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Monday, September 10, 2007

China and the Subprime Scorpion -

China and the Subprime Scorpion
September 2007

by Daniel H. Rosen

In the late 1990s, China managed to avoid the gravest consequences of the Asian financial crisis due to its idiosyncratic policy positions and economic structure. The country had not opened its capital account, relied on foreign debt, floated its currency, freed monetary policy from political control or even relinquished the role of the state as a predominant force in financial flows.

A decade later, with a new sort of financial crisis unfolding in the United States subprime mortgage market, many believe the factors that insulated China in the past still buffer it today. With its capital account still largely closed, China’s financial institutions—sovereign, quasisovereign and nonsovereign—have little exposure to the higher-yielding debt securities that have come under pressure, particularly in comparison to their total asset bases.

But the potential impact on China of global risk repricing is more complex than the short-term direct exposure suggests. The indirect implications are far more significant, and while some of the effects are likely to be net-positive rather than negative, this crisis may well mark a turning point in the way China’s economy functions and is perceived.

The current thinking in Chinese policy circles is that the local impact of the subprime mess depends on which scenario plays out in the U.S. housing market. If the housing market makes a soft landing and the U.S. Federal Reserve can maintain the current monetary cycle of interest rate hikes, then Beijing will have leeway with its own exchange rates and interest-rate policy. The government can continue to appreciate the currency and raise interest rates at a gradual pace to contain inflation, dampen overinvestment and prevent asset-market bubbles.

On the other hand, if there is a hard landing for the U.S. housing market, and the Fed reduces rates and increases liquidity more dramatically, Beijing will be constrained from raising its own rates for fear of encouraging hot money inflows. Without the interest-rate policy tool, China will face more severe pressure for the yuan to appreciate.

These scenarios, like Western fixation on the direct exposure of Chinese financial institutions to subprime securities, are too narrow. The larger problem behind the U.S. subprime correction was a series of faulty underlying assumptions about risk and return. These assumptions turned out to be wrong—for fundamental reasons (the ability of households to service mortgages, income, employment and vacancies), technical aspects (the number of quantitative funds using similar models to drive trading patterns), psychological factors (investors still flee to quality in a downturn despite arguments that risk is dispersed adequately) and structural factors (overreliance on the role of credit-rating agencies in risk management).

What’s important for China is not that it has direct exposure to U.S. subprime markets, or a domestic subprime market of its own prone to direct contagion, but that investors everywhere are likely to become more demanding in risk assessment.

Re-examining China Risk

There are myriad assumptions about risk in China that are due for reappraisal and which will have a real effect on the country in a number of ways:

· Public equities. With limited direct exposure and a largely closed capital account, there should not be much liquidation of Chinese equities to cover positions outside China. The official open window on the capital account—the qualified foreign institutional investor scheme—is small in size and comes with a waiting period of several months to remit funds out.

But the indirect impact could be significant. China’s A-share market is up 80% for 2007 as of late August and average price-earnings ratios are over 50 (and as high as 100 in construction and retail). There have been reasons to expect a correction from this level regardless of external credit market troubles. Labor and environmental operating costs for corporate China are rising, diminishing two key sources of profitability. Trade problems threaten to limit exports which are central to a number of industries (especially industries that produce primarily for domestic consumption). But they rely on external demand to mop up overcapacity during investment booms.

Some state companies will be required to pay dividends to the state for the first time starting this fall, reducing retained earnings and forcing them back to financiers to fund fixed-asset investments. This will, in turn, moderate investment and the massive depreciation allowances that represent such a large component of operating profit. Cost of living inflation, especially for food, is tempering the appetite of households to pile further into already overvalued shares.

To the current subprime situation we add the likelihood of moderate to significant contraction in U.S. demand, reduced availability of QFII investment to take up a proposed additional $40 billion in listing quotas and enhanced scrutiny of the financial reporting of Chinese firms. If there is a correction in the A-share market— and there are reasonable grounds to expect one—then the dynamic repercussions of the subprime story will surely be identified as a key cause.

