Emerging markets have greatly increased in importance since the 1990s. In particular, local-currency bonds and foreign-currency corporate debt have expanded rapidly. Emerging economies and political systems are now highly dependent on global financial conditions and their feedback onto developed markets is powerful. A particular concern is China, due to its size and aggressive use of financial repression to sustain high levels of leverage and investment. The expected decline in China’s medium-term growth will put the sustainability of private debt, corporate earnings and property prices to a test.
Emerging market economies face many country-specific systemic risks, typically associated with weak institutions. However, what makes emerging countries a key part of global systemic risk is their dependence on financial conditions in the developed world. Empirical evidence shows that emerging markets financial conditions are particularly dependent on global and U.S. financial conditions (view post here). And importantly, they cannot normally influence these conditions or even just isolate themselves from them. Indeed, the expansion of EM local-currency bond markets with large foreign participation and the rise in foreign-currency EM corporate bond issuance have increased dependence on foreign funding (view post here). In particular, US dollar funding has pervasive influence on emerging financial systems (view post here). For example, there is empirical evidence that non-conventional monetary policy in developed markets has a significant impact on EM capital flows and financial conditions (view post here). Accentuating this dependence, trading flows in and out emerging markets have become highly correlated due to the widespread use of common benchmarks and the pro-cyclical behavior of end investors (view post here).
Policymakers options for mitigating these risks are limited:
- The shift of most EM foreign exchange regimes from pegs in the 1990s to managed floats in the 2000s has given them more flexibility to deal with capital inflows and outflows. However, it did not insulate emerging economies from external developments. In particular, capital inflows often drive currency appreciation, declining local interest rates and narrowing credit spreads at the same time. This broad-based financial easing turns into broad-based tightening when capital flows revert. Hence, EM currency depreciation often compounds financial dislocations and gives rise to self-reinforcing dynamics (view post here) before its medium-term benefits for competitiveness make a more significant difference.
- The standard response to large capital flows has been central bank interventions in the foreign exchange market. However, evidence suggests that interventions cannot shield emerging countries from excessive appreciation and overheating at the same time. This holds true even if such interventions are sterilized, i.e. if the money creation is reversed through the issuance of local securities. Indeed, sterilized interventions seem to have an expansionary impact on local financial conditions, because securities issued in the process of sterilization function as substitutes for bank reserves. Hence, sterilization can expand the collateral available for lending and encourage an expansion of loan-to-securities ratios (view post here).
- Another response to large financial flows has been capital controls. Most capital controls come at high costs, however, in form of distortions and unpredictable patterns of evasion. Moreover, evidence is growing that one country’s capital inflow controls deflects flows to other countries with similar economic characteristics (view post here).
China’s financial system
Macroeconomic management in China has predominantly relied on “financial policy”, a combination of credit, monetary and regulatory policies with powerful direct effects on growth and stability. This “financial policy” has critically shaped the structural development of the economy, fostering particularly state-owned enterprises, heavy industry, and real estate (view post here). As a result, China’s economic rise has long been associated with a massive expansion in domestic credit. Easy lending conditions have reflected two major financial distortions (view post here).
- First, low controlled bank deposit rates in conjunction with capital controls have subsidized banks and borrowers.
- Second, implicit loan guarantees by the state have spurred excessive lending and neglect of profitability.
This credit boom even gained pace in the wake of the great financial crisis, as the authorities sought to shield the economic expansion from a global recession. Thus, China’s total household, corporate and public sector debt quadrupled between 2007 and 2014 with credit quality critically dependent on the real estate sector (view post here). Total credit to non-financial institutions soared to over 230% by the end of 2016, while credit efficiency, i.e. the benefit of new lending in terms of economic output, deteriorated markedly (view post here).
The rapid build-up of leverage in the country alongside elevated property prices and declining potential economic growth has been reminiscent of pre-crisis excesses or “bubbles” in Japan, the U.S., and some European countries (view post here). For example, housing prices in metropolitan areas soared 8-13% per year in 2003-2013, comparable to Japan’s real estate boom in the 1980s (view post here). According to IMF research, historically almost all credit booms that were similar to China’s in the in size and speed ended in a major downturn or credit crisis (view post here).
