The markets seem impervious to anything that is not good news. A burning pandemic and rising deaths; no problem, softening retail sales and downward economic indicators; no problem, rising jobless claims; again no problem. It seems that nothing can stop this raging bull or prick this bubble, whichever way your thinking is so inclined.
There seems to be an ever permanent promise of stimulus – it’s coming – it’s only a matter of time - to keep the positive sentiment alive. Oh and it’s going to cause inflation apparently, lots of it, like the last lots of stimulus were suppose to (only this time it’s different – of course).
Markets seem not to agree, but we at MacroTOMI aren’t as convinced that stimulus begetting stimulus is going to kick start the economy, post vaccine; into a roaring, healthy growth engine. We have written about a few different scenarios that could play out, ‘black swans’ if you will, that could alter the status quo (read: The Black Swan that breaks the Camel’s back).
One of those such scenarios is the coming apart of an emerging market country’s Sovereign Debt Market and/or a sovereign default(s). We’ve had our eye (and still do) on Brazil, Turkey; possibly South Africa, Russia and Mexico.
But there is another BRICS country that we think requires more attention, China. My colleague wrote recently about China’s history with default which provides interesting context (read: Financial Storm’s Last Port: Sovereign Bonds).
China is the world’s second largest economy and often not seen anymore as an emerging market. China also has the world’s second deepest bond market – about $15 Trillion in size. But what is quite concerning is that given how big that debt market is, its oversight, transparency and functioning, is much more aligned to that of an emerging market economy than a mature one.
Depending on the ratings source, approximately 60%-70% of all outstanding Chinese corporate and Government debt was rated AAA. Most of the rest was AA. AA- is the minimum required to raise new bonds on the debt markets. This year saw only 5 of 5,000 Chinese corporations downgraded below AA by domestic ratings agencies.
This never mattered – it was assumed that a planned and controlled economy would plan and control debt repayments too and that it was assumed (not so much unlike the Fed these days), that the Chinese Government as lender of last resort would make good on all of it’s quasi-government agency issued debt.
No so, as it happens; two Chinese State Owned Enterprises (SOEs) recently defaulted on their debts.
Yongcheng Coal & Electricity is one such Chinese SOE that failed to make interest and principle payments on 1 billion Yuan of debt on November 10th.
Huachen Automotive Group, another Chinese SOE, defaulted on a 1 billion Yuan bond in October. Both were rated AAA.
Curiously, it was announced this week that the former general manager of one of the two big credit ratings agencies, Golden Credit Ratings, would be prosecuted for taking bribes from debt issuers who were covered by the agency.
Foreign investors have had considerable appetite for Chinese Sovereign and corporate debt, as with other instruments, ignoring risk to follow the yield; with these new events coming to light, Chinese debt yields are rising (and representing rising capital loses for already existing holders).
The vast majority of Chinese debt is onshore, local currency denominated. Which means that China could, in theory, print its way out of a mess. While China’s corporate debt ratios are lower by advanced economy standards, and China itself is sitting on over $1T in US Treasuries, a Sovereign default is a highly unlikely event. But what is much more likely, is a disorderly unraveling of highly indebted SOEs and Corporates that were assumed to have AA ratings or higher, but are in fact junk or lower.
It’s estimated that as much as $1T of Chinese debt is USD denominated.
Another headache for China is the large amount of its external lending. Huge numbers have gone to Belt and Road initiatives, some years surpassing the total World Bank issuance of that year. Additionally, several developing countries have lending arrangements with China, of which many of these countries can’t repay – Venezuela, Zambia, Kenya; and instead of allowing these loans to go into default, China is rolling them over, so it’s kind of similar to rating all of your corporate debt at AA or higher.
A chaotic event could bear pressure on other Chinese markets (equities), a flurry of foreign investors running for cover, a fire sale of some US Treasury positions and you have a recipe for contagion spreading to other markets, overseas banks and the US.
We’re keeping a watchful eye – somewhere, something, will disrupt the status quo.
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