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The Big Conversation

Episode 70: Are Chinese authorities tightening their policy?

This week we look at the latest Chinese data and the signs that the authorities are starting to tighten their policy and reign in the excess credit from last year’s support programs. The troubles at asset manager Huarong could be a sign that policymakers will now tolerate higher levels of credit impairment. In this week’s Chatter, Refinitiv’s lead analyst for carbon markets, Ingvild Sorhus, outlines the challenges that the European market faces, now that speculators are starting to take an interest.

  • Roger Hirst: Over the last few months, we've seen a significant rebound in Chinese data, which has benefited from the base effects of year-on-year comparisons. Now, obviously, this comes with the caveat that China's data is probably massaged for release. But when China booms, other emerging markets usually catch fire. Not however this time. EM currencies have lagged many of their G7 counterparts. EM equities have underperformed the US for most of this year, and even China's benchmark equity indices have been weak. In recent years we've often seen Chinese equities diverge from global equities ahead of broader market pullbacks. So the recent weakness is a cause for concern. And now difficulties at a major government-backed asset manager have highlighted the risk that Chinese authorities may be removing their unqualified support for markets and investors. In this week's Big Conversation we will look at the implications that a Chinese pivot could have on global asset prices.

    Last year, China's credit boom went back into overdrive as it sought to recover lost output from the effects of the pandemic. Social financing, one of the broadest measures of government support, hit a new annual record. Now China has been increasing its social financing pretty much every year for two decades, although when measured against GDP, it has actually been flatlining since that first spike during the 2008 crisis. Last year, however, saw a marginal new all-time high in the credit to GDP ratio. And China has long been the king of credit, where domestic issuance through state-backed entities has dwarfed the efforts of US commercial banks. After briefly putting on the brakes in 2018, china reverted to type in order to deal with the pandemic. Other global central banks also opened the floodgates. China wasn't acting in isolation, but they focused on a supply-side response, bidding up raw materials rather than supporting wages. But the size of the rebound in China may well have overshot the aims of the authorities. It may even be that the authorities are happy to massage the data higher to make it clear that a tightening is now needed. Even by China's standards, the 18.3% annualized Q1 GDP growth estimate released last week, looks like an overcooked rebound. As a result there are tentative signs that Beijing's policymakers are beginning to apply the economic brakes. Some of China's data was given added impetus by policies that encouraged people not to travel for the traditional Lunar New Year. It meant that people took less time off work than usual for the festive period, and fewer working days were lost than in previous years. And although social financing looks set to fall, it nearly always gets ramped up ahead of the New Year. And 2021 was no exception. So it's no surprise that the rebounds have become supercharged, even allowing for year-on-year comparisons. And even if we can see that China cherry-picks its data, its publication therefore highlights the leadership's political thinking. Showing extremely strong data conveys the message that China has successfully recovered from the pandemic and can now start reversing course back to the direction it had taken in 2018, where a domestic focus had started to take priority. In the meantime, exporting last year's buildup of consumer goods will help to smooth the transition and reduce the social cost that it may incur. China's goods exports jumped over 60% year on year in dollar terms from February last year, well above expectations. China needs to sustain that export growth to offset any tightening of domestic credit, although it dropped below forecast for March, these are historically high numbers, but it is unlikely that they will be sustained if the pre-pandemic levels of 2019 are a guide. Although it's very hard to make year-on-year comparisons considering the extremes experienced during this period last year, it does look like the authorities are now shifting their stance. Even the slightest tightening can manifest itself in extreme action if companies have been overzealous in former periods of easy credit. One such Chinese entity, Huarong Asset Management, saw a collapse in bond prices and a massive surge in the price of its five-year credit default swap, which was triggered when it missed a deadline to release its 2020 financial reports. According to Japan's Nikkei Shinbun paper, various Huarong entities have assets of about 260 billion, with total debt between 162 billion and 209 billion. Huarong has 44 billion of outstanding bonds, of which about half are dollar-denominated and due within a year. Huarong is one of a group of companies that was set up to deal with some of the bad debts of China's largest state-owned banks. With its implicit backing from Beijing and associated top bond ratings, Huarong borrowed heavily and expanded across many business lines. After days of silence, China's financial regulator announced last Friday that the bad debt manager was operating normally and had ample liquidity, its first official comment since the company jolted Asian credit markets at the end of March. But the regulator's statement was hardly a full-throated pledge of government support, even though it did arrest the plunge in the company's bonds and credit default swaps. Yields on the bonds are still well above where they were a mere two weeks ago. And market rumors persist that Beijing's regulators plan to impose losses on Huarong bondholders in a debt