Wednesday, January 6, 2016

2016 A Dangerous Year.....

2016 A Dangerous Year

Since 2011, there has been a debate about the potential of hard landing and financial instability every year. So far, the financial system has held up reasonably well, notwithstanding some periodic short term volatilities. Many view the absence of any severe disturbance as proof of the government's ability to tame financial sector volatility and believe that the risk of this happening has diminished over time. 

We disagree. We believe that the government has maintained a superficial stability largely by debt-funded stimulus and an ever-greening of bad debts. These strengthened various implicit guarantees which have been generating destabilizing forces beneath the surface - a classic case of short term stability breeding long term instability. It's our assessment that the longer this practice drags on, the higher the risk of financial system instability, and the more painful the ultimate fall-out will be.

Whether the government intended for it or not, we summarize that investors and other market participants have been counting on five government guarantees over the past few years: 

1) the government will prevent a sharp slowdown in GDP growth by running pro-growth macro policies, including fiscal stimulus; 

2) up until about two years ago, the government would always appreciate RMB vs. the USD, at least moderately a year; and since then, the government will not allow a sharp devaluation of RMB; 

3) since about 2014, the government will always support the A-share market; 

4) the government will not allow major debt default; and 

5) the government will always hold up the property market because it's so essential to the financial system and local government income.

In our view, so far these implicit guarantees have helped to maintain public confidence in the financial system and have prevented investors from realizing the risks. However, they are also creating powerful destabilizing forces. For example, the GDP growth guarantee means that the best strategy for many businesses over the past few years was to keep borrowing and expand during any downturn, anticipating government stimulus; the RMB guarantee means that carry-trades designed to arbitrage interest rates and RMB appreciation became prevalent; the A-share market support prompted many investors to use leverage, counting on the government being the buyer of last resort; the no-default guarantee means many investors turned a blind eye to potential default risks (or simply not aware of them) and fund uneconomic projects; the property guarantee drove a significant portion of national savings into one of the most unproductive areas of the economy and the financial system has increasingly become a hostage to the property market via direct lending or through collaterals.

The problem with this stability-maintaining strategy is that many of the goals are conflicting so maintaining all of them are logically irreconcilable. 

It seems to us that the government's policy options are rapidly narrowing – one only needs to look at how difficult it has been for the government to hold up GDP growth since mid-2014. A slow-down in economic growth is typically a prelude to financial sector instability. Putting it all together, it seems to us that many of these conflicts may come to a head in 2016.

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