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Seven years on, emerging markets remain traumatized by the Federal Reserve’s “taper tantrum.”
In late 2013, just the hint that the world’s most powerful central bank might trim asset purchases tanked markets from Jakarta to Johannesburg.
Fast forward to today. What happens if the tapering is being done by the developing world’s biggest monetary authority?
Multiple signals from Beijing suggest that the People’s Bank of China is on course to withdraw its Covid-19 emergency support. If that is the case, it is flying in the face of powerful headwinds.
These headwinds include a number of recent defaults by state-linked borrowers, a powerful selloff in the corporate bond market, and worries among investors that China’s recovery is less durable than hoped.
These, and other issues currently circulating in China’s finance sector, are above the People’s Bank of China’s pay-grade.
Liu He, who calls the shots on financial risks in China, made it clear that “allowing defaults by a few state-backed firms showed that [Beijing] wants a market-based approach, but in an orderly manner.”
Earlier this month, China’s top financial regulators, presided over by Vice Premier He, signaled “zero tolerance” of fraud and other violations in the bond market to protect investors. And China’s interbank bond market watchdog, it’s worth noting, waded in to probe banks and others linked to a major coal company which recently reneged on debt.
Not to bail them out, but to investigate. The idea being that for a major economy to get anywhere, and to permit investors to assess risk and credit ratings credibly, defaults must be allowed to happen.
So it remains to be seen whether PBOC Governor Yi Gang’s team can pull off this most perilous of balancing acts. Still, the world has much riding on Yi’s staff succeeding – and ditto on Beijing permitting struggling SOEs to default.
Stern tasks ahead
Some context: Neither the US Fed nor the Bank of Japan has yet to succeed in yanking away the proverbial punchbowl. The reference here is the observation of one-time Fed chairman William McChesney Martin that a central banker’s role is to “take away the punch bowl just as the party gets going.”
And a party of sorts is indeed unfolding in Beijing. China is the only G10 economy likely to end 2020 with growth safely in the plus column. Granted, the 2% it is expected to expand this year is a world away from 2019’s 6.1% pace. Even so, it’s a rate of expansion of which the US and Japan can only dream as second waves of coronavirus infections slam demand anew.
Yet, China, too, is suffering elements of a hangover. A week after Yongcheng Coal & Electricity Holding Group missed a payment on a $151 million note, a major car manufacturer (Brilliance Auto Group) and a top chipmaker (Tsinghua Unigroup) announced debt defaults. That grew the list of state-sector companies in turmoil – a list that is spooking credit markets.
While Chinese regulators move into these companies, the trick the PBOC must pull off is withdrawing stimulus in keeping with President Xi Jinping’s deleveraging strategy – but without generating panics the way the Fed did in 2013.
On the plus side, the PBOC, to be sure, hasn’t gone down the quantitative easing rabbit hole the way the BOJ and Fed did. Nor is the PBOC technically independent.
Yet officials in neither Tokyo nor Washington have yet begun to plot their escape from life-support efforts dating back to Japan’s 1990s and America’s 2008 reckonings.
There’s been plentiful political plotting in Washington, though. Look no further than how US President Donald Trump has abused Governor Jerome Powell’s Fed.
First, by morphing it into a ginormous ATM to boost the stock market in ways that dented its credibility and independence. Now, by using the Fed in Trump’s political proxy war with President-elect Joe Biden.
Trump’s Treasury Secretary Steven Mnuchin spent the last 12 coronavirus-wracked months prodding the Fed to support business and sectors across the economy.
Those Herculean efforts pushed the Fed’s balance sheet to a Japan-like $5 trillion-plus. Now, with a Covid-19 second wave raging and economic growth teetering anew, Mnuchin is ending the Fed’s support to sabotage a Biden presidency beginning on January 20.
Yi’s tightrope walk
Thankfully, Beijing is devoid of such shenanigans. That leaves Yi’s PBOC to figure out how to plot a course between two sharply divergent constituencies.
One is a sprawling and complacent state sector hoping for another round of PBOC liquidity. The other is reformists who see now as the ideal moment to enforce some discipline over credit markets.
The latter point, those with long memories will recall, was one of Xi’s signature pledges when he rose to power in 2012. Since then, his calls for letting market forces play a “decisive” role in decision-making have largely fallen by the wayside.
