged: you’re at risk.”

Andrews says the mechanics of what’s happening are this: mainland companies deposit 20 percent to get a letter of credit from an onshore lender. They take that document to get a low-interest dollar loan from a Hong Kong bank, which treats it like a no-risk check fully backed by the guarantor.

Leveraging Up

The companies flip those dollars back to the mainland, where they use them as collateral to get even more letters of credit, leveraging even further, said Andrews. That money is then used to invest in China’s high-yield and often risky trust products or in the booming stock market. The profits are then used to pay off dollar borrowings.

Hong Kong banks mainland-related lending stood at HK$3.06 trillion ($394 billion) at the end of September, 14.7 percent of total assets, according to the city’s monetary authority. Andrews said his estimate is higher as he includes trade bills and other forms of lending not captured by the data, such as between sister companies in intergroup corporate transfers or letters of credit between onshore and offshore bank branches.

“There were too many cheap dollars in the market for everyone to borrow,” Kevin Lai, an economist at Daiwa in Hong Kong, said Dec. 16. “If you just put the money in China, the carry plus appreciation is about 5 percent, so why not, right?”

Lai estimates $1 trillion of carry-trade inflows since the first round of U.S. quantitative easing in 2008, of which $380 billion entered China disguised as commerce flows.

Carry Trades

Global markets became flooded with cash after the Fed started the bond-purchase program. Meanwhile, steady growth and tighter monetary conditions pushed up yields in China, widening their premium to similar U.S. securities. The gap between 10-year Chinese and U.S. sovereign yields rose to a record 235 basis points in 2011. It has since shrunk to 140 basis points.

Chinese companies issued a record $5.4 billion of bonds offshore that were supported by standby letters of credit from national banks this year, according to data compiled by Bloomberg. The 18 securities compare with only four last year and two before 2013 in data going back to 1999. They sold a total of $224.8 billion of notes offshore in 2014.

Limited Similarities

Andrews says the similarities between pre-Asian financial crisis Thailand and China today are limited. The amount involved is still small relative to China’s $9.2 trillion gross domestic product. The nation’s overall loan to deposit ratio is healthy and China has foreign-exchange reserves that peaked at $4 trillion in June, he said.

Chen Long, Beijing-based China economist at research consultancy Gavekal Dragonomics, said China’s overseas debt has been growing in line with the economy and banks are healthy enough to absorb any changes in interest rates or currencies.

“The renminbi is controlled by the People’s Bank of China and no one has enough resources to bet against the PBOC’s foreign-exchange reserves,” he said.

The yuan has dropped to 6.2280 a dollar as of 10:11 a.m. in Shanghai today, its first annual loss since 2009, as monetary policies in the world’s two largest economies diverge. A month after faster jobs growth allowed the Fed to end its record stimulus in October, paving the way for an expected rate increase next year, China lowered loan rates for the first time since 2012. The Bloomberg Dollar Spot Index has advanced 11 percent in 2014.

Carry trades may become less active next year, reversing the trend of inflows, Hao Hong, head of China research at Bocom International Holdings Co., wrote in Dec. 17 note.

Fake Trade

While China had a trade surplus of $57.47 billion in November, export growth slowed to 4.7 percent due to a government crackdown on fake invoicing. Shipments to Hong Kong grew 1 percent, compared with surges of 24 percent and 34 percent in October and September. Currency reserves declined to $3.89 trillion at the end of the third quarter.

“For many years China offered high yields, absorbing a lot of dollar liquidity,” Daiwa’s Lai said. “Much of the supposedly healthy trade surplus is fake, just short-term speculative carry-trade inflows. When the money leaves, the impact may be huge.”

While lending to Chinese firms with letters of credit shields the city’s banks from corporate risks, this has left them exposed to China’s financial system, said Sabine Bauer, an analyst at Fitch Ratings Ltd. in Hong Kong. China’s bad loans jumped by the most since 2005 in the third quarter.

“If there are problems in the Chinese banking system, either real or perceived, that could spill over to the Hong Kong banks and their liquidity may tighten as well,” Bauer said.

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