As Joe Biden grows into the US presidency, he faces a growing math problem. How does a traumatized economy afford a US$4 trillion-plus Covid-19 rescue bill at a moment when investors might be less willing to lend to you?
Since a bad US inflation report last month, Treasury bond yields have moved higher amid fears the Federal Reserve might pull back on support for the economy. Turmoil reached a fever pitch on March 12, in what the Financial Times termed a brewing financial “storm.” It sent 10-year yields toward 1.7%.
Though negligible historically-speaking, rising borrowing costs are a clear and present danger for a US bumbling toward a $30 trillion debt burden. The disconnect between surging debt and demand for it will tantalize traders for weeks to come.
“There will be no peace until US 10s reach 2%,” says Kit Juckes, global macro strategist at Société Générale.
Or after, as changes in the risk profile of the linchpin asset of global finance unnerve debt and equity valuations, and prompt a search for shelter from the storm.
And making life even worse for Biden’s Treasury Department is the fact that punters have an increasing number of viable options – none more obvious than China, whose debt markets are a surprising oasis of calm as a mini “taper tantrum” spans the globe.
Part of the appeal is at 3.27%, 10-year Chinese debt yields are roughly double those of US bonds. In a near-zero-rate world, such returns on an A+ rated credit – in S&P Global terms – are hard for investors to resist.
But the appeal is wider than yields.
China steps up
One of the least noticed outcomes of Beijing’s latest National People’s Congress is how it adds momentum to Xi Jinping’s bond market ambitions. Make that President Xi, along with those of former People’s Bank of China Governor Zhou Xiaochuan, whose 2002 to 2018 tenure helped set the stage.
Xi’s 2013 pledge to let market forces play a “decisive” role gained credibility in 2016 when Zhou lobbied the International Monetary Fund (IMF) to add the yuan to its top-five reserve currency grouping. For Zhou, putting the yuan into the IMF’s “special drawing rights” program was about institutionalizing the reform process.
The headline effect surely mattered. It was the first time the IMF had added a new currency since the euro in 1999, a signal that the yuan’s moment had arrived. But being in the IMF’s basket compelled Beijing to adhere to previously unthinkable levels of transparency. That includes disclosing data on the foreign-exchange reserve holdings Beijing previously treated as a state secret and easing up on currency manipulation and capital controls.
Those upgrades primed China’s $16 trillion government debt market to be added to global indices, most recently the FTSE Russell. And just as important, they led to a new tolerance for a stronger yuan.
The culmination of these policies came in late 2020, when top fixed-income names like Ray Dalio, the founder of the $148 billion Bridgewater Associates, began talking more forcefully about the need to take on a “significant portion” of Chinese assets.
Given the returns on offer, foreign funds added China debt at the fastest pace on record in January. Data since suggest no throttling back on inflows. February alone saw foreign punters plow nearly $15 billion into mainland debt.
Part of the demand is increased access to Chinese debt and the need for global funds to boost their share of Asia’s biggest economy in portfolios. Yet Biden’s math problem is also a key driver behind China’s moment in the spotlight.
Treasuries trumped
Only time will tell if Donald Trump’s rogue 2017-2021 presidency cost Washington, in the words of 1960s French Finance Minister Giscard d’Estaing, the “exorbitant privilege” it enjoys from printing the reserve currency.
That privilege includes wide latitude to run unsustainable deficits in times of turmoil.
There’s a common view that, all things considered, the dollar’s status will remain intact. “Absent a catastrophic US policy error, I would expect the dollar to remain the most important reserve currency for the next several decades,” says Brad Setser, a senior fellow at the Council on Foreign Relations.
Yet the wreckage of the Trump era may have been that catastrophe – albeit, perhaps in slow motion. Dislocations related to a pandemic that Trump largely ignored and epic Federal Reserve easing leaves Biden with little choice but to continue borrowing.
“This outcome would have consequences for any economy,” says Stephen Roach at Yale University and former chairman of Morgan Stanley Asia, who’s warned of a 35% dollar plunge. But “for saving-short America,” he says, “it spells a weaker dollar.”
Strategist Sameer Goel at Deutsche Bank Asia isn’t alone in connecting dots between waning trust in the dollar and Bitcoin’s powerful rally. The question, he says, is whether the “emergency dollar demand” Washington long took for granted is now a thing of the past.
One plus for Biden is his new Treasury Secretary Janet Yellen is a former Fed chair who understands the risks of the moment. Surely, many find Yellen a comforting replacement for Trump sycophant Steven Mnuchin, producer of Hollywood films Suicide Squad and The LEGO Batman Movie.
That experience is needed if forthcoming debt auctions confront demand troubles that impede liquidity. The US market functions incredibly well – until suddenly it doesn’t. Traders around the globe are suddenly on the lookout for what Henry St John, strategist at JPMorgan & Chase, terms “notable episodes in recent years, in which a deterioration in the Treasury market microstructure was primarily to blame.”
