The ECB's China Challenge
Mario Draghi surprised everybody by announcing Thursday that the European Central Bank will buy investment-grade corporate bonds, a move that will reduce credit costs for companies and, he hopes, spur stronger economic growth. As soon as the ECB press conference was over, treasurers were questioning whether corporations from Madrid to Frankfurt would sell more debt as a result.
Chinese companies, however, may be happy to oblige. To make matters worse, their debt sales probably will be unhedged, which should trouble investors in Europe and regulators in China.
Corporate borrowers from China sold a record 11.1 billion euros ($12.4 billion) of bonds in the European currency last year, as investment-grade yields dropped below 1 percent. Expect more debt-shopping trips.
While companies from other emerging markets may follow, China is the nation most likely to make significant use of the cheaper money. The reason is that Chinese companies don't usually hedge their foreign borrowings.
If swapped to floating-rate dollars, which is what more conservative international treasurers do, the actual yield on euro-denominated debt is not so low. The ECB's unprecedented monetary easing has pushed the euro-dollar cross-currency basis swap, the instrument used to hedge bond cashflows in the single currency, to the lowest level in three years. The more it drops, the more expensive it is for borrowers to shift liabilities to dollars.
Years of yuan appreciation left Chinese treasurers with little incentive to hedge overseas borrowings: Not only did they get lower yields, the local-currency cost of their interest payments also dropped. That dynamic changed as the yuan depreciated against the dollar. The consensus forecast among economists surveyed by Bloomberg is for the yuan to end this year unchanged against the euro and almost 4 percent lower versus the dollar.
Paying a yield of less than 1 percent without hedging costs may prove hard to resist for investment-grade Chinese companies. That could undermine Draghi's efforts, as European companies may be unwilling to take the cheap debt.
European investors, faced with negative rates, will find Chinese bonds more alluring. They may be walking into a minefield: Investment-grade companies in China have started to lose their higher rankings amid a corporate debt pile that is already twice as big as the world's second-largest economy.
With more than $1 trillion in foreign bonds, these very leveraged corporations are adding to their risks by taking on unhedged obligations. Their expectations of yuan strength against the euro may be misplaced. In the last 12 months, the Chinese currency depreciated 8.9 percent against the single currency, while it weakened only 3.5 percent versus the greenback. The pattern could be similar this year, those forecasts notwithstanding.
With defaults and downgrades nearing record levels in China, European investors should be careful about chasing yields all the way to Beijing, and Chinese companies should weigh their offshore borrowing costs using more conservative metrics.
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