China & Systemic Risk
Updated: Apr 1, 2022
Most crises throughout history have been caused or exacerbated by a build up of excess credit. When the economic history books are written on the current episode that will likely be true again.
Most crises throughout history have been caused or exacerbated by a build up of excess credit. When the economic history books are written on the current episode that will likely be true again. As we have often noted, credit is inflationary when taken on and deflationary when paid back. Of course, debt can be written off rapidly, or over time due to inflation. The impact on creditors and the system is a permanent loss of capital. That is “proper risk” in contrast to volatility of returns or value at risk. In- deed, the latter measures of risk can be entirely misleading in a credit event where the cash flow re- turns are stable until the “sudden stop” where risk builds slowly and then all of a sudden.
A number of investors we have spoken to this week have been (quite rightly) concerned about the potential systemic risk in China Real Estate and high yield. The impending default of China’s second largest developer and one of the largest issuers of high yield bonds is a non-trivial event for the Asian high yield market which has just under 40% in that sector. Our understanding is that Evergrande has around $300 billion in dollar debt outstanding and around $300 billion in liabilities to other creditors. On the positive side, only around $19 billion is to offshore lenders. In other words, most of the expo- sure is to domestic entities. That is probably a key reason why there has been little impact (so far) on the currency.
In Japanese bubble, the 1997 Asia Crisis and the real estate bubble in Ireland and Spain in 2008, a key warning sign was the rapid build up in private sector credit. In the time series below we have shown the acceleration in private sector credit in Thailand which is comparable to the current build up in China over the past decade. Similarly, private sector credit in the Japanese and Spanish episodes (not shown) also peaked at around 220% of GDP before slowing down after the bubble burst. (chart 1). Of course, the challenge in Thailand and the other Asian “Tigers” in the lead up to the 1997 episode was that a large proportion of external debt, combined with a fixed (or managed) exchange rate relative to the US dollar. Thailand’s external debt peaked at over 70% of GDP just after the currency collapsed. Also note that the THB was around 22% overvalued on a real effective basis prior to the crisis (chart 2).
The impact of this episode has also weighed on EM/Asian markets more broadly and has been exacer- bated by a relatively firm US dollar. On the positive side, the S&P500 or the global risk proxy has re- mained quite resilient (so far). We are also hedged on our long exposure with a short position in the MSCI EM futures contract. Returning to the 1997 crisis, while the rise in US rates and tighter dollar liquidity in 1994 contributed to the peak in MSCI Asia equity. While the crash occurred sometime after that, Asia never regained the 1993 high (chart 3). The combination of excess build up in private sector credit, elevated external debt and tighter dollar rates and liquidity was the proximate cause of the crisis. The underlying assets and local currencies were also expensive and levered when the bubble burst.
In the current episode, the assets to avoid (or stand aside from) are the highly levered and expensive liquidity beneficiaries or what we call “HARM” stocks based on hopes and dreams at a ridiculous multi- ple. They are the ones that will likely be the naked swimmers when the king tide of liquidity rolls out.
Content contributed by Nick Ferres, Advisory Board Member of Conduit Asset Management Pte. Ltd. All information contained in this document is sourced from public source documents, media releases and not from Conduit Asset Management Pte. Ltd., (the “Company”). All due diligence onus, including and not limited to that related to legal and financial documentation, rests on the investor. This document is intended for distribution to “institutional investor” and "accredited investor" types as per definition by the Securities and Futures Act (Cap. 289) of Singapore, or to those who would qualify as such, under one or more of the categories of “institutional investor” and "accredited investor" so described therein. The information and data contained herein are strictly confidential and for information purposes only, and shall not be construed as investment advice, an offer, or solicitation, to deal in any securities. The information is not to be reproduced or transmitted, in whole or in part, to third parties, without the prior consent of the Company. This information is not directed at or intended for distribution to any person or entity who is a citizen or resident of, or located in any jurisdiction where such distribution, publication, availability or use would be contrary to applicable law or regulation or which would subject the Company to any registration or licensing requirement. This information has not been reviewed or authorized by the Monetary Authority of Singapore, or any regulatory authority elsewhere. Consequently, you should not act or rely upon the information contained herein without seeking professional counsel. The information contained herein may contain statements that are not purely historical in nature, but are “forward-looking statements”. This includes, among other things, projections, forecasts, targets, samples or proforma investment structures, portfolio composition models and hypothetical investment strategies. These forward-looking statements are based on certain assumptions and actual events may differ from those assumed. Neither the Company nor any of its respective affiliates make any representations as to the accuracy of these forward-looking statements or that all appropriate assumptions relating thereto have been considered or stated and none of them assumes any duty to update any forward-looking statement. Accordingly, there can be no assurance that estimated returns or projections can be realized, that forward-looking statements will materialize or that actual results will not be materially different or lower than those presented. Please note that the Company and/or its related companies, and investment staffs, may from time to time hold direct or indirect economic interests via non-controlling stakes into underlying Funds’ Investment Advisory Companies that control the Funds into which the Conduit Partners’ Capital Fund invests. Past performance is no guarantee of future results, and there is no assurance that the investment’s objectives will be achieved. In addition, certain financial information is contained herein. While the Company has made reasonable efforts to include information from sources that it believes to be reliable, the timeliness, accuracy and completeness of the underlying information, and any computations based thereon, cannot be assumed. While the Company has attempted to minimize errors, it has not verified, nor does it guarantee or warrant, the accuracy, validity, timeliness, completeness or suitability of such information and data. The Company is not responsible for any trading decisions, damages or other losses related to the information or its use. Please note that our references to a “Tradeflow USD/EUR Series” herein is made specifically to the CEMP – USD/EUR Tradeflow Fund, ISIN NUMBER: KYG1988M6375/KYG198751300. Conduit Pte. Ltd. is a part owner the referenced commodity trade finance fund’s investment advisor, Tradeflow Capital Management. The Company is currently invested in, and receives compensation for referenced Fund distribution and rebates on direct Fund investments from the Conduit Partners’ Capital Fund into the CEMP – USD/EUR Tradeflow Fund. For references to “VPAM Asian Macro” herein is made specifically to the “Vantage Point Asian Macro Fund”, the Company received compensation for the referenced Fund distribution and rebates from Vantage Point Asset Management Pte. Ltd.