China’s credit boom is widely seen as a consequence of ambitious growth targets. This ambition manifested in a highly accommodative monetary policy framework (view post here), implicit subsidies for banks and implicit loan guarantees for a range of corporate borrowers:
- A large share of the banking sector is state-owned, as is much of banks’ corporate client base. As the principal shareholder, the state appoints senior management in all major banks. There is ample anecdotal evidence of government sponsoring of bank lending to specific projects enterprises at the central and provincial level.
- In the absence of an explicit deposit insurance system and a resolution framework, the state also implicitly insures all deposits.
- Implicit loan guarantees by the state have spurred excessive lending and neglect of profitability. Financial support for distressed borrowers has long been the norm. Thus, bad loan problems are commonly pushed into the future through rollovers and restructurings, new loans and bond issuance. These practices produce invariably low non-performing loans ratios in the official statistics, regardless of broader economic conditions.
- Captive deposits have been the single most important factor upholding financial system stability. Prior to the crisis of 2008/09, net new deposits entering the system were so huge that loan repayments had little impact on banks’ ability to meet obligations. Low state-controlled deposit rates alongside tight capital controls have long secured cheap funding for banks and their clients.
Easy credit conditions have fostered neglect of profitability and default risk. The economy may be on an unsustainable path where generous credit supply is necessary to sustain growth and debt-servicing capacity. There is evidence of ensuing systemic risk in many fields:
- The leverage of China’s corporates reached record highs, particularly for state-owned enterprises. According to Morgan Stanley, the sector’s leverage is about 50% higher that that of U.S. or European sub-investment grade corporates. Some economists are worried that increased debt financing has partly served to cover funding gaps and bodes ill for credit quality (view post here). Private estimates of corporate debt financing costs put them as high as 29% of GDP for 2013.
- Another concern is the rapid growth of the shadow banking sector. Non-bank social financing is estimated to account for 30% of outstanding debt (view post here). A major form of shadow finance has been entrusted loans, mediated cross-company lending, partly motivated by banks circumventing policy restrictions and regulations. Entrusted lending appears to involve high default risk and fragile wholesale funding (view post here). On the investor side, wealth management products (a form of asset backed shadow banking deposits) have become sizeable. Although many households consider them virtually risk free, they are actually subject to maturity mismatches and credit risk. Unlike elsewhere, shadow banking in China is dominated by commercial banks, not securities markets. Regulated banks operate most shadow banking activity, take direct risks, provide implicit guarantees and use non-bank entities to shift assets off their balance sheets (view post here).
- China’s property market boom appears to have led to an oversupply of residential floor space in urban areas. Although demographic factors point to a slowdown of urbanization, land conversion for the creation of residential structures shows no signs of abating. Property investment is a key engine of growth for China, accounting for 16% of GDP, 20% of outstanding loans, 26% of new loans, and 39% of government revenues in 2013. A sharp slowdown of that sector would have severe economic and financial consequences (view post here).
- Many researchers point to broader imbalances related to excess credit. For example an ECB paper notes that “[economic] imbalances include a share of investment over GDP which is too high, a private sector which is still too small, a relatively weak services sector, financial repression, rising income inequality and inefficiencies in the use of production factors” (view post here)
- China’s excessive and distorted financial expansion also poses global risks. China now accounts for over 13% of global GDP and its financial and economic integration with the rest of the world has become deep. Regionally, there is an increasing risk that capital outflows may trigger sudden stops in financial leverage growth with crisis-like consequences across emerging Asia (view post here). Globally, concerns over China’s economic and financial sustainability have proven to be major shocks for financial markets (view post here). China’s influence on commodity markets is particularly strong, because its economy consumes about one third of the world’s raw materials and because its financial system makes intensive use of commodities as collateral (view post here).