In 2015, for example, there were hints of tolerance to let markets call the shots. That year, Kaisa Group became the first mainland property developer to default on dollar bonds. It was an epochal moment – one signaling Xi’s confidence that Asia’s biggest economy could handle a big stumble or two and continue marching forward.
However, Xi’s Communist Party didn’t much like the resulting turmoil in credit spreads and Shanghai stocks. So, they returned to the age-old habit of papering over China Inc.’s cracks.
Enter 2020, which is proving to be both a uniquely challenging year and a fruitful one.
For all of Trump’s efforts to tackle China Inc., Xi’s economy is back in the black. Xi’s ambitious “Made in China 2025” and Greater Bay Area projects are progressing. Beijing just signed history’s biggest trade deal with 14 nations, putting China at the center of the decade to come. And Xi’s campaign to internationalize the yuan is getting endorsements from high places.
Case in point: state-controlled oil company Saudi Aramco may be about to float yuan-denominated bonds. That could signal an about-face for a pivotal industry that long favored the US dollar.
Last year, Saudi Aramco pulled off history’s biggest initial public offering. Earlier this month, Jack Ma’s Ant Group was on a path to grab the No. 1 IPO spot — until Xi’s crackdown on risk forced a postponement.
Frankly, it’s hard to know precisely what’s afoot.
One common reading: Ma’s speech last month in Shanghai urging Xi’s team to be more thoughtful about financial reform prompted angry retaliation from on high.
Another: Xi’s team worries that online finance operations like Ant might morph into Frankenstein’s monsters that spiral into systemic risks that accelerate beyond Beijing’s control.
Risks abound in the conventional banking sector, too. As Fitch Ratings analyst Vivian Xue points out, capital positions across many of the Chinese banking sector’s small and medium-sized institutions “remain vulnerable to varying degrees of stress.”
The good news, Xue says, is that “China’s economy has been one of the more resilient to the coronavirus pandemic.” Yet there is still a “need for China’s largest banks to raise substantial capital or loss-absorbing debt over the next few years to fulfill their total loss absorbing capacity requirements.”
This complicates the PBOC’s deleveraging job. Xue notes that “the vulnerabilities illustrated in the PBOC’s latest stress tests reinforce these views and the need for continued financial sector reform to enhance the resilience of bank balance sheets.”
It won’t be easy.
“Normalizing policy after a crisis is tricky for any country, but it is particularly challenging for China owing to the unique circumstances of the pandemic,” says Eurasia Group analyst Michael Hirson.
China’s “rebound,” Hirson says, “is gaining strength but still has pockets of weakness — such as the small business sector — and policymakers are concerned about the dim outlook for the global economy in light of rising coronavirus cases in a number of advanced economies. “
Against this backdrop — that China’s economy is likely to be the only one among G20 nations that expands this year — global and domestic enthusiasm for Chinese assets is racing ahead of fundamentals.
It’s not that China is an unattractive bet for investors. Look no further than the global bull run into China’s $16 trillion bond market, one offering punters higher yields than they’ll find virtually anywhere else.
Worryingly, the yuan is “now back to its highest level against the dollar in more than two years, despite a number of recent measures to dampen appreciation,” Hirson notes. “This limits the ability of the PBOC to raise interest rates to cool speculative pressure in the real estate sector.”
How to deal with what Hirson calls a “hot-and-cold” economic environment?
“The PBOC and other agencies,” he says, “are likely to take a fine-tuned approach favoring administrative tools — such as property market rules-tightening — rather than broad measures such as rate increases.”
Chinese authorities, in other words, many tolerate a moderately stronger currency but seek to control the appreciation as best they can.
The PBOC might, for example, employ a mix of currency intervention, signals sent to investors via the daily fixing rate and incremental measures to allow greater capital outflows. It won’t fall asleep on the job, though.
“It is clear that, at the moment, it would be risky for the central bank to taper,” Althea Spinozzi, fixed income strategist at Saxo Bank. “It is therefore doubtful that the PBOC will stay watching as a selloff in Chinese sovereigns might correspond with a fast widening of Chinese corporate spreads.”
But tapering is coming – it is just a matter of time. Last week Guoqiang Liu, vice PBOC governor, said that the central bank would “sooner or later exit” stimulus policies set in place for the Covid-19 pandemic.
And when that process gets started, it will hopefully do so without the global tantrum that still haunts the Fed’s failed effort to normalize rates.