China's Debt_ Opinion: China’s MSCI reality check is too big to ignore

MarketWatch.Com

Opinion: China’s MSCI reality check is too big to ignore

Published: June 15, 2015 5:14 p.m. ET

Photo: A brokerage house in Fuyang, China.

By Craig Stephen Columnist

HONG KONG (MarketWatch) — In recent weeks, much of the debate on China has centered on the idea that it is “too big to be ignored,” meaning the rest of the world would inevitably need to own its equities and currency. But now it’s set for a reality check.

In the same week that Chinese A-shares failed to be included in MSCI’s emerging-market benchmark, it was also revealed that global investors pulled $7.9 billion out of Asia. This was the biggest weekly withdrawal in almost 15 years, according to data provider EPFR Global, and the majority reportedly related to China.

Take this as a cue to look past China’s size and, instead, consider again its questionable fundamentals.

So far this year, concerns over a potential debt crisis have been drowned out by the roar of China’s domestic equity bull market — the best performing in the world this year by a long margin.

But last week’s decision by MSCI MSCI, +0.78% tells us it’s too early to consider China a mainstream asset class. Despite much talk of reform, Beijing’s efforts to open its capital markets or make its financial system more transparent have been limited. Yuan USDCNY, -0.0370% internationalization might be accelerating, but a capital-account opening still looks like a distant promise.

The decision against effectively forcing global fund managers to benchmark against an index they can still not freely buy and sell, in a currency that is not freely traded, is hard to take issue with.

As well as A-shares, Beijing has been angling to have the yuan recognized as one of the International Monetary Fund’s benchmark currencies. This again follows the “too big to be ignored” line of thinking for the world’s second-largest economy. But this could be similarly premature when the yuan’s value is still determined by Beijing and not the market.

The fact that the People’s Bank of China doesn’t issue currency notes larger than 100 yuan ($16) suggests it’s still preoccupied with the risk of capital flight. Rather than IMF technical tests, a simple one would be whether the Communist Party is willing to test its own people’s confidence in the yuan by letting it be freely exchanged?

After that, it might be time to consider its merits as a global reserve currency, or whether Chinese shares SHCOMP, -3.47% should become cornerstone holdings in global equities.

For many investors, the key issue with China is that behind its big economy lies an even bigger mountain of debt. According to Charlene Chu at Autonomous Asia, when compared against recent major credit crises, China’s pace of credit expansion is already without precedent.

Here again though, China’s size is used to trump concerns. Bur rather than “too big not to own,” the argument becomes that China is “too big to fail.”

The prevailing risk-on trade assumes that Beijing can successfully manage the economy through its “new normal” of slower growth and avoid a property-market collapse, debt panic or currency crisis. Anything else is unthinkable.

The main conviction here is based on fear, however, as the economic and political repercussions of a “hard landing” are so unpleasant that policy makers will simply not allow it. But every now and again doubts resurface, raising the possibility that China’s leaders might not really have all the answers.

The explanation for investors remaining sanguine about debt levels is that there has been little in the way of an accompanying spike in bankruptcies and bad debt. But there is a greater appreciation today that this comes down to a policy of “extend and pretend.”

Now cracks are appearing as debt keeps being rolled over. Debt restructuring has proven problematic, and analysts say credit risks are beginning to choke the banking system.

Société Générale notes that while new bank loans grew by 900 billion yuan in May, outstanding loans didn’t move up at all. This is because new credit is now being used to cover liquidity tensions instead of funding productive investment. With interest costs now amounting to 15% of GDP, this is understandable.

Further, they add, credit risk is getting in the way of monetary-policy transmission, and what is needed now is debt restructuring, not more easing.

China has made efforts at such debt restructuring but has done little to put in place a regime for dealing with insolvency. Last week, the central government doubled the quota on its local-government debt swap, bringing the total to 2 trillion yuan. After earlier resistance from banks, this time the government resorted to ordering the banks to buy bonds. And this comes just weeks after banks were told not to stop lending to insolvent state projects.

It promises to be a fraught process as China seeks to remove the implicit guarantee on state debt without undermining wider confidence in the banking system. Signs are that China will struggle to keep easing monetary policy, never mind avoid a banking crisis.

As a result, investors need to pay more attention to another aspect of China that is too big to be ignored: its debt.

Craig Stephen Craig
Stephen is a MarketWatch columnist and author of the column, "This Week in China".

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