Over the past year, a large amount of international capital market hot money has poured into China’s bond and stock markets due to Beijing‘s strict control of the new crown Epidemic coupled with China’s continued economic growth during the epidemic. However, experts believe that with the rapid and strong recovery of the U.S. economy, this hot money will flow back to the U.S. because of rising interest rates and could further exacerbate the default on Chinese state-owned enterprises’ bonds.
The Biden administration’s recently passed $1.9 trillion stimulus bill, and the $4 trillion economic reboot being discussed, will push up nominal interest rates in the U.S., attracting money back in the short term; while experts say that in the long term it is the lack of a free market philosophy that is causing foreign capital to pull out of China, and the massive debt defaults it is causing.
Beijing has mixed feelings as 2020 hot money pours in
Desmond Lachman, resident fellow at the American Enterprise Institute, said the influx of hot money into China during the epidemic came from the world’s major economies. “Last year we saw an economic crisis in the U.S., the European Union, and Japan, so there was a very accommodative monetary policy. They borrowed a lot of bonds, expanded their balance sheets, increased the money supply and also lowered interest rates to incredible levels, an environment that will lead investors to look elsewhere for yields and put their money where growth rates and interest rates are higher. China last year, because of the effective control of the epidemic, was one such place.”
According to Bloomberg, more than $400 billion in foreign capital poured into China’s bond and stock markets last year, which has caused great concern in Beijing.
At a press conference held by China’s State Council Information Office on March 2 this year, Guo Shuqing, chairman of the China Banking and Insurance Regulatory Commission, said he was “very worried.” He pointed out that the aggressive fiscal policy and extremely loose monetary policy adopted by countries during the epidemic would lead to a serious backlash between the financial markets and the real economy of developed countries in Europe and the United States. As a result, he is “very worried that the bubble in foreign financial markets will burst one day, and now the Chinese market is highly connected to foreign markets and foreign capital continues to flow in.”
On March 5, Premier Li Keqiang’s “Government Work Report” to the 13th National People’s Congress set a conservative growth target of no less than 6% for the next five-year plan and 2021, and suggested that the fiscal deficit should be strictly controlled and monetary policy tightened. This is in stark contrast to Washington, where President Joe Biden is preparing a second $4 trillion economic recovery plan, following a $1.9 trillion stimulus package.
Li Keqiang, while warning of the risks associated with the influx of foreign capital, also proposed “further opening up to the outside world proactively and promoting a new round of reform and opening up with greater determination and courage.
China’s determination to attract foreign investment is reflected first and foremost in the cooperation between Wall Street financial giants and China. 2020 saw Goldman Sachs become the first foreign bank to take 100% ownership of its Chinese joint venture, despite deteriorating US-China relations. JPMorgan Chase also has roots in China. And the Chinese market is a top priority in the eyes of Hollywood, consumer goods makers and high-tech giants.
General Motors has outsold the U.S. in China for 11 consecutive years, according to The Washington Post. Apple’s sales in mainland China (including Hong Kong and Taiwan) rose 57 percent last quarter, almost five times the growth in its own country. Overall, the U.S. buys more Chinese goods each month than it did before the trade war in 2018.
Tianlei Huang, a research fellow at the Peterson Institute for International Economics, believes the rapid increase in foreign onshore yuan-denominated Chinese securities in 2020 is driven by multiple reasons, including a strong yuan, the inclusion of Chinese securities in global stock and bond indices, and investments in them by various U.S. funds, and higher interest rates on policy bank bonds.
Not long ago, Beijing’s listing restrictions on the $35 billion Ant Group shocked millions of potential investors. The restrictions on the fintech sector also caused shares of Tencent, which has a market cap of nearly $1 trillion, to suffer their worst week since 2011. The rapid retreat in asset prices reflects growing regulatory control over business models, which has worried a growing number of foreign investors entering the Chinese market.
Rahman believes that last year when everyone was desperately looking for a place to invest, they may not have paid much attention to the problems that exist in China.
Economic reboot, rising interest rates and the release of long-suppressed demand will attract capital back to the U.S.
Rahman expects U.S. interest rates to rise this year, attracting capital back to the country. “The Biden Administration‘s $1.9 trillion stimulus package and the $900 billion passed by both parties at the end of 2020 are huge, equivalent to roughly 13% of GDP, the largest peacetime stimulus budget. It will push up U.S. interest rates.”
