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.
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