Our ‘conspiracy theory’ is that economic and financial conditions in China, and particularly the over-levered Chinese banking system, are the ‘global financial risks’ that they are most concerned about.  The value of the Chinese Yuan is tied directly to the U.S. dollar.   Therefore, any rise in U.S. rates, which would theoretically lead to a strengthening of the U.S. dollar, would also push the value of the Yuan higher which, in turn, would hurt its competitiveness versus its emerging market trading partners and lead to economic damage, much like we saw for most of 2015.   The U.S. does not want to exacerbate this risk, so they are staying more cautious on moving interest rates than the domestic U.S. economic data would have them be.

Where is the evidence for such a connection?  By all accounts, the economic slowdown in China was the major cause of the U.S. stock market corrections in both August of last year and during the first six weeks of this year. The fear was that trouble in China would drag down global growth, particularly since China’s growth carried much of the global expansion from 1998-2008 and then it was China’s massive infrastructure spending that helped the global economy recover from the financial crisis.   The recent rally off the February lows was driven in large part by active traders, who were seemingly encouraged by better first-quarter numbers out of China that indicated at least some stabilization in its economy.  Then, in March, China’s foreign-currency reserves grew for the first time in months, as the Yuan steadied in value and capital flight seemed less of a risk.  It seems more than a coincidence that, as fears about China abated, global risk assets rallied.   But the more we look at the first quarter stabilization in China, the more we see another case of spending that was mostly driven again by increased borrowing.  As the reserves used to support the currency decline, the markets will eventually panic and begin to believe that the government can no longer control it.  Corporate debt in China is $14 trillion – larger than in the U.S. – and yet the debt continued to expand at an even greater rate in the first quarter.  This is a dangerous situation for the banking system.  A lot of debt is being rolled over and non-performing loans are much worse than they look.  China did manage to engineer a 6.7% annual growth rate in the first quarter, but this growth was accomplished by a huge injection of credit.  Borrowing increased at a stratospheric 58% annual rate in the first quarter.  Moreover, most of this lending has been to very unproductive ends such as housing, manufacturing, infrastructure and state-owned companies.  In the short term, this has helped to stabilize Chinese markets and growth, but longer term it leaves China with more debt with which to deal, more unneeded capacity to ultimately cut, and further away from its goal of an economy balanced more on domestic consumption and less on investment.

The fact that China is going further down this road is also a problem for the rest of the world and particularly for financial markets.  It is likely no coincidence that China’s borrowing binge has come at the same time as a sharp recovery in global stocks and the price of oil.    On a rolling annual basis it now takes more than five yuan of new credit to produce every yuan of new gross domestic product.  That rising ratio of new debt to new growth is a massive flashing red sign that the quality of investment, which wasn’t high in the first place, is dropping.  It is also remarkable to note that while China was pumping up growth via near-record injections of credit, the Federal Reserve has had to back gently away from its earlier intentions of continuing to raise interest rates. China has become a key variable and consideration in how the Fed makes policy now; arguably it was the reason the Fed delayed its first hike until December.

Standard & Poor’s is cutting its assessment of Chinese firms at a pace unseen since 2003.  Economic figures for March reveal a growing dependence on debt.  Analysts are also getting more downbeat. Twelve-month earnings forecasts for Shanghai Composite companies have dropped by 7.8% this year, the most since 2009.  Beijing seemed to panic in the first quarter, shoving nearly $1 trillion in new credit into the Chinese economy. That’s an epic amount for any economy, especially in a nation with a GDP of $10 trillion. The liquidity boost is the largest quarterly credit surge on record.  So for all the talk of Beijing restructuring away from an industrial and into a consumer-based economy, China seems to be resorting to an old model of debt-fueled growth that has seen its debt-to-GDP ratio surge from around 150% to well over 300% since 2008.

China's banking system = Fed's "Global Risk"

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