· Hot money. In addition to registered crossborder portfolio flows through the QFII quotas, there is a large pool of “hot money” in China for equities, property and other investments, much of it predicated on yuan appreciation expectations. The volume of hot money deployed in China that could be extracted in the near term is not likely to be destabilizing. Beijing knows about hot money channels and can reduce the flow during crises. In a recent paper, Guonan Ma and Robert McCauley of the Bank for International Settlements found that China’s capital account controls are still binding (when the government wants them to, anyway). As it tries to moderate inflation, Beijing may even be happy to see the exodus of some hot money since it would take pressure off the yuan and deflate asset bubbles.

The hot money capital flows into China—which show up in the errors and omissions column in balance of payments data—play a role in shaping expectations of hedge-fund traders, money managers and the architects of China’s capital outflow opening (the qualified domestic institutional investor program). Many investors outside China have assumed the yuan was a “one-way bet” due to the consistent inflow of hot money. In the wake of the subprime meltdown some analysts, such as Qing Wang and Denise Yam of Morgan Stanley, even considered that flows to China might increase in a “flight to quality.”

However the owners of hot money outside China will be influenced by the same need that subprime mortgage makers and the firms that bought their securitized obligations have—to be more diligent about contingency risk, liquidity, enforceability and transparency. During good times, investors have been more than willing to accept the implicit safety of investing in China, based on a great macro story and expected sovereign support if needed. But appraised more strictly, there are a host of risks that cannot be adequately quantified according to Western standards—and this could be more significant in a bear market for credit.

A sea change in the direction of hot money flows resulting from a recalculation of risk-return considerations would affect the pace of yuan appreciation, the pricing of nondeliverable forwards in the off-shore—and now, onshore—markets, the mindset of property and A-share speculators (who are not small in either number or stake), and the distinction between healthy diversification of the Chinese savings portfolio and unhealthy capital flight. A change in the direction of hot money flows would alter the mistaken notion that China is ready to play the role of safe haven in the storm.

· Domestic credit. China does not have a subprime market per se but it does have domestic credit-market problems of its own. These will be taken more seriously in a climate of global credit-risk reassessment. Commercial and residential lending is often based on sketchy credit histories, multiple sets of books and inadequately audited financial statements. Political interference and corruption in investment decision-making is rife; the legal system is incapable of enforcing creditor rights; and the assumptions that households will continue to deposit savings at negative real interest rates, that firms will honor debts and that the government will guarantee subprovincial debts are all dubious. One cannot deny that these problems exist; however, Beijing has been generally capable of guaranteeing the system and fundamental macro growth is strong and productively oriented.

The U.S. subprime situation will encourage creditors in China to look with greater wariness at borrowers’ ability to repay. There are already yellow flags. The total pool of mortgages in China is around $315 billion to $330 billion and is growing at 20% to 25% a year. But as in the U.S. subprime situation, China’s lenders do not appear to know the quantitative parameters of the market they are playing in.

For instance, basic data like the number of mortgages outstanding, the income/mortgage service ratio and the number of mortgages falling into each of the five default categories (normal, alert, irregular, distress and default) are tracked by individual lenders and reported to the China Banking Regulatory Commission. But the data on the aggregates is not publicly available. Anecdotal evidence suggests that about one-third of mortgage holders use 50% or more of their income to service their mortgage. With household meat and poultry expenses up 50% year-on-year, this burden is getting harder to carry. But with so many basic variables essentially unknown to institutional economists, how can one be comfortable?

· Exports. China runs a monthly trade surplus of $10 billion to $15 billion with the U.S. With the EU, the monthly surplus is now also above $10 billion. China’s exports to the EU were up 80% year-on-year in July. While sourcing from China is nearing its limit in the U.S., Europe still has a long way to go. China’s global trade surplus for the month of July was $24 billion. At this level, net exports are about 10% of GDP and 20% of GDP growth at the margin, which China and others alike agree is unacceptable and unsustainable.

Since 25% to 30% of China’s exports go to the U.S., a contraction in U.S. demand would be painful for export-oriented sectors. Foreign firms account for a large share of China’s exports in these industries. Much of the growth in Chinese exports has been in steel destined for infrastructure projects abroad. This demand is now under a cloud due to global outlook worries. And steel is produced by big Chinese firms, not foreign-invested ones.

Beijing has been trying to reduce its trade surplus, for example by slashing value-added tax rebates on 2,831 products at the end of June. A cyclical contraction in U.S. demand may provide Beijing the political cover it needs to redirect growth back to domestic demand, which is already showing signs of an uptick. Domestic retail consumption growth in July was at a 10-year high of 16.4%.

