China haters have been waiting for a financial crisis out of China since at least the early 2000s. Each and every time, the People’s Bank of China’s plunge protection team or the central planners in Beijing would throw buckets of ice water on their heads.
This time might be different. This time they are dealing with a trade war.
Most investment banks have some proprietary model that gives their fund managers a gauge on crises. For Nomura Securities, no country is flashing red more than China.
“China has the second-highest number of flashing early warning indicators after Hong Kong,” says Rob Subbaraman, an Asia economist for Nomura in Singapore. Months of protests against an stalled prisoner extradition bill with China have turned into protests against the Hong Kong government, with the very real possibility of the U.S. doing away with its special trade relationship with Hong Kong. If that ever happened, the Hong Kong dollar would no longer be a de facto source of U.S. dollars for mainland China, assuming Washington included Hong Kong in its mainland China tariff regime.
Chinese policymakers need to guard against a renewed build-up of financial stability risks, Subbaraman says.
Out of 60 early warning indicators flashing on Nomura’s Cassandra risk assessment program, Hong Kong has 49 covered. China has 25. The U.S. has precisely zero.
Cassandra has reliably signaled around two thirds of the past 50 financial crises in a sample of 30 emerging market and advanced countries, including the U.S., since the early 1990s, Nomura says.
Casandra looks at five early warning indicators, including debt-service ratio gap (DSR) with a particular country’s historic average; joint credit and real property price gaps with the average; joint credit and real effective exchange rate (REER) gaps; joint DSR and REER gaps; and finally, a combination of all three credit indicators above.
The predefined thresholds of pain-points for a country are set in a way that the early warning indicators flash when one of those thresholds is breached. That means a crisis is likely to hit within three years.
However, China haters, don’t get your hopes up. A financial crisis doesn’t have to be all-encompassing like the Great Recession. And China has tightened its credit conditions (until recently, actually), so it started the year with fewer red lights going off on the Cassandra dash board than it did in 2018.
From historical results, at least 30 flashing early warning indicators has signaled a threshold breach since the early 1990s, and 17 countries that have had 30 or more flashing indicators either experienced a financial crisis (14 out of 17 countries) or a large-scale drop in domestic demand (12 of the 17) within three years.
Chinese growth is critical for many emerging markets, especially those inhabiting China’s orbit. In fact, the only other countries facing a higher potential for a financial crisis in the next 12 quarters are all in Asia.
China is also important for global fund managers. Emerging-market equities are barely above 2007 peaks even though the Chinese economy has grown from $3.5 trillion to $13.6 trillion as of Dec. 2018.
In other words, no one but the China uber-bears wants a financial crisis in China.
Chinese GDP growth over the last several years has centered on a number of things beyond the market’s favorite—consumer spending. It’s been based on commodity hoarding, oversupply, and fixed asset investment in things like roads, rail, and real estate, primarily.
Drive through second- and third-tier cities in China and one is bound to see lanes and lanes of roads with few drivers. Rows upon rows of identical apartment buildings, but no curtains in the windows and very few cars in the parking lots.
China’s investment share in GDP was greater than South Korea and Japan when they pursued “investment led growth,” though some many say that is because China has 1.2 billion mouths to feed.
China’s GDP growth is driven, in large part, over manufacturing widgets they cannot sell and houses no one has yet moved into. Much of this is a provincial problem rather than a Beijing problem. Beijing has tried to get this under control, with varying degrees of success.
But as the economy slows to 6% and under, as Barclays Capital predicted last month, due to tariffs, China is loosening its credit policies, allowing for banks to lend more to small and midsize businesses. As these risks increase, China’s early warning indicators on Nomura’s Cassandra program will start catching up to Hong Kong.