He said, “This is already reflected in the U.S. bond market, where the yield on the 10-year U.S. Treasury note, which started the year at less than 1 percent, has risen to 1.7 percent now. Once that happens, U.S. interest rates will start to rise and the U.S. market will become more attractive to hot money.”
Dorn, deputy director of the Cato Institute, gave a similar forecast but also warned of possible Inflation: “We are in the midst of a high fiscal deficit rarely seen in history, and the Federal Reserve is financing new debt by buying it and providing money for it. The money supply has been growing at a double-digit rate over the past few months, and this year’s big spending plans have increased borrowing and put pressure on the real economic growth generated.”
“The Fed has now reached what they call their flexible average inflation target, and they are willing to exceed the unachievable 2% over the last 10 years to reach 3% or 4%, while the policy rate will be raised only after full employment is obtained. So even if bond market pressures send market rates up, the policy rate will be close to zero for the next few years. The market may generate interest rates faster than the Fed. Therefore, some investors because of these higher rates will reverse capital flows back to the United States for higher returns,” Dorn said.
The most important reason for attracting capital back to the United States is still the high growth expectations of the U.S. economy. Rahman believes the economy will benefit from the Biden administration’s big stimulus package and the Federal Reserve’s loose monetary policy. “With the vaccine rollout, the economy reopening, pent-up demand will be released, and these add up and we expect the U.S. economy to grow at the fastest rate in the last 40 years. in 2021, we’re likely to see at least 6, 7 or 8% growth, which is a growth rate we’ve never seen before, so there’s a fear that the U.S. economy will overheat and will trigger inflation. “
Rahman noted that high growth “will push up interest rates, which are currently low, and that will draw capital back to the U.S. from emerging economies outside the U.S.” “Given that they can get 2.5 percent interest rates instead of 1 percent, investors will wonder why they have to take so much risk to put money where there are so many corporate defaults.”
Former advisor to China’s central bank, renowned economist Li Daokui, also warned of capital reversals, arguing that the $1.9 trillion U.S. stimulus package would “seriously damage emerging market economies.” Li was quoted in China Macroeconomics as saying, “Many investors are exiting emerging market economies. China has emerging market characteristics, although for the Time being it is considered a stable market due to its relatively good performance in fighting the epidemic.”
Mr. LT, a senior analyst in the U.S.-China investment community, echoed Li Daokui’s warning, but argued that the exact extent to which capital returns will also depend on the U.S. economy and the trend in Treasury yields. lt believes that the U.S. and international capital markets are still in a wait-and-see period for the U.S. economy, and that the $1.9 trillion has not yet fully produced the great uplifting effect it should have on international capital markets. It will have to wait until the economy opens up and vaccination rates are much higher before the stimulus package will come to the fore, at which point capital will likely flow out of China uncontrollably and back into the U.S. as it did in late 2013.
LT said that in early 2013, Chinese mainstream economists, including Li Daokui, have warned that international capital will flee China because at that time the Federal Reserve withdrew from quantitative easing, so monetary policy tightened, but the U.S. domestic economic momentum is particularly good, Treasury yields fell, resulting in a large number of capital flows to the United States. At the time, China took many measures that failed to stop the flow of hot money out of China.
At the end of 2014, Chinese media reported that China’s foreign exchange reserves shrunk by $300 billion because of the rapid development of the U.S. economy and the decline in Treasury yields, which led to a large amount of hot money fleeing emerging markets.
Huang Tianlei agrees that Li is basing his hypothesis on the assumption that inflation and nominal interest rates in the U.S. will rise, with the result of making U.S. assets more attractive than ever, allowing capital that has been stranded in emerging market economies such as China to flow back. “I think it’s a legitimate question, and Chinese regulators should really take that risk into account.”
But he also doesn’t think capital outflows will get out of hand this year, and if there are some, they won’t be catastrophic. “While capital outflow pressures may increase in China as inflation expectations rise in the U.S., foreign holdings as a percentage of total outstanding bonds and total domestic stock market capitalization remain low compared to other countries (both below 5%). Mature markets that are more open to foreign portfolio investment. Moving some foreign investment from China’s onshore market may not be disastrous.”
