In this first of a two-part report, Chi Lo, Senior Market Strategist APAC, examines the macroeconomic impact of China’s latest credit events. In part II, he assesses whether these same events could trigger a property market crash.
Financial market observers have drawn parallels between the recent credit events in China and past crises such as the 2008 US subprime crisis triggered by the collapse of US investment bank Lehman Brothers and the 1998 collapse of hedge fund Long-Term Capital Management. Others have linked these events to the bursting of Japan’s real-estate bubble in the 1990s.
Excessive indebtedness and overvalued assets triggered market instability in those earlier cases. However, none of those situations offers pertinent insights into events in China. These have involved systemically important institutions (SIIs) in a system that is driven by policy rather than by the market.
Bailouts the Chinese way
While developed countries may provide a bailout when a systemic crisis seems imminent, the Chinese government intervenes regularly in its capital markets and tolerates few risks to financial stability. This means the monetary authorities know how to manage home-grown financial stress and are adept in containing contagion, preventing financial system seizure and providing selective help.
Financial stability is the overriding policy objective in China’s rescue efforts in a crisis. Given the benefit of a relatively closed capital account, Beijing can likely continue to keep systemic risks under control. Its record on managing past crises at big companies (those with assets of more than RMB 2 trillion (some USD 312 billion) speaks volumes about its skills and successes.
However, as the country gradually opens up its capital account, its financial system is becoming one of the world’s largest, integrating with global markets through trade and financial flows. Any volatility arising from China’s market and economic policies would thus have far-reaching effects on both its domestic and global markets.
Implications – Relaxing monetary policy
The risks now associated with China’s expansive and often heavily indebted property sector look set to persist for longer, which will likely create volatility in Chinese markets. Even though systemic risk is unlikely, the latest credit events are piling up financial stress and growth headwinds for the economy. This will likely prompt Beijing to relax monetary policy further to support growth, setting the stage for a return of the reflation trade.
Foreign investor exposure to Chinese assets will not be sheltered from any financial volatility. This will doubtlessly knock confidence, especially in the offshore credit market, which is exposed to the credit risks. To illustrate the point, offshore yields on China’s junk-rated US dollar bonds have jumped to decade-high levels recently.
The creation of the offshore market in 2010 was central to Beijing’s strategy to reform its capital markets and internationalise the renminbi. The offshore market involves a two-way trading mechanism for renminbi financial transactions. This, in turn, helps to create an incentive for foreigners to hold and trade the renminbi, thus facilitating internationalisation.
However, foreign investors have been extremely cautious about trading renminbi-denominated assets in this market. The recent credit events will reinforce their misgivings, at least in the near term, which could prompt Beijing to rethink its renminbi and capital market reform strategies.
Is there a big enough safety net?
More broadly, while the Chinese financial system has become systemically important, it is unclear whether the international financial safety net – provided by multilateral financial institutions – has expanded adequately to accommodate the emergence of China’s system.
The International Monetary Fund has estimated that the global safety net – based on immediately available financial resources such as foreign exchange reserves and central bank swap agreements – amounts to about USD 2.7 trillion. However, this is less than China’s current foreign currency reserves of USD 3.3 trillion and may not be enough to stave off disaster in the event of a systemic crisis in China.
While such a crisis scenario still seems unlikely, one should not dismiss it out of hand. After all, low-probability events have been known to happen. Recent events in China could well – and indeed should – shake global markets and authorities from their complacency regarding global financial risks. Those same authorities should arguably build systemic resilience via a multilateral financial architecture. In the meantime, of course, investors should remain vigilant in their risk management. If more Chinese defaults occur in the short term, they could inflict deflationary pressures on the world’s financial and commodity markets.
 The most recent events have involved state-owned Huarong Asset Management in August and the second largest property developer, Everglade, in September 2021.
 See “Chi on China: China’s Bond Defaults Could be a Blessing in Disguise”, 7 July 2021.
 “Adequacy of the Global Financial Safety Net”, IMF Policy Papers, International Monetary Fund, Washington, DC, March 2016. file:///C:/Users/826222/Downloads/_031016.pdf