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Evergrande: Turning Point for China or Tempest in a Teapot? - Global Exchanges

FICC Podcasts September 21, 2021
FICC Podcasts September 21, 2021

 

In this week's episode, we are joined by Art Woo to discuss the Evergrande situation and what it might mean for China's economy, Chinese financial markets, and global FX.


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About Global Exchanges

BMO’s FX Strategists, Greg Anderson and Stephen Gallo, offer perspectives from strategy, sales and trading on the foreign exchange market, related financial markets, and the global economy.

Podcast Disclaimer

 

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Greg Anderson:

Hi, welcome to episode 19 of Global Exchanges, a podcast about foreign exchange markets and related issues. I'm Greg Anderson. In this week's episode, my co-host, Stephen Gallo and I, will be joined by Art Woo from BMO's economics team in Toronto. We will be talking about the Evergrande situation in what it might mean for China's economy, Chinese financial markets, and GLOBAL FX. The title for this episode is, Evergrande, turning point for China, or tempest in a teapot.

Stephen Gallo:

Hi, I'm Stephen Gallo, a London-based FX strategist. Welcome to Global Exchanges, presented by BMO Capital Markets.

Greg Anderson:

Hi, I'm Greg Anderson, a New York-based FX strategist. I'm Steven's co-host.

Stephen Gallo:

In each weekly podcast, like today's. We discuss our perspectives on the global economy and the foreign exchange market. We also bring in guests from the FX industry and from related financial markets, like commodities.

Greg Anderson:

We strive to make this show as interactive as possible. So, don't hesitate to reach out by going to B-M-O-C-M.com/globalexchanges. Thanks for joining us.

Speaker 3:

The views expressed here are those of the participants and not those of BMO Capital Markets, it's affiliates, or subsidiaries.

Stephen Gallo:

Greg, thanks very much for that intro. And of course the title, I certainly can't take full credit for "Tempest in a teapot." That's a good one. So for the record, we're 21 days into the months of September now. And, when I take a look at the broader FX market, I can't see any major currency pairs that have had a year to day range break. But, what I do see is that the BBDXY, which of course is one measure of the broad value of the dollar, is trading 0.6 to 0.7% higher, so far this month. And a portion of that move has coincided with a decline in risk assets, like equities. Now, it seems likely that financial stress related to Evergrande has been responsible for part of that move, we don't really know how much. But, in order to delve into this issue, as you've already mentioned, Greg, we've brought in Art Woo. Art is a BMO senior economist based in Toronto, and he's got many years of watching the Chinese economy behind him. Art, welcome to Global Exchanges.

Art Woo:

Well, thanks for having me on board, and I'm glad to be here.

Stephen Gallo:

Art, one of the things that stands out from my vantage point, is the number of headlines I've seen with the infamous name Lehman in the title. And so, I think, with that in mind, we'll dive right in with a question perhaps many investors are trying to answer, is Evergrande's potential failure, China's Lehman moment? Art, what do you think? Take it away for us.

Art Woo:

In a nutshell, no. It's certainly not good news for the economy, but if we take a step back, we just don't think it's going to lead to widespread contagion, bringing down numerous home builders, or lead to a widespread banking crisis, or a deep economic downturn.

Stephen Gallo:

Okay, Art. If I can just stop you there, for my benefit and the benefit of all our listeners, can you tell us why you think we should not be comparing the potential failure of Evergrande to the class of Lehman Brothers and the '08, '09 subprime crisis in the U.S.?

Art Woo:

Yeah, I don't think the current situation facing in China is really that comparable, as, from what I understand the U.S. financial crisis. Back then, was more about weak lend in standards. And banks offloaded their housing exposure through securitization. In China's case, bank record standards have actually been quite tight to both developers and final house buyers.

Greg Anderson:

If I could just jump in, and help Art a little bit, Steven. The comparison to the U.S. crisis, look when Lehman Brothers failed, it was a financial institution with unknown and unknowable derivative contracts with many other financial institutions. So, the concern wasn't just Lehman Brothers, it was Merrill Lynch, it was Countrywide. It was every bank in this system. Things are much different when we're just talking about a property developer, rather than a financial institution.

Art Woo:

Yep, Greg. I can't agree more. If you look at Evergrande's liabilities, which roughly amount to less than a half a percent of bank loans, they can easily be absorbed by the entire banking system. But I would like to stress that China's housing market, it's not problem free, home builders have been under increasing stress in recent years, as authorities have been trying to prevent a bubble, reduce financial stability risk, and promote affordability. Thus, sector profit margins have been heavily squeezed. But in Evergrande's case, whose financial issues or problems have been well known for quite a while, government's efforts to get the company to shed its debt load, have obviously not been that successful. So, I would view their problems somewhat more idiosyncratic, rather than completely reflective of the entire home-building sector.