Therefore, one can agree that the direct hit on the export component of Chinese growth from the subprime situation is still contingent on the degree of second- and third-round mortgage problems in the U.S. as the bulk of subprime mortgages become problematic over the next nine months. Even in a severe U.S. contraction scenario, the export sensitivity in China is concentrated in a handful of sectors.

But consider the larger context. These effects are in addition to major efforts Beijing is already making to curtail exports in energy intensive sectors which have seen outsized shares of domestic investment in China. The product quality and safety fiasco is far from over and will affect higher-value Chinese products. Protectionist U.S. and European trade policies are increasing and could increase further as a function of recession, election cycles and, quite possibly, as a reaction to any hiatus in the pace of yuan appreciation (which Beijing would use to buy time to find sufficient yield to beat foreign-exchange losses). The shrunken external demand which may result from the subprime crisis might be manageable by itself, but it may also be pro-cyclical to a correction in trade patterns that is already being promoted—and which may be more intense than Beijing intended.

· Exchange rates. Before the subprime crisis the smart money was on faster yuan appreciation. China’s global trade surplus is growing at an extraordinary pace. Domestic productivity has been increasing, suggesting that the annual 4% to 5% pace of appreciation against the U.S. dollar (less against the Euro) is too slow. This has created trade-policy pressures from the U.S. and monetary pressures within China.

Undervaluation of the yuan, of course, does not explain the U.S. trade deficit since U.S. imports would come from other cheap labor economies if not China, but Beijing is nonetheless obligated to address the issue. Their preference has been for trade policy interventions rather than exchange-rate reform—in part, as a result of understandable concern about financial crises like the one we are having now. Voluntary export restraints such as the slashed vat refunds and export taxes on energy-intensive goods were given a chance to work. But July’s export data suggests these measures are not working, which leaves few alternatives to faster appreciation.

Underwhelming Action on Yuan

The case for a more pronounced appreciation of the yuan is stronger than ever for both internal and external economic reasons. But the political economy of China makes it likely that the pace will slow during the short-term. The reason, as stated at the outset, is that the subprime crisis makes it difficult for China to avoid a foreign-exchange loss at the existing 4% to 5% annual pace of appreciation, let alone at an accelerated pace. The same officials who would be blamed for a multi-billion dollar exchange-rate loss also control the pace of appreciation that would contribute to that loss. There are certainly a number of considerations that impact Chinese exchange-rate policy. But in my opinion, this consideration will prevail and lead to underwhelming action on the exchange rate for the coming year.

There are also a number of upsides for China from the global risk reappraisal. With diminished expectations for U.S. growth, commodity prices—the biggest cost variable for corporate China—could well take a breather from their secular increase. Assets in the emerging world (and in some developed economies) may see price moderation, which could benefit the many Chinese firms on the cusp of acquiring or establishing operations overseas—in extractive, manufacturing and distribution. An improved discipline in credit allocation (and in equity markets) in China would lead to improved long-term growth fundamentals. In a tighter credit environment, foreign private-equity firms seeking to invest in China should find a warmer reception as well. The upshot is that China is ripe for a major economic adjustment. Conditions are such that the global reassessment of credit risk will likely play a catalytic role in accelerating those adjustments.

This contrarian perspective on the relationship of China to the subprime crisis is fully compatible with the consensus view that macroeconomic performance in China is not at risk. But it differs in the microeconomic outlook: Companies, equities and the industry mix are much more vulnerable than many think. The macro outlook is strong not because China is immune from adjustment pressures amplified by global credit conditions, but because it has a demonstrated willingness to accept adjustment when necessary. That very willingness to accept adjustment—the wellspring of gains in the aggregate—is what spells difficulties for firms and sectors. The herd of creditors and borrowers is being culled in the U.S., and the remaining population will be stronger. China’s financial intermediation system has its own weaknesses and if it were to be exempt from such adjustment while markets elsewhere corrected, it would be all the more vulnerable in the coming era of even greater capital mobility. Rather than a warning of failure, therefore, this analysis of changes to come in China is a prediction of further strengthening and the dynamism essential to the next phase of sustainable economic gains.

Mr. Rosen is principal of China Strategic Advisory, a New York-based consultancy, and a visiting fellow at the Peterson Institute for International Economics in Washington, D.C.

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