A few days before the world woke up to the menace of coronavirus in late January, I had lunch with an emerging market bond portfolio manager in London. We talked about the large and unresolved problem of debt accumulation since the global financial crisis; the manager’s view was that policymakers would continue to keep global growth ticking over with a blend of monetary and fiscal stimulus until, at some point in the future, the whole edifice came crashing down in a wholesale and catastrophic repricing of assets.
With Covid-19 well and truly upon us, it is worth asking if that outcome may be drawing closer.
In the view of David Hauner, EM strategist and economist at Bank of America Merrill Lynch, “The key thing is whether central banks can continue to be the main drivers of risk.” Central bank liquidity and low interest rates have kept assets afloat, he said. The surprising resilience of EM sovereign and corporate bonds during the first round of market mayhem brought on by the virus, at least until this week’s big step down, was one example.
“But this is getting more and more problematic from a long-term point of view,” he added. “It cannot be the case that central banks, by allowing everyone to take on more and more leverage, can prevent a credit event. The question is, how much longer can you stretch the rubber band?”
The susceptibility of asset prices to public policy has been clear during the outbreak. The CSI 300 index of Chinese equities is down about 2 per cent since the coronavirus first really shook markets on January 21, set against a 15 per cent fall in the S&P 500 index of the biggest US companies. Chinese authorities, investors appear to believe, can be relied on to step in if companies get into distress. US authorities have yet to provide that level of reassurance.
But there must be doubts about Chinese policy, too. Total debt in the country is fast approaching 310 per cent of gross domestic product, according to the Institute of International Finance. China accounts for almost 60 per cent of the $72.5tn in EM debt — and for 80 per cent of the growth in that debt stock over the past decade, when it more than doubled in size.
Some argue that there is no need to fret about the country’s debt, because much of it is quasi-fiscal in nature and is backed by a powerful sovereign and a largely trapped and very deep pool of domestic savings.
But the size of China’s debts may nevertheless restrict its ability to help its economy out of the Covid-19 crisis.
As the IIF data show, China reduced its debt mountain in 2018 as it sought to unwind the leverage it piled on in bouts of credit-driven stimulus since the global financial crisis. But it has since turned the stimulus back on to support growth.
One of the main channels has been the property sector. But property ownership in China is already at a very high level. According to a survey last October by FT Confidential Research, 90 per cent of Chinese households own at least one property and 35 per cent own two or more.
Moreover, 61 per cent of the survey’s respondents said they expected house prices to keep rising, despite a long-running government campaign to cut down on property speculation.
In the words of Bhanu Baweja, chief cross-asset strategist at UBS in London, “at some point, the price of that tulip is going to fall”.
Mr Baweja argues that, unlike other EMs with debt crises such as Argentina and Lebanon, China does not have a liability problem but an asset problem: the stock of property that serves as collateral for its mountain of borrowings.
“Credit blows up when the price of the collateral behind it stops rising,” he said. “How far are we from the peak of Chinese property prices? . . . That’s when the plumbing of Chinese credit becomes a problem, and with it all of EM credit.”
The difficulty for China’s policymakers is that, after the collapse of economic output in the first half of this year, they would have to deliver a gigantic boost to activity to keep annual GDP growth on target at 5.5 to 6 per cent. Even if such a boost were possible, it would make the risk of a credit event that much greater.
On the other hand, if Beijing were to exercise restraint and allow its economy to slow, the immediate concern would be the hit to European and global growth. The problem of a credit event, though not solved, would be kicked down the road.
Ideally, policymakers from the G20 group of nations would be working together to deliver a co-ordinated response. But there is little sign of that. As a consequence, it is not only the magnitude of the coronavirus crisis and the world’s ability to deal with it that remain in doubt, but also the ability of the post-crisis economy to deal with the debt overhang that preceded it.
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