Editor’s note: Below is an interview with Stephen Green, head of greater China research at Standard Chartered. This Q&A went out to subscribers of our “10 Things You Need To Know Before The Opening Bell” newsletter on Thursday morning. Sign up below to get the newsletter and more of these interviews in your inbox every day.
BUSINESS INSIDER: China fears have resurfaced as a catalyst for risk aversion in global markets. Are those fears justified?
STEPHEN GREEN: Well, it depends on what you’re scared about. More non-performing loans (NPLs) and some defaults on bonds and trust products? You bet, they’re coming. A systemic financial crisis and a hard landing for the economy? Unlikely, we think. There are a number of reasons but the main one is that for all the worry about “shadow banking” in China, the credit intermediation by non-banks is no more than 15% of GDP, and its unleveraged and unsecuritised. So, unlike in the U.S. system, a few bad loans do not have to generate a financial crisis. Now, of course, a large amount of NPLs within the banking and trust systems will be a problem, and there will likely need to be a recap of the system in the next 2-3 years, but that can be accomplished without too much disruption for the broader economy we believe. Overall, the new administration has decided that to do the reforms that everyone has been asking them to do, they need to run some risks. So for the bears to turn around and argue that the results of slower credit growth etc. for which they were calling will be the collapse they predicted is a bit cheeky, I think.
BI: The People’s Bank of China (PBoC) has been moving to shake investors out of carry trades designed to make money on a rising renminbi. Do you think they will be successful in having a lasting effect, or will trades just get put on again when the renminbi resumes strengthening?
SG: As an economist, I think the problem is simple: still large current and capital account surpluses. In 2013, the PBoC bought at least $US430 billion in intervention operations, and $US70 billion in January alone. I don’t think the PBoC has dissuaded the market of a medium-term CNY appreciation story, but it’s clearly raised the costs, and potential costs, of betting on that expectation. As a central bank in the last few months, the PBoC has discovered the utility of behaving a little crazy — both in the interbank system and now in the FX market. It affects behaviour — domestic banks are more cautious about their liquidity management, and now speculators are more cautious about positioning on the CNY. To keep that up, I think the CNY continues to be moved around — and maybe even breaks 6.20 on the upside, while 6.30 would I think be pretty aggressive. More volatility on the way down to a 5.9 handle by the end of the year I think.
BI: What do you think the impact of the sell-off in the copper market has had on the state of affairs in China’s shadow banking system?
SG: Limited. The sell-off has been partly triggered by local regulators guiding banks away from accepting copper as collateral on loans. Some firms have liquidity problems repaying loans since the funds they borrowed having been tied up in business, or in loans. To raise cash, they sell their copper, which has pushed prices down. It’s generated a lot of noise, and it will probably carry on for a while, but we think it will have limited impact. Most copper traders do not appear to be under financial pressure to unwind their positions. Fundamental physical demand for copper at present has weakened a bit — housing construction appears to have slowed, and onshore air conditioner manufacturers are holding quite a bit of inventory. That said, this year’s grid build-out is expected to be strong, which could impact demand a lot.
BI: More generally, the prospects of corporate defaults have many investors wondering what’s next in China’s onshore bond market. What should they expect?
SG: A few more defaults — which is what the central government wants (though local governments will often to their best to restructure and evergreen the debt). Credit conditions will remain tough this year — as loan growth slows. And this is the third year of relatively slow growth, and some parts of the corporate sector, especially heavy industry, are leveraged up. High leverage and weak cash flow means more trouble. If we are going to solve the issues of over-capacity in a few industries, and remove some of the moral hazard problems, this is needed. I think Beijing is ready to accept some bankruptcies. They also believe that the banks and other losses will be absorbed and written-off without systemic effects. In the U.S., which had a housing bubble and a financial crisis, much of the seriousness of that crisis was created by leverage in the financial sector and securitisation of assets. Neither of these things — leverage or securitisation — exists to any meaningful scale in the Chinese financial system. So we’ll likely be dealing with simpler and cleaner financial market problems — rising NPLs and the need to recapitalise banks over the next few years. As long as nominal growth can remain around 10%, that growth will ultimately forgive many of those sins.
BI: The Standard Chartered Renminbi Globalization Index has been surging, and the PBoC took historic action over the weekend in widening the daily trading band in which the yuan is allowed to fluctuate. When do you expect them to abandon the daily reference rate and embrace a fully market-determined exchange rate?
SG: Well, let’s be patient. They have got their hands full with the current ambition — to limit FX intervention and at the same time prevent excessive moves. Given the current account is in significance surplus, they need a certain amount of capital account outflow to balance things up. With the weaker CNY trading, they seem to have achieved that. For the moment. At the back of my head though I still think we are on an appreciation path, but with more volatility, which will mean some of the speculative money will leave. A lot of people say that the CNY has appreciated a lot; it is now near fair value. It’s just PBoC bought at least $US430 billion last year, and $US70 billion in January. I don’t see any fundamental change since then.