China's Deleveraging Puts the Yuan Closer to a Free Float
China's financial markets are fascinating to watch these days. Efforts by officials to decrease the nation’s enormous debt pile without destabilizing domestic markets are having profound consequences, most visibly in the bond market, where the yields on short-term debt have risen above those on longer maturities for the first time. The implications are more than just academic. In fact, they will likely pressure China to allow the yuan to become a free-floating currency sooner rather than later.
Market historians know that an inverted yield curve generally means tougher economic times ahead and the potential for capital flight. Presumably, China knows this as well, which is why it has embarked on a flurry of initiatives to give foreign investors broader access to the nation’s markets. China’s State Administration of Foreign Exchange allowed foreign investors to hedge onshore yuan forwards, Chinese government bond futures were launched by the Hong Kong Exchange, and China Bond Connect was established to provide mutual access between mainland and Hong Kong bond markets. And by year-end, China could be included in major bond indices, resulting in an estimated $250 billion flowing into its debt securities as global investors scoop them up to maintain pace with changes to benchmark indexes.
Although China’s situation is unique because of the state’s control of banks and currency, there’s still a big risk in capital outflows, which have totaled $700 billion since 2014. That’s why financial liberalization is more than likely to intensify. But, if not done properly, greater access to Chinese capital markets can invert the yield curve more severely, and exacerbate the pace of debt deleveraging and capital outflows.
Think of it as tightrope policy, with the People’s Bank of China managing liquidity in the financial system and the government managing financial regulation to contain excess leverage. Just look at China’s debt position relative to other Asian nations. Foreign investors hold a significant portion of their external debt following a surge in issuance. If China’s financial liberalization policies continue, it is likely that external corporate debt issuance will pick up to meet foreign demand.
The flip side is that corporate issuance of local, or yuan-denominated, debt may contract, mostly as a result of the regulatory environment. Unlike external debt, China’s local corporate issuance has been explosive compared with the rest of Asia. But given that more than 40 percent is held by domestic funds and “shadow banking” institutions, any drop in issuance would only partially be offset by demand from foreign investors. In fact, corporate debt issuance in China could fall sharply, from $1 trillion in 2015 and 2016 to somewhere in the $200 billion to $300 billion range this year.
One byproduct of this sharp credit contraction would be a normalization of corporate bond risk premiums relative to option adjusted spreads on indexes. That’s driven by greater liquidity risk as the investor base for local corporate debt shifts to external debt. This process is already well under way, with AA- and lower-rated Chinese corporate bond spreads widening sharply since the fall of 2016. This widening is likely to continue as the yield curve stays inverted and deleveraging picks up.
Perhaps the fallout from China’s credit contraction on the economy is larger than feared. The 12-month percent change in the credit impulse index is showing a drop similar to that during the 2008 global financial crisis. China’s economic surprise index, however, has been on the rise due to a combination of improved manufacturing, trade and real-estate investment driven by a weaker yuan and the large amount of credit creation in 2015 to 2016. Yet history shows that positive economic momentum tends to roll over a few months after the credit impulse index contracts.
A slower economy is all the more reason for China to allow foreign capital to flow into the economy, putting more pressure on officials to allow the yuan to float more freely, perhaps as soon as this year. Central bank policy stipulates that the yuan is restricted to moves of no more than 2 percent either side of the reference rate. A quicker transition to a market-determined exchange rate would allow China to stem the drop in foreign-currency reserves, maintain control over domestic monetary policy, and deter political criticism of currency manipulation. In the case of China, it has become necessary to provide foreign investors greater capital market access to cope with the negative effects of debt deleveraging. Liberalizing capital markets is generally not achieved without liberalizing the exchange-rate mechanism.
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