Why the biggest victim of rising US yields could be China

Sid Verma
Published on:

How rising US short-term rates would complicate China’s credit challenge amid fears that a second, bank-led wave of outflows from emerging markets could be on the horizon.

While huge monetary stimulus in the G7 over the years has been designed to repair western bank and corporate balance sheets, the direct transmission channel from loose monetary policy and emerging markets (EMs) is subject of fierce dispute.

At first blush, there should be little.

After all, according to one fund-manager estimate, the 14 economies, with an effective nominal policy rate of near-0%, are host to a combined equity and bond market capitalization of $65 trillion.

No wonder the global fight for EM yield has been so aggressive, say those that fear the normalization of G7 interest-rate policy will trigger prolonged weakness in portfolio flows to EM assets markets relative to the post-Lehman boom.

Put simply, the prospect of a rising risk-free return on longer-dated assets, in theory, reduces the relative attractiveness of yield-seeking behaviour.

Others disagree with the view that quantitative easing accounts for the post-Lehman EM inflow boom, citing roaring flows to EM between 2004 and 2007 while the Fed was hiking, and argue tapering has not been the principal outflow trigger for the past year.

Instead, fundamentals drove the sell-off, they say, such as a smaller growth differential between EM and developed markets, and weaker commodity prices.

In recent weeks, with currencies of EM current-account-deficit nations rebounding, real-money investors and sell-side analysts have expressed cautious optimism that the tide is turning in favour of EMs even with the Fed’s tapering policy, thanks to decisive monetary action in key EMs, attractive FX, credit and equity valuations, and the return of the carry trade.

In truth, however, the portfolio-flow appetite towards EMs – in response to a reduction in the Fed’s central-bank balance sheet and rising US yields – is unclear. If short-term US yields rise in response to a growing US economy, that has historically boosted EM output and portfolio flows. However, the latest US rebound has been less consumption-intensive compared with the past, a blow to EM exports, fear portfolio managers.

This debate, however, neglects one big impact of low US yields: the explosion of a cross-border bank-lending boom to key EMs, such as China, during the past five years.

In short, could EM face a second bank-led, rather than portfolio-led, wave of outflows, as the steeper front-end of the US curve raises commercial banks’ financing costs, and reduces the allure of carry trades?

According to Citi, this prospect is real. “The risk here is that rising short-term rates in the US might cause commercial banks to shrink their risk-appetite towards EM, take repayments from EM borrowers, and thus create a second round of capital outflows, following the first round that accompanied tapering fears in 2013,” it states.

Bulls cite two factors in EMs favour. Firstly, such economies have been forced to correct current-account imbalances since May, suggesting they are now better placed to withstand pressure from the steepening US yield curve.

Secondly, the relative importance of cross-border bank financing to EMs has fallen thanks to liquid EM banks and a boom in bond issuance. In fact, banks represent just 15% of net private cross-border funding for EM compared with the 1980s, while international-investor appetite for local EM debt has jumped.

However, this latter argument neglects a key point: though many key markets in Asia are net creditors and boast huge dollar reserves, these are mostly trapped in central-bank coffers. As a result, international banks play a crucial role in FX-denominated funding.

Take figure 4 of the aforementioned Citi report, which compares the supply of international funding to EM: banks versus international securities.

According to Citi, citing Bank for International Settlements (BIS) statistics, the stock of banks’ international claims in developing countries is around $3.5 trillion, more than $1 trillion greater than the stock of international debt securities issued by EM. In addition, the increase in the international claims of banks in EM has been just as sizeable as the increase in international securities issuance since early 2009: both have gone up by around $1.2 trillion each.

In other words, the supply of cross-border funding to EM by banks has jumped dramatically and in line with the much-touted jump in EM bond issuance.

At first blush, this is counter-intuitive. After all, in August, RBS estimated European banks will need to divest a further €3.2 trillion of assets by 2018 to fulfil Basel III rules, after eurozone banks reduced their risk-weighted assets by $1.3 trillion between the third quarter of 2011 and the second quarter of 2013, according to the IMF.

However, the jump in international bank claims on EMs has been heavily orientated towards China, according to the BIS.

Says Citi: “Net international borrowing from banks in the past five years by the 23 countries covered in Figure 5 amounts to around $1.1 trillion, but almost 60% of that borrowing has been done by China.