The amount of SOE defaults fears to exceed last year and will accelerate the outflow of foreign hot money
Li Daokui also mentioned in the interview another risk facing China’s capital markets this year, namely defaults by state-owned enterprises. He expects the possibility of Chinese bond defaults to be greater than last year, and the risk of contagion from defaults will increase due to mutual guarantees of debt between companies.
Since last year, several large Chinese conglomerates with hundreds of billions of dollars have defaulted on their debts one after another. Early last year, Founder Group, a super state-owned enterprise backed by Peking University and known as the “most powerful school enterprise,” was announced to be “unable to pay off its debts” and underwent asset restructuring. Earlier this year, the trillion-dollar asset HNA Group was also led by the Hainan provincial government to restructure its assets and resolve the financial risks associated with its default. Typical cases of debt default of large state-owned enterprises at the end of last year also include the Shenyang municipal government’s wholly owned company Shengjing Energy defaulted on hundreds of millions, and eventually the Shenyang government stepped in to help regulate the contradictions in the capital market.
Huang Tianlei believes that in the short term, the increase in SOE bond defaults will certainly wreak havoc. Indeed, as Professor Li says, there could be a risk of contagion, and if a series of defaults occur, central banks and regulators may need to step in to help. It seems to be the government’s intention to let more dysfunctional SOEs go bankrupt and acknowledge the bankruptcies, but the government also does not want defaults to get out of hand. It will be important to take individual cases seriously. Ultimately, however, I believe that the Chinese economy would benefit from letting these unsound SOEs default without a bailout. This would at least help reduce the impact of implicit state guarantees on SOE liabilities. It would also force the SOE sector to adhere to stricter budget constraints and impose stricter credit discipline. Finally, it would help level the playing field and improve the efficiency of the SOE sector.
Mr. LT believes that if there is a withdrawal of hot money from China this year, or a return of capital to the United States, defaults by China’s state-owned enterprises will intensify.
“China’s real estate industry has borrowed a lot of dollar debt in recent years, and once the dollar flows back, it will have a huge impact on capital in emerging markets.” LT believes that the two phenomena described by Li Daokui do have a cascading effect. There is already a large number of defaults by state-owned enterprises, and if the external force of the international capital market is added, it will definitely intensify the wave of defaults by state-owned enterprises.
Huang Tianlei said that the impact on foreign investors is minimal, because foreign investors in general hold very few Chinese corporate bonds in China, but mostly central government bonds and policy bank bonds. One reason for this is that foreign investors are extremely skeptical of the credit ratings of China’s domestic rating agencies, so they choose to hold only a small portion of the Chinese corporate bond market. Such a decision was the right one, judging from the SOE defaults that occurred last year, when all state-owned bond issuers received the highest ratings from domestic agencies prior to their defaults.
“I think in the short term, foreign investors will continue to be cautious about Chinese SOE bonds. But in the medium to long term, this may change as more and more Chinese companies will request ratings from foreign agencies to provide better information to foreign investors. Now that all three major international credit rating agencies have received regulatory approval to operate in China, it is reasonable to expect that foreign holdings of Chinese corporate bonds will increase in the medium to long term.”
Dorn, who has known Li Daokui for years, told Voice of America that Li has always been concerned about the vulnerability of China’s financial sector, known as “financial repression.” “China doesn’t have a free capital market, interests are controlled, state-owned banks are the main lenders, and private sector borrowing remains problematic – all of which leads to a repressed financial sector, which is a long-standing problem. I think what China really needs is a free market concept, and without the free flow of information and capital, there can be no world class capital markets.
Private investors in China need a lot of capital to convert into more foreign currency, but have to sell it to the central bank because it’s not allowed to be sold in the market and the government fears it will push up the exchange rate,” Dorn said. Whereas in a free capital market capital flows freely and the central bank accumulates large amounts of foreign currency, converting it into its own currency and increasing its own money supply, which can lead to inflation. But this is not the case for China because the government has full power to control capital.”
As for the possible withdrawal of foreign capital, Dorn said Chinese regulators do not want to see that happen and may take more control measures and tighten policies, which would also be the wrong thing to do. China has strong protections against foreign investment and can open up its capital markets, but in the long run, freedom of capital, freedom of information and a full free market philosophy are what will attract investment. The lack of a free market philosophy can be particularly damaging to financial markets.