Asian Banks-China Debt:Testing the "Impossible Trinity"

Balancing the "Impossible Trinity" becoming even harderA shifting external environment is making China's task of balancing thetrilemma of independent monetary policy, freedom of capital flows & a stableFX rate increasingly challenging. In this report, we look at how China loweredits total debt servicing cost via rate cuts/debt restructuring to cushion theweight of a rising debt load. However, against a backdrop of rising US ratesthis has come at the expense of increasing pressure on the capital account.

    Our rate sensitivity analysis suggests that debt servicing costs are likely to be areal constraint on China ability to raise rates over the next 2-3 years. This lackof rate flexibility threatens to exacerbate capital outflows.

    Financial stresses rise rapidly once debt servicing cost to GDP reaches 13-15%Our analysis of a variety of different banking systems over the past 20-30 yearssuggests that the level of financial stress in a banking system starts to increasesignificantly if total debt servicing cost/GDP rises above c13-15%. China’s debtservicing cost peaked at 12.9% of GDP in 2014. Since that date throughcutting interest rates and restructuring debt this has fallen back to 10.7% in Q416. This gives China some head room but not much given China’s debt loadwill need to continue to compound at 13-15% to meet a 6.5% GDP growthtarget. China therefore faces a policy dilemma – rising debt servicing burdenthat requires lower rates, and potentially higher inflation and higher US interestrates that require high rates domestically. This dilemma will likely becomemore challenging in the next 2-3 years.

    Liquidity risk not credit risk: The capital account will remain in focusA backdrop of higher US rates and flat to falling Chinese rates is likely to onlyincrease the propensity of the holders of RMB liquidity to convert it to USdollars placing further downward pressure on China’s already depleted FXreserves. Despite the investor focus on bank asset quality we are of theopinion that it is a change in the flow or cost of liquidity that actually precedesrising stress in a financial system. In this regard we view the building pressureon China’s capital account as a real and present danger for Chinese bankinvestors over the next 1-2 years that receives far less attention than bank loanimpairment charges (which continue to be actively “managed”). If US ratesrise as expect we see a further tightening of capital controls as a very realpossibility.

    Cautious on China banks: A weaker credit impulse & fading reflation tradeThe MSCI China banks index is now trading 1 standard deviation above its 5year average 1 year forward P/E multiple and a 5 year low implied cost ofequity (i.e. expensive vs where it has traded for the past 5 years). We think therisk reward profile now looks poor given the rising risks to what we believehave been the core drivers of the re-rating (i.e. the China reflation trade).

    Whilst we remain underweight the China banks in a regional context withinChina we have a clear preference for the retail-orientated banks (ICBC andCMB) over the more wholesale funded orientated bank (joint-stock banks andsome city commercial banks). The latter, we believe, would be more sensitiveto the current rise in market rates as we laid out in our recent report March23rd “Chinese Banks – Financial deleveraging: Rising funding pressure”.