Yet China’s move upmarket in debt circles thickens the plot for the US. During – and after – the worst of the post-2008 Wall Street crash period, the dollar maintained its cornerstone role.
Turmoil and debt tantrums in the Eurozone gave the dollar little competition from across the Atlantic. And the insular nature of the Japanese market – with nearly 90% of government bonds held domestically – meant there was little rivalry from the East.
Though South Korea enjoys the occasional safe-haven bid, won-denominated assets lack scale for funds with tens of billions of dollars to deploy. Enter China, which has that scale and more.
China’s opportunity
Never was that clearer than during last week’s NPC in Beijing, where Xi’s team spelled out the next five-year plan. Most headlines touted China’s rather modest 6% growth estimate.
Far more important were plans to create deep, broad social safety nets to supercharge the Communist Party’s multi-decade success in eradicating poverty.
China has long since beaten the “middle-income trap,” with per capita income now above $10,000 in nominal terms. Now, the prize Xi eyes is developed-market status. Efforts to spreading the benefits of economic growth in the most populous nation will be titanically expensive. Funding it will require a huge, liquid and globally-trusted bond market.
One big question mark surrounding China’s bonding experience is whether Xi sees fit to continue hoarding US Treasury debt. At present, Beijing holds nearly $1.1 trillion of US government debt.
Getting China to buy more is pivotal to Biden’s hopes of financing the nearly 20% of gross domestic product (GDP) Washington borrowed just for Covid-related stimulus.
Will the Fed need to start monetizing US debt? As the Fed and US Treasury struggle to cap yields, Xi’s government has a window of opportunity to make the most of a bond advantage that seems China’s for the taking.
Social stability going forward may depend on it.
China’s challenges
Beijing, notes economist Brad Hebert at the Center for Strategic & International Studies, “faces intensifying demographic changes that will lead to a declining workforce and an aging population over the next decade. With this, China’s working class is due to suffer the gravest consequences of a poorly funded unemployment insurance system in the absence of any meaningful reform.”
The broad contours of this reform can be seen as Xi declares victory over poverty and sets his sights on upper-middle-income status. This doesn’t mean, however, that the road ahead will be a smooth one.
Efforts to curb financial leverage, for example, are a work in progress. By the end of August, China’s overall debt-to-GDP ratio was 277%. Multiple government stimulus injections during 2020 to keep companies afloat complicated the problem.
“China saw a more modest fiscal deterioration in 2020 than many other countries, which reflected its swift economic recovery as well as the restrained nature of its fiscal relief package,” says analyst Andrew Fennell at Fitch Ratings. “However, its consolidation in 2021 will also be milder than at many peers.”
In other words, Beijing has quite a balancing act to perform. Xi’s deleveraging challenge extends far beyond the $10 trillion-plus shadow banking system.
It includes municipal government lending programs far beyond Beijing. An explosion of local government financing vehicles, or LGFV, has made it hard for overseas investors to know where risks lie – and their true magnitude. All this could prompt the People’s Bank of China to guide borrowing costs upward at any moment.
Another snag is the Chinese market can also experience liquidity droughts of the kind overseas investors abhor. One reason South Korean debt is so popular is the ease with which traders can change positions or exit the market altogether.
China needs to make exiting the market easier. Along with market depth concerns, traders also gripe about limited hedging options.
That includes increasing investment options in general. A case in point is Beijing’s efforts to make its nearly $11 trillion stock market a bigger driver – and funder – of GDP trends.
The big float
This was the other underappreciated shift flowing out of last week’s NPC confab. A key strategy to reduce corporate debt levels and increase wealth creation is incentivizing mainland companies to float shares.
Hints are that Beijing will be upgrading the listing process at exchanges in Shanghai and Shenzhen to increase the speed at which companies can sell shares. Regulators are mulling loosening the daily price-swing limit on trading in individual stocks to boost liquidity. This change alone could allay concerns about any single large mutual fund having an outsized influence on trading dynamics.
There also are steps afoot to increase market transparency, including tightening reporting and compliance requirements for startups looking to list on the Nasdaq-like STAR board. Ditto for fiscal and tax tweaks that could benefit businesses and foreign investors alike over the next few years.
Though reforms are always a work in progress, analyst Qian Zhou at Dezan Shira & Associates notes that the blueprint emerging from Beijing last week “can be traced back to the Deng Xiaoping era when China started ‘Reform and Opening Up.’”
Again, all this is a work in progress. And, clearly, Xi’s government is still grappling with how to smooth over the fallout from Ant Group’s delayed initial public offering. Ditto, the confusion over regulatory efforts to rein in Alibaba Group founder Jack Ma’s business empire.
Even so, last week’s moves to take Chinese capital markets to the next level make for quite a split-screen. On one side, you have an America that’s never needed Beijing’s money more. On the other, you have China developing a debt arena that gives investors excellent reasons to look East.
Perhaps sooner than Washington realizes.