Two recent notes to investors — one from UBS, the other from Macquarie — are eye-catching because they discuss the possibility that the Chinese bond market may be heading for a major correction. The Chinese bond market is worth RMB 47 trillion ($7.3 trillion), more than 50% of Chinese GDP.
To be clear: Both notes say that scenario is unlikely.
But the notes are interesting because they discuss the possibility.
And, of course, investors in the West are already jittery about the US high-yield debt market, where yields have gone through the roof — a signal that investors are scared of the risk and want out.
No one is saying the two scares are connected.
But is sure is scary that the market is worrying about both at the same time.
This is the type of chart that has people worried, according to UBS: Bond market leverage has gone up as money has poured out of Chinese stocks, looking for a safer haven:
China’s debt is heavily concentrated in “non-financial” entities. There has been a sudden increase in debt issued by local Chinese governments, according to Macquarie. Look at the bars on the far right:
UBS shows the same thing. There has been a big increase in local government debt in the last 12 months, as the bright green bar on the right shows:
OK, so China has loaded up on debt. But this is a market that’s bigger than the US, and is growing at 6% GDP per year — twice the rate of the US.
The problem is that growth in China is slowing. Every year, the Chinese economy becomes slightly less capable of servicing its debt than the year before, according to this Macquarie chart:
So is this debt a problem, given China’s growing-but-slowing economy? “Currently, total debt (corporate + government + household) accounts for 218% of China’s GDP.
It’s not an outrageous number compared with 233% in the US and 400% in Japan. Rather, the problem lies in the structure, especially with corporate and local government debt.
First, corporate debt in China is high at 125% of GDP, vs. 101% in Japan and 67% in the US. Second, the local government debt accounts for 70% of total government debt in China,” writes Larry Hu and his team at Macquarie.
The market seems to be agreeing, for now. Yields — a measure of perceived risk — are still going down:
Harrison Hu and his team at UBS describe the problem this way (emphasis ours):
Investors are concerned that loosening bond market regulations and inflows after the stock market correction, combined with reported big rise in bond market leverage, have led to a growing bond market bubble. More importantly, investors are worried that a correction in the bond market, similar to the one in the stock market earlier this year, could have serious knock-on effect on the credit market, the equity market, and the real economy.
We agree that the sharp narrowing of credit spread may reflect over-stretched valuation in parts of the corporate bond market and the risk is high for increased volatility ahead. However, we think concerns on a bond market “bubble” may be overdone amidst some misunderstandings. In line with our expectations of weakening economic growth and further monetary easing, we expect bond yields to decline further, though credit spread may rise and the market may see increased volatility ahead.
“Having debunked major concerns in the bond market,” Hu writes, “we agree that the current rich valuation and very low credit spreads face risks of correction in the market.”
Hu thinks that correction will come as the government tries to clean up “zombie” companies that exist only to pay off the debts that were used to rescue them, and as the government becomes bolder about allowing hopeless cases to default.
Macquarie’s Larry Hu agrees that Chinese bonds are not yet nearing a “Lehman” moment:
Will China have a debt crisis in 2016? It’s still a low probability. It’s still a low probability event, but the odds are getting higher. The leverage level is indeed high and growing fast in China. However, the majority of debt in China is owed by SOEs and local governments to state-owned banks. In other words, they are more like the left hand of the government borrowing from the right hand of the government. Moreover, the Chinese government still controls the whole banking system, so it could inject liquidity to the system very quickly. Therefore, the likelihood for an imminent debt crisis is very low.
Huge debt actually reflects capital misallocation on a large scale. Private companies are crowded out by SOEs and local governments, whose returns on assets (ROA) are drifting lower and lower. Such capital misallocation would lower China’s potential growth in the long run, although another “Lehman moment” seems not very likely in the near term.