Why the biggest victim of rising US yields could be China
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.
"While banks have been eager to de-lever from eastern Europe – hence net repayments taken from Hungary, Ukraine, Romania, Bulgaria for example – risk appetite for China has been exceptionally robust; and to a lesser degree has risk appetite for some other big EMs: Brazil, India, Indonesia and Turkey.
"Robust risk appetite by international lenders has helped to finance build-up of external debt by corporates in these countries, among other things.”
There are three risks on the horizon from this jump in cross-border bank exposures:
1. Brazil, India, Indonesia and Turkey – the four countries ex-China that have seen a significant jump in offshore bank borrowing and that tend to have structural portfolio-financed current-account deficits – face an external headwind to credit cycles, given the prospect that rising US treasuries would increase the cost of international banks’ providing dollar liquidity to these markets.
2. A moderation in the pace of external bank funding will force EM policymakers to find new ways to substitute the withdrawal of domestic liquidity without pressuring exchange-rate policies, including loan extensions, sub-market rates for loans, expansion of eligible collateral for central-bank financing and lower bank capital requirements.
3. So where does this leave China? According to the BIS, cross-border lending by international banks to China has dominated lending behaviour in EM during the past five years – but in maturities of one year or less. What’s more, the acceleration of cross-border lending by banks into China really took off last year.
In fact, international bank claims in China are now more than $1 trillion, or 12%, of China’s GDP. The fast pace of this growth – $320 billion, or 4%, of GDP, during the past 12 months – suggest the drivers are less to do with economic fundamentals and more to do with speculation, thanks to high carry, which reflects the difference between high onshore rates and relatively low US and CNH rates, and expectations of RMB appreciation.
This view correlates with JPMorgan analysts, who estimate a cumulative capital outflow of $100 billion since May out of 22 EM economies – ex-China and Middle East.
By contrast, China appears to have attracted a similar $100 billion of capital inflow over that period, Nikolaos Panigirtzoglou, lead author of the bank’s benchmark Flows and Liquidity report, concludes. In other words, for all the noise, China has benefited at the expense of other EMs.
Market access has been boosted by the launch of the CNH market, fuelling expectations of full-scale internationalization of the RMB. What’s more, international banks have been filling the credit gap created by Beijing’s tightening of access to credit and greater scrutiny of off-balance-sheet financing.
Says a BNP Paribas report in February: “The resulting squeeze has forced borrowers to turn to short-dated and more expensive channels that are still available to them – witness the surge in wealth-management product issuance in Q4.
"As we understand, onshore lending by foreign banks is mainly deployed in trade financing, inter-bank deposits, and investment in short-dated financial bonds – which is why over 60% of the outstanding $1 trillion amount is revolving credit with less than one-year maturity.”
According to BNP, as a proportion of GDP, Hong Kong, Singapore, Taiwan, and UK-based institutions have the largest China exposures – the Hong Kong exposure at 164% is a case of double-counting, say the authors.
The June 2013 mini-liquidity crunch was an aberration then. China, in fact, has been chocking on an excess of liquidity, fuelling its imbalanced, credit-driven growth model.
Citi concludes that rising US yields, and the behaviour of cross-border banks in response, will be a crucial in determining the success of Beijing’s balancing act: stabilizing growth while reforming its imbalanced economy.
“Capital outflows are not naturally conducive to strong domestic credit creation, and that might raise concern about GDP growth in an economy that has been as credit-hungry as China’s has been in the past five years.
"So, one of China’s challenges will be to make sure that more exchange rate volatility doesn’t come at the expense of a sudden slowdown in credit growth that could squeeze the economy.
"That challenge will be particularly difficult at a time when the front end of the US yield curve might shift up in the next few months: rising short term interest rates in the US might erode banks’ willingness to roll over their cross-border loans to borrowers in China, especially when there is more uncertainty about the path of the exchange rate. To that extent, higher ‘China risk’ might be the most important consequence of higher short term US rates.”
BNP analysts agree. “The large stock of short-term cross-border loans now exposes China to volatility in USD funding rates. China’s financial system was immune to the collapse of wholesale funding markets in 2008.
"That will not be the case in the next global banking crisis – if foreign banks are forced to pull the plug due to crisis elsewhere, China will feel the pinch. Conversely, foreign banks are now more exposed to a collapse in China’s financial system.”
Capital controls in China then are effectively broken. Say analysts at the French bank: “Note that thanks to easing of curbs on backflow of RMB and cross-border lending, the only real hurdle to cross-border lending is banks’ internal country and risk-management limits.
"In theory, the carry trade can go on indefinitely, until a shock to the system or a change in regulations causes a major disruption.”
In other words, China is much more vulnerable to the vagaries of international finance and exchange-rate volatility than is typically appreciated, given the speculative nature of positioning, and one-way bets on currency appreciation.
What’s more, risk of rising US yields on EM credit cycles should not be dismissed, given data that highlight how the EM credit cycle is enslaved to the Fed.
If past performance is any guide then, the prospect of higher short-term US rates could cast a shadow over the capital account of key EMs.