restructuring. That would be the nation's most consequential credit event since the late 1990s and the clearest sign yet that Beijing is serious about reducing the moral hazard of its 54 trillion dollar financial industry. Although the government has stabilized the market and provided assurances after some bonds nearly halved, it looks like Huarong bondholders could still lose between 10 and 20 cents in the dollar. And obviously that has implications for all foreign holders of corporate bonds because it means that the state put is no longer at 100. And that means investors could recalibrate China as a destination for capital. It might also trigger the beginnings of a scramble for U.S. dollars from the Chinese corporate sector. China's FX reserves have been stable at three trillion dollars, but as a percentage of GDP, they have been in a sharp decline for the best part of a decade, indicating to the potential sensitivities to internal issues that are actually increasing on a relative basis. The challenge for Beijing is to sustain its growth whilst simultaneously reining in that wildcat finance. Of course, that risks both financial instability and rising unemployment, which is something the authorities have largely tried to avoid. But how serious is Beijing about reining in those government guarantees and moral hazard? And what will be the effects of China does engage in serious tightening? Clearly the authorities belatedly recognise some of the dangers associated with market distortions, resource misallocation and structural impairment. They are probably also quite apprehensive about the size of the central government obligations that will be required for massive bailouts and recapitalizations. Some analysts have suggested that Chinese banks have lent trillions of dollars to the asset management companies, essentially providing the funds necessary to offload the banks' non-performing assets. This conveniently gets low-quality loans off the banking system's books, though the problems are then allowed to fester on the asset managers balance sheets, reminiscent of how the U.S. savings and loan industry mushroomed from a few billion-dollar problem to a several hundred-billion-dollar fiasco in the 1980s and 1990s. Actual Chinese bank non-performing assets could be 15 to 20% of the total vs. about 2% reported today, which implies a problem approaching 10 trillion dollars. And with bank loans expanding at an unprecedented four point two trillion dollars over the past 15 months, it's a fair bet the problem loan issue is poised to get a lot worse, especially if China continues to tighten credit. The entire Chinese credit edifice has become too big to fail, which, just like in the US and Europe, has generally been viewed in a positive light because of that implicit support. But equally, policymakers could now readdress the risks of excess credit and leverage as part of the pivot away from production and towards consumption. The credit binge through 2020 was a necessary response to the pandemic, which has been repeated by policymakers the world over. Whilst Western policymakers have taken the view that excess credit can continue unless it's a real response from inflation, China has been grappling with a policy shift to curb speculation since well before the pandemic. The worry is that Beijing is only starting to implement very cautious tightening measures, and yet we're already witnessing a major blow-up. Many people will therefore again be looking for a real credit crisis to commence in China, where marginal borrowers might lose access to cheap capital, whilst debt in peripheral credit instruments starts to see an exodus that builds momentum before investors can escape. There will also be the typical and in many ways well-founded concerns that China's financial system will start to come under pressure. However, these issues have been something of an investor's graveyard over the last decade. Perhaps of greater concern is that the Chinese authorities would be happy to let their currency slide in order to help shift the backlog of export inventory that was built up whilst the rest of the world was still in lockdown. Over recent sessions. We've actually seen small but steady gains by the Chinese currency against the dollar. But the dollar index is now at a key juncture. Further weakness would be a relief for emerging market assets which have been struggling recently. If dollar strength resumes, however, then the DXY could be carving out a bottoming formation that could target a level of 99. As we've already seen, a stronger US dollar leads to EM equity underperformance relative to the US. The Indian stock market would be particularly vulnerable, given that it has tended to retrace at least 38% of all the major rallies since 2000. And a stronger US dollar would also have an impact on the performance of commodities such as copper, which benefited from China restocking last year, as well as the weakness of the dollar through the second half of 2020. Over the longer term, the relationship between the dollar, here inverted, and commodities such as oil is relatively clear. Therefore, a stronger dollar would severely curtail the reflation trade. This is why for global investors, the biggest threat from China is not a sudden credit crisis, but an adjustment that sees a Chinese currency decline from current levels. That might accelerate outflows and drive demand from Chinese corporates for the U.S. dollar to offset their debts. Whilst China will continue to shield its corporates from the worst of any credit crunch, the recent weakness in the Chinese equity market may maybe an indication that policymakers are in it for the long run with a domestic focus that would have significant repercussions for global risk assets. And one of China's policy changes on the domestic front is a focus on global leadership in green technologies. In Europe, the carbon market is now starting to reach a critical mass that's drawing in the non-corporate sector investor. And in the next section, I talked to Refinitiv's Ingvild Sorhus about these developments.

