CHINA’S TRIPLE-D NIGHTMARE OF DEFLATION, DEVALUATION AND DEFAULT

China is at mounting risk of a financial crisis this year as growth sputters and deflationary pressures trigger a wave of defaults.

This is the warning issued by Bank of America Merrill Lynch. The US lender is telling clients that a confluence of forces is threatening to chill the speculative mania on the Shanghai stock exchange and to expose the underlying fragility of China’s $26 trillion edifice of debt.

"A credit crunch is highly probable," says the investment bank in a clients-only report entitled "Focus on the Triple D: Deflation, Devaluation, and Default," written by David Cui, Tracy Tian and Katherine Tai.  Mr. Cui, Head of China Equity Strategy at BofA Merrill Lynch, is the No. 1 ranked China strategist by Institutional Investor magazine.

They say the country’s highly-leveraged companies cannot safely withstand President Xi Jinping’s drive to stamp out moral hazard and wean the country off excess credit, warning that the mix of slower growth and excess debt "could prove lethal for the financial system."

The report warned that it is rare for countries to escape either a financial crisis, or major bank failures, a currency upset, a sovereign crisis – or a mix of these – after letting credit grow at such vertiginous rates.

"The most likely scenario is a bad debt surge as growth slows, followed by a credit crunch in the shadow banking system, followed by a major recapitalization of the banks," says Mr. Cui.

The report says China spent 15% of GDP to rescue lenders in the late 1990s but the scale of the problem is much greater today, and this time the government cannot resort to fresh stimulus so easily.

Loans have jumped by roughly 100% of GDP in the past five years under most estimates. This is twice the pace of growth in Japan over a comparable period before the Nikkei bubble burst in 1990, or in the US before the Lehman crisis in 2008.

Standard Chartered says total credit has surpassed 250% of GDP once shadow banking and offshore lending are included, an extremely high level for an emerging economy without mature markets or layers of accumulated wealth.

Mr. Cui says the explosive rise on the Shanghai stock market – up 50% in barely three months – is being driven by "blue-sky talk" and $180bn of margin lending from brokers. It is happening at a time of deteriorating earnings.

"When the sell-off happens, we suspect that it will not be orderly," he said. The Shanghai composite index may fall back from 3,300 to 2,400 before it settles in a trading range.

He advised investors to stick to defense stocks or equities linked to the nuclear industry given that both are shielded from Mr. Xi’s efforts to shake out excessive capacity in Chinese industry.

BofA says China has been in factory gate deflation for 33 months and the downward slide appears to be deepening: "We believe stimulus-induced overcapacity is the main culprit." 

China has been in producer price deflation before. The index plunged in the late 1990s and it took six years to reverse. All the problems are on a greater scale today, while the country is struggling to find a new "demand driver" to restore dynamism. There is nothing on the horizon comparable with China’s accession to the World Trade Organization in 2001.

One of the side-effects of falling inflation is to raise the real cost of borrowing. The average one-year rate for companies has spiked from zero to 5.50% in real terms since 2011. This amounts to drastic financial tightening, which the central bank has chosen not to offset, beyond a token 0.25% cut in rates.

BofA says hot money outflows raise the risk of devaluation. This will drain money from the stock market and tighten the vice on those with dollar debts. Chinese firms have borrowed an estimated $1.2 trillion in external currencies, mostly through Hong Kong.

The relentless rise in the US dollar is pulling up the Chinese yuan along with it as a result of the China’s "soft-peg." The yuan has soared 60% against the Japanese yen in barely two years.

Diana Choyleva, from Lombard Street Research, says the yuan is 10% to 20% overvalued, warning that China has "lost its competitive edge" as wages race ahead of productivity. The real effective exchange rate based on unit labor costs has risen 40% since 2008. She says investors are acutely alert to risks in the shadow banking system, but have overlooked the mounting threat of a liquidity crisis caused by currency effects.

Guan Qingyou, from Minsheng Securities, says hot money may soon start to leave the country as the US Federal Reserve prepares to raise interest rates, sucking in funds from across the world.

"Capital outflow on a large scale may cause a currency crisis and this is what triggered the Asian Financial Crisis in 1997," he told Caixin Magazine. Trackers at the central bank say the capital account has been in deficit for the past two quarters.

At the end of the day, China has great economic depth and is likely to eventually muddle through without too much trauma. Getting to that eventuality may require, however, the Triple-D Nightmare.

The challenge for investors right now is judging how far Xi Jinping intends to go in clamping down on excess debt and over-investment before considering the job done, and then reverting to stimulus. He has not blinked yet.

Ambrose Evans-Pritchard is the International Business Editor of the London Telegraph.

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