China's troubles deserve a closer look

IFR 2115 9 January to 15 January 2016
6 min read

IT’S BARELY THREE weeks since the US Federal Reserve raised interest rates but the concerns that had apparently caused the central bank’s policymakers to hold fire month after month – China’s shaky equity markets and scant evidence of US inflationary pressure – are again on full display.

China equities collapsed last Monday, prompting the newly installed circuit breakers to halt trading after a 5% decline in the CSI 300, which is comprised of the largest 300 stocks listed in Shanghai and Shenzhen. After the prescribed 15 minute hiatus in trading, on resumption, the index fell to the 7% daily limit whereupon trading is automatically halted for the day.

Chinese stocks again triggered the circuit breaker on Thursday, which turned out to be the shortest trading day in the 25-year history of the Chinese equity markets. I wonder if Janet Yellen et al are suddenly ruing their pre-Christmas gift to the markets on digesting this information.

In the meantime, oil fell to its lowest level in 11 years on Thursday. So if the Fed policymakers were expressing concern about the low level of inflation in the US as a reason not to hike rates over the autumn it’s difficult to see how that argument no longer applies. Show us the inflation. There isn’t any.

Against this backdrop, which looks as queasy as 1987, 1998 or 2007, Asia’s credit markets were remarkably sanguine. The iTraxx Asia index nudged up just 5bp last Thursday and after Monday’s China stock meltdown, remarkably, new issues from Asia managed to cross the line, including one from a first-time Chinese local government-linked issuer and another from Korea Development Bank, Asia’s go-to investment grade market reopener.

Nevertheless I can’t recall a less auspicious start to the year in the Asian primary markets. There are grumbles in some quarters that China’s now-defunct equity market circuit breaker actually caused much of the volatility, but the reality is that the global investment community is now beginning to ask some fundamental questions about the health of the Chinese economy – and the answers may be unsettling.

A SINGAPORE-BASED DEBT trader last week told me of the latest theory: that China’s economy is not just failing to grow at the supposedly crucial 7% clip, but that it is actually contracting. This is based on collapsing electricity utilisation rates in the world’s second-largest economy.

That’s the kind of rumour-mongering that could get you locked up for rather a long time in China. But the market will have to make do with the official national income accounting statistics from China for a while yet.

Whatever the true rate of growth, it seems fair to say all is not right with the Chinese economy, and the unexpected 0.5% weakening of the daily renminbi-US dollar exchange rate last Thursday reinforces that view.

I wrote in this column late last year that the renminbi was going to be in the cross-hairs for shorting and last week’s price action appears to be just the start. The offshore renminbi has lost almost 3% against the US dollar with barely a week of trading registered so far in 2016 and it appears that the Chinese financial authorities are perfectly happy to see it fall.

I suggested last year in this column that a round of default and restructuring of Chinese offshore debt – principally denominated in US dollars – of epic proportions was about to kick off.

I can’t recall a less auspicious start to the year in the Asian primary markets

IF YOU TAKE into account the fact that the renminbi has lost more than 6% of its value against the dollar since August, factor in sharp reductions in cashflow due to the China economic slowdown and question the will to repay offshore creditors – something I have done since the horrendous outcome of the Asia Aluminum restructuring of 2009 – I suggest that scenario is about to play out.

If I were an investor shown an offshore corporate bond from the sales desks of investment banks in Asia, I would suggest employing the old school approach that used to be applied to Indonesian high-yield credits. I would want to see at least two coupons in escrow and covenants of the full belt-and-braces variety. That’s for starters. I would probably want to see decent dollar cashflow on the balance sheet as well.

The truth is that I probably wouldn’t touch it, even if the 20% internal rates of return on offer before the global financial crisis, including sweeteners in the form of warrants, were thrown into the mix.

In the meantime, of course, there’s always something that should stand above the renminbi melee and that’s the Chinese domestic bond market. It’s easier to get in these days as an offshore investor and, with a rates backdrop that looks more certain than anything in any major global economy these days, you will probably make money.

Load up on duration in China bonds, because the Chinese authorities have more meat to slice off interest rates than anyone else. As for the credit part of that equation? I would just hope that my scare-mongering trader’s theory isn’t on the mark.

Jonathan Rogers