    Regardless of people's views on the carbon markets, the largest one, the European trading system, appears to have reached an inflection point which has ignited interest from speculative money. Although historically that should help to increase liquidity, it may not be plain sailing if prices move faster than corporates can adapt. Ingvild explains the basic concepts of the market and the issues at hand.

    Yeah, so the EU emission trading system or kind of the European carbon market, is a policy instrument, so it's one of the tools in that policymakers have in their toolbox, in how to meet climate targets. That's been kind of up and running since 2005. There has been some kind of issues, has been suffering from oversupply, that you have allowed more emissions than the actual emissions have been. But you have had kind of policy fixes on the road. So now you have a system that you have confidence in and that is actually delivering a carbon price, which kind of drives emission reductions in Europe.

    So how is it, how is the market structured and how is it sort of set up and who are the key players in order that these greening targets that have been set in Europe can be reached? What is the main sort of mechanism and who are the main players at the moment?

    Yeah, so it's really set up for industry and power sector, so it's for industry and power, they need to report on their emissions on a yearly basis and have to hand in emission allowances that corresponds to their yearly emissions. So that's kind of the key players in the market. And, of course, you have set a cap on how much emissions you are allowing in the system. And these kind of power and industry players need to make sure that the emissions are below this cap. So how these emission allowances are coming to the market is either via daily auctions. So, for instance, if you're a power company, you need to buy on on the market and have to pay the price, the market price of a carbon allowance. Whilst industry is a bit different because they also get free allocations. So if you're an industry player, you will receive some of the emission allowances that you need for free. And that's because, I mean, for a lot of the industry players, there are, they are competing on a global playing ground. So you don't want industry to move out of Europe because you have this carbon cost in Europe that you don't have in other parts of the world. So the risk kind of to minimize this risk of 'carbon leakage'. And then you also kind of have these emission allowances that are traded on exchanges. So then anyone can really kind of participate in in the market. And of course, power and industry sectors have to be in in this market because they need to. But then we have seen also kind of there are other actors in the market. So financials, hedge funds, which see this as an interesting market, and especially now with last year, when you regain confidence that the European emission trading system is a tool that will actually deliver a carbon, a carbon price signal, that will lead to a greening of the European economy.

    And as you mentioned, there are new actors coming into it, so we're starting to see financial players coming in. What are the challenges that that's going to pose going forward? Because this 10 year plan, is there going to be some problems or distortions created by kind of non-corporate and non-industry players coming in and getting involved in this market?

    You just raised the ambition for the 2030 target for Europe, or you're finalizing the final goal now. But in December, you had all the member states in EU agreeing that you were going to lift the emission reduction target from 40% to 50%, at least 55% by 2030, which is kind of a massive increase in ambition. So of course, that has been partly responsible also for the upturn you've seen in prices since November, really, combined with fundamental factors like you had a really cold winter, more power demand, high gas prices. So so you really had to have a high carbon price in order to kind of release some of these emission reductions that you see taking place when you have a high carbon price, for instance, switching from coal to gas. But of course, in the summer, you kind of you can say that you now have fixed the overall target, which is, I would say the easy bit, because now you have to really dig into all the details in all kind of sort of legislation on how these changes should be implemented also into the EU emission trading scheme. And in the summer, the European Commission will come out with their proposal on how you should kind of revise the whole framework and the rules and regulations on how to meet this new target. And of course, if you see prices are rising and policymakers will have this, if kind of they think that this price rise, or if you see prices continuing to rise without kind of any kind of fundamental reasons behind it or any kind of policymaking behind it, then maybe you get more resistance to make all these changes that you need to do. You need kind of the common support from everyone that this is not squeezing out emitters from Europe, but actually are delivering a price signal that will lead to this green transition that the world needs.

    The success of the latest iteration of the European carbon market appears to be a double edged sword. Rapidly rising carbon prices could push companies out of Europe if costs rise too quickly compared to other jurisdictions. As ever policymakers will have to walk a tightrope between achieving their goals but without encouraging companies to relocate or not invest in Europe at all.