China provides lip service about confronting its debt woes, but so far has made few meaningful steps in that direction.
Global financial watchdog Bank of International Settlements (BIS) reported last weekend the gap between credit and gross domestic product (GDP), considered an early warning of financial overheating, hit 30.1 in the first quarter of this year. The second highest reading among countries assessed by BIS was Canada at 12.1. Any level above 10 suggests a banking crisis will occur within three years, according to the BIS, although China has remained above that level since 2009. The Chinese state insists its control of the financial system, combined with low levels of overseas debt, reduces the risk of a domestic banking crisis.
The ratio of Chinese debt to GDP hit 255% in 2015 as corporate borrowing more than tripled in just two years to make up for a slowdown in economic growth. While the Communist leadership has made noises about cutting down on credit expansion, Chinese bank lending in August more than doubled from the previous month due to strong mortgage demand. Prices for new homes in tech boomtown Shenzen rose 36.8% year-over-year in August, only to be outdone by the coastal city of Xiamen, which saw prices rise 43.8% from the year-ago period. The credit-fueled growth is naturally stoking fears of a major destabilizing bubble in Chinese real estate.
In addition, China's corporate bond market is starting to crack. Guangxi Nonferrous Metals became the first state-owned enterprise given permission by the Chinese government to go bankrupt. The company collapsed under $2.2 billion in bad debt amid a slowdown in global natural resource demand. Japanese bank Nomura believes the Guangxi bankruptcy is only the beginning: "more defaults and bankruptcies are likely to be permitted, leading to a rise in risk premia."
All of these factors have led some analysts to believe China will at some point be forced to massively devalue its currency in order to cope with an inevitable banking crisis. However, after hitting a six-year low in July, net forex sales from Chinese banks fell to a one-year low in August. Traders suspect state-run banks of supporting the currency. Meanwhile, Chinese regulators are also cracking down on fake overseas deals that are allegedly being used to move capital out of the country. China's outbound direct investment was up 62% year-over-year in the first seven months of 2016.
Global skepticism of the Chinese market was underscored this week by tepid demand for shares in the Postal Savings Bank of China initial public offering (IPO). The offering raised $7.4 billion, the world's largest IPO in two years, but priced at the low end of the range. The deal was propped up by a group of six cornerstone investors, which accounted for 77% of the shares on offer.
Europe may be the most imminent risk factor, but China remains the elephant in the room for the global economy.
Federal Reserve, Bank of Japan (BOJ) Stand Pat
All eyes this week were on the Federal Reserve and Bank of Japan (BoJ), and neither central bank did anything to jolt markets out of their current reverie.
On Wednesday afternoon the Federal Reserve's Federal Open Market Committee (FOMC) voted 7-3 to keep the Fed Funds Rate at 0.25-0.50%. However, the three dissents, by Esther George of Kansas City, Loretta Mester of Cleveland and Eric Rosengren of Boston, were the most for a monetary policy decision since December 2014. The Fed generally tries to send a clear, unified message to markets, and the extent of disagreement puts more pressure on the FOMC to follow through with a rate hike at its December meeting barring a "yuge" surprise.
In her post-decision press conference, Janet Yellen emphasized the committee's decision "does not reflect a lack of confidence in the economy. We're generally pleased with how the U.S. economy is doing." Rather, the decision was born out of an abundance of caution. Yellen also put a positive spin on discord within the committee, saying, "I think it's a very good thing that the FOMC is not a body that suffers from group-think."
Earlier in the day, the Bank of Japan (BoJ) refrained from expanding its asset-buying program or pushing short-term interest rates further into negative territory, instead shifting its focus to targeting long-term rates. The long-term rate target was the first in the BoJ's 134-year history and runs counter to conventional wisdom that long-term rates are dictated by natural markets forces rather than central planning. Instead of showing its hand regarding future asset purchases, the BoJ will adjust the pace of its bond buying with the goal of keeping Japanese government bond (JGB) yields around 0%. The announcement drove Japanese investors into risk assets, with the Topix Index rallying 2.7% by Wednesday's close, its biggest jump since July. Yield on Japan's 10-year government bond closed back in positive territory for the first time since March.
With the BoJ having already bought massive quantities of government bonds, corporate bonds and equity exchange-traded funds (ETFs), the policy shift is seen as a tacit acknowledgement by Japanese officials that they're running up against the limits of monetary policy. It's also seen as taking into the account the detrimental effect negative interest rates have on bank balance sheets, an unpleasant externality that has become an urgent problem across Europe. In a September 5th speech, BoJ Governor Huroki Kuroda said, "The potential impact on the financial intermediation needs to be taken into account." Running out of policy tools, BoJ officials may also be standing pat in hopes the Fed does them a favor by hiking rates (thus boosting the dollar) later this year.
Global bond yields have spiked in recent weeks amid concern the BoJ and European Central Bank (ECB) are running out of things to buy. Recent policy decisions from both central banks would seem to confirm investors' fears. During the past three years of this bull market run, investors have held their noses and bought risk assets despite high valuations and reservations about the central bank-driven nature of the tape. They have done so because there has been no catalyst for a change in the status quo. However, with the diminishing returns of monetary policy and little hope for fiscal policy cooperation around the world, time is running out for economic officials to grow their way out of an inevitable debt reckoning. After the Fed likely hikes rates in December, global officials will be looking anxiously to see who fires the next shot, knowing full well two of the biggest guns are nearly out of ammunition. What happens after that is anyone's guess.
European Banking Woes Intensify
European banks are not in good shape.
Deutsche Bank, fresh off news the U.S. Department of Justice will seek a $14 billion penalty related to mortgage securities sold during the economic crisis, was dragged through the mud again this week as the Federal Deposit Insurance Corporation (FDIC) named it the world's riskiest bank. The German bank's leverage ratio (which measures a bank's capital cushion divided by its risk exposure) of 2.68% is only around half the average of its eight biggest peers in the U.S. FDIC Vice Chairman Thomas Hoenig noted Deutsche Bank has a lower leverage ratio than the average U.S. bank (3.10%) prior to 2008. In a bid to shore up its capital base and reduce risk exposure, Deutsche Bank is said to be eyeing another massive sale of collateralized loan obligations (CLOs). The deal is rumored to be larger than the $5.5 billion securitization conducted last year.
In Germany's state-owned savings banks and landesbanks alone, overall costs of negative interest rates are estimated at more than 500 million euros ($559 million) per year.
Beleaguered Monte dei Paschi di Siena (MPS), Italy's oldest bank, last month unveiled a comprehensive recapitalization plan that included offloading around 30 billion euros-worth of bad loans and raising an additional 5 billion euros-worth of equity capital. Investors and government officials cheered the news, and rightfully so - it was a great plan! The only problem is because the assets in question are highly toxic and MPS currently has a market capitalization of only 550 million euros, the plan never really had any chance of being consummated. This week shares in MPS were halted after dropping nearly 6% amid investor concern the bank won't be able to pull off the recapitalization plan.
The crisis in confidence comes as a particular blow to embattled Italian Prime Minister Matteo Renzi, whose job is on the line in a constitutional referendum now expected to take place in late November or early December. If a market-driven solution to MPS' debt woes is not found, under EU rules the bank will have to be bailed-in, meaning junior bond holders (a substantial portion of which are mom and pop Italian investors) will take a hair cut. The rest of the Italian banking system isn't in much better shape and facing a similar fate. Such a development would further undermine support for Renzi and the EU, increasing the likelihood of political upheaval and further unraveling of the EU.
Along with the U.S. election, Italy's banking crisis and constitutional referendum is right now the greatest imminent risk event keeping global investors up at night.