- Hao Hong at Bocom International sees strains in property, debt
- ``All roads to hell are paved with positive carry,'' Hong says
One of the few forecasters to predict both the start and peak of China’s equity boom is now warning the nation will be buffeted by the same forces that caused financial crises around the world over the past four decades.
Hao Hong, chief China strategist at Bocom International Holdings Co. in Hong Kong, says a shortage of dollars was the common feature in the oil rout in the 1970s, Latin American debt turmoil in the 1980s, the Asian currencies collapse in 1997 and the global crisis in 2008. Next year will see Federal Reserve interest-rate increases, an improving U.S. current-account balance and a stronger greenback, putting strains on the most-leveraged parts of the world’s second-largest economy, he says.
"Historically, every time the U.S. current account improved, concurrent with dollar strength, some country somewhere in the world plunged into some sort of crisis," Hong said. “The pressure from a Fed tightening and thus a dollar liquidity shortage scenario will more likely show up” in Hong Kong property as well as China’s online lending and high-yield corporate bonds, he said in an interview.
The yuan, for many years Asia’s most-profitable carry trade when adjusted for volatility, has weakened 4.2 percent against the dollar in 2015 as the yield advantage of China’s sovereign debt over U.S. Treasuries fell to the narrowest in five years. Chinese companies that borrowed in foreign currency at a record pace in the past three years are now buying dollars to protect against losses. Hot money that entered China with fake export invoicing, metals purchases and disguised foreign investment is now heading for the exit.
“All roads to hell are paved with positive carry,” said Hong. “Over the past few years, one of the biggest carry trades was to borrow dollar debt unhedged given the one-way expectation for yuan appreciation. We are seeing companies paying down dollar-denominated debt fast, and thus alleviating some of the risks, but not all.”
The yuan strengthened 13 percent against the dollar in the four years through 2013, before retreating 2.4 percent in 2014. This year’s loss is set to be the biggest in more than two decades. The currency’s Sharpe ratio, a gauge of rewards that factors in the risks investors take, is the highest among 22 emerging markets for the period since 2010, reflecting its appeal to investors who buy higher-yielding currencies with funds borrowed in countries that have lower interest rates.
With online financial services exploding, the total amount of outstanding peer-to-peer loans in China stood at 351 billion yuan ($54 billion) in October, according to iResearch Consulting Group, and Hong highlighted this as an area that’s experienced a hefty buildup in leverage. Hong Kong’s house prices, which more than doubled from 2009, may drop as much as 20 percent in the next three to six months, Bocom forecast. Dollar bond issuance by Chinese companies increased every year since 2008, jumping to a record $94 billion in 2015 from $2.4 billion seven years ago.
The yield premium that investors demand to hold dollar-denominated high-yield Chinese bonds over U.S. Treasuries declined to a two-year low of 607 basis points in October and was at 705 basis points on Dec. 22, according to Bank of America Merrill Lynch data. The credit spread is “not enough to justify its risks,” Hong said.
Chinese companies are struggling to generate the cash flow needed to service their obligations as economic growth slows to the weakest pace in 25 years and corporate profits shrink. While the debt burden has been eased by six central bank interest-rate cuts in 12 months and a tumble in corporate borrowing costs to five-year lows, the number of defaults is on the rise. The amount of bad debt reported by Chinese banks rose 10 percent in the third quarter from the previous three months to 1.2 trillion yuan.
The Communist Party’s Politburo vowed on Dec. 14 to prevent systemic financial risks in 2016, according to a statement on the State Council’s website after a meeting chaired by President Xi Jinping. China listed de-leveraging as the government’s major task next year, along with cutting industrial capacity and lowering corporate costs, Xinhua News Agency reported Dec. 21, citing a statement released after an economic planning meeting attended by the nation’s leaders.
The prospect of further easing in China and interest-rate increases in the U.S. risks accelerating capital outflows. Financial institutions including the People’s Bank of China sold 221 billion yuan of foreign exchange in November, a sign funds are heading overseas. In the U.S., Federal Reserve officials forecast borrowing costs will rise to 1.375 percent by the end of 2016, implying four 0.25 percentage point moves. The gap between Chinese and U.S. five-year government bond yields has narrowed 86 basis points this year to around 100 basis points, lessening the appeal of the Asian nation’s notes.
The Fed’s trade-weighted dollar index reached a 12-year high on Dec. 17 as the world’s largest economy strengthened and a rout in emerging markets propelled the greenback higher against the currencies of a broad swathe of U.S. trading partners including China. That followed an improvement in the U.S. current-account deficit, which was equivalent to 2.5 percent of gross domestic product in September, down from 5.9 percent a decade ago.
Hong recommended investors stick to assets of companies that have relatively low balance-sheet leverage in 2016 given the elevated risk of a liquidity event. He forecast the yuan will depreciate by 5 percent versus the dollar in 2016 and estimated that fair value for the Shanghai Composite Index is around the 2,900 level, implying a 20 percent decline from Wednesday’s close.
The yuan was little changed at 6.4778 a dollar in Shanghai, while the 10-year yield fell four basis points to 2.84 percent. The benchmark stock index fell 0.4 percent to 3,636.09.
Hong turned positive on Chinese stocks in September 2014, saying government support for the market meant it was "time to throw our senses out of the window," ignore weakening economic data and buy on dips. The Shanghai Composite more than doubled from the time of his recommendation through its June 12 peak. In a June 16 interview with Bloomberg Television, Hong said China’s stocks were heading for a "notable crash" after entering a bubble. The equity gauge plunged 40 percent from that date through its low on Aug. 26.
“In the new year, the challenge is that we become too complacent with our reform achievements, and lose sight of risks of financial contagion as China’s financial system gradually opens up,” Hong said. “Risks will also flare up in other unexpected sectors with high leverage should the U.S. rate hikes progress faster than expected.”