Yuan Bear in Wilderness in 2014 Now Warns of China Credit Crisis

Yuan Tumble Tests China’s Free-Market Resolve

In a March 2014 report, Daiwa Securities Co. economist Kevin Lai forecast a 10 percent drop in the yuan by the end of 2015 and warned China needed “very delicate” policy to avert a crisis. He’s still worried, and no longer so alone.

The currency has devalued 3.7 percent since Tuesday morning, when the People’s Bank of China cut its daily reference rate by a record and said it would let the market play a greater role in the fixing. Lai, whose uber-bearish prediction is now halfway to fulfillment, estimates China has some $3 trillion of dollar-denominated debt outstanding which has suddenly become more expensive.

“The PBOC is telling people that if they want to take their money out, please do,” Lai, chief economist Asia ex-Japan, said in an interview Wednesday. “As the selling pressure increases, this could spin into a currency and a credit crisis. They’re exporting the crisis.”

The yuan’s tumble roiled Asian currencies and equities this week, even as the central bank said there’s no economic basis for a continuous fall. The cost to insure Chinese government debt against nonpayment rose to the highest in two years, advancing six basis points Tuesday to 107.5 basis points, according to data provider CMA.

Chinese corporations have sold bonds and gotten bank loans offshore at a record pace in the past three years and now are the biggest component of major fixed-income indexes in the region. These issuers will buy dollars as they seek to protect themselves from the currency move, Lai said, increasing the pressure on the yuan and making it even more difficult to pay back their foreign dues.

Unwinding Trades

In his March 2014 note and a subsequent report in October, Lai outlined how fake export invoicing, metals purchases and disguised foreign investment had driven $1 trillion of short-term speculative flows into China. He sees the yuan falling to 6.60 per dollar, or more, by the end of 2015, from 6.44 now.

Royal Bank of Canada earlier this year cut its yuan forecast and now sees 6.56 per dollar, while other banks are also cutting their expectations.

China has used the past two years to crack down on the carry trade that saw borrowed dollars pumped into its economy. The government intensified a probe into irregularities in the country’s trade figures last year, uncovered fraudulent copper dealings and cracked down on illicit shadow financing.

“It is a lot of leverage and we may be just at the beginning of the unwind,” Lai said. “The PBOC can transfer the pressure offshore, they are saying you guys, foreign demons, have to foot the bill.”

Currency Outflows

Already there are signs of cash draining from the country. The one-year sovereign yield jumped 20 basis points in two days and the similar interest-rate swap rose nine basis points. The PBOC is likely to lower bank reserve requirements and use other alternatives to replace cash leaving the country, according to economists from JPMorgan Chase & Co. to HSBC Holdings Plc.

Currency reserves have slumped $315 billion in the past year to $3.65 trillion and Bloomberg Intelligence estimates that every 1 percent yuan depreciation against the greenback triggers about $40 billion of outflows.

Asia’s largest economy expanded 7 percent in the first two quarters, the slowest since 2009, as the outflows drained a source of funds. Aggregate financing slumped to 718.8 billion yuan ($111.5 billion) in July from 1.86 trillion yuan originally reported for June, central bank data showed Tuesday.

There’s some $8.5 billion of dollar- and euro-denominated loans and bonds from China coming due in the next six months, Bloomberg-compiled data show, though Lai suggests the number may be bigger.

Among the companies that have to pay back international investors are developer Glorious Property Holdings Ltd., billet-producer China Oriental Group Co. and Hidili Industry International Development Ltd. All three are rated in the C category, which suggests a very high chance of default.

Chinese home builders with junk ratings have $28.6 billion of dollar notes outstanding, meaning that a 3.5 percent devaluation in the yuan threatens to add $1 billion to their debt servicing costs. That adds to stress as the industry grapples with excess inventory, following the first default on dollar notes by a Chinese builder when Kaisa Group Holdings Ltd. missed a payment in April.

“Our view has been that the number of defaults will increase,” Lai said.

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