Stephen Gallo:

Really useful comments there Art, but I just want to go backwards for a second, because you mentioned that the property sector in mainland China does have its share of problems. So, I want to drill down a bit further into that issue. Are we talking about an issue for the property sector, which is directly related to a massive supply/demand imbalance? Is that a problem, do you think Art?

Art Woo:

You know what? That's a great, but not such an easy question to answer, because to me that gets to the heart of the matter, given how large real estate development has been to the economy in recent years. Most people think it estimated accounts for roughly 15% of GDP. However, I don't think that nationwide housing supply/demand fundamentals are severely out of whack, or basically, new supply coming on-stream is going to severely outstrip demand. Proving this is difficult. Okay, because we just simply don't have hard, detailed statistics. A couple factors lead me to believe this. The first is, the authorities have been trying to prevent speculation, multiple loan ownership, and curb financial leverage in property related activities for a number of years. Particularly over the past five years. Last year we had the famous three red lines come up to curb home builder leverage.

Art Woo:

Two, China's housing market, it's just simply not one large homogenous market. So, there will be pockets of strength, and they're going to pockets of weakness among different regions and different cities. So, it's not surprising that we've seen some home builders default and get into trouble over the past years, as they probably simply are exposed to geographically weaker parts of the country. So, there's been this growing divide between the countries more develop coastal regions, the manufacturing powerhouse of the country, versus the less developed inner regions or the Northern rust out, for example. And, this divide has risen during the pandemic.

Greg Anderson:

Hey Art, can I ask the next question? I'm hyper-focused on spillovers and contagion. You mentioned that Evergrande's liabilities are only a tiny fraction of bank loans. So, there's unlikely to be a banking system issue, but I'm wondering if that's not all there is. If Evergrande has got problems and is going to miss some payments, could it be a sign that a bunch of property developers will go under, and that the combination of all of them could cause a major problem in the Chinese banking system?

Art Woo:

Well, that's the trailing you on question. It can't be entirely ruled out, but I guess I would place that as a very low probability. I would also revert to my previous answer that, the housing market is not homogenous China. And that, generally speaking housing demand was incredibly strong in the first part of the year. Our new housing measures were being implemented in many parts of the country to take heat off the market. Another perhaps underappreciated factor that also protects the housing market more or broadly, is the lack of investment alternatives in the country. And, housing is simply viewed as a great place to park money. And, it's been underpinned by the fact that it's harder for citizens to move their money offshore in recent years.

Stephen Gallo:

Okay, Art. So, you mentioned in your last response, something to do with the inertia related to outbound capital flows, or specifically the difficulty associated with moving money offshore. And that triggered something in my brain. And so, I'm wondering if we can transition the come conversation over to something I've actually learnt from listening to you in the past, in your coverage of the Chinese economy, which is this notion of the so-called trapped money hypothesis. Can you just give us and our listeners a brief overview of this theory, and how it relates to the situation in China's property?

Art Woo:

I don't know whether it's so much a theory, but an observation. But if you recall, back in the middle of the last decade, China's foreign reserves fell very rapidly. They were over four trillion U.S. dollars in 2014, and they tumbled to just over three trillion by the end of 2016. And during that year we had the mini-devaluation of the downturn in the stock market and all sorts of concerns of over finding stability. But, in response, the one thing Beijing did is that they tighten capital controls. These controls are specifically on outbound outflows stating the obvious by Chinese residents. And, that response has effectively remained in place since then. So, it's basically not so easy for Chinese individuals or companies to take money outside of the country for investment purposes. And, that keeps more money on shore than would otherwise be the case.

Stephen Gallo:

Those are all fantastic points Art, and I couldn't agree with you more. In fact, what I would point out is that over the past year or so, this imbalance, which you alluded to between inbound and outbound capital flows, has added a lot of support to China's overall external position. And certainly, with less tourism going out of China and more export receipts flowing in, the effect from the net flow of capital has merely been compounded. And I think there are a few implications of this that we need to keep in mind.

Stephen Gallo:

First, I think regulators have become more adept over time at managing China's balance of payments, because this situation that we're looking at, it doesn't seem like it's happened by chance. Let's just say that. Secondly, this all points to me, to the fact that it's very difficult as a speculator to bet against the Chinese Yuan, the currency, because the balance of payments keeps the currency well-anchored. And third, at least in my opinion, this backdrop makes me a bit less bullish, I think, than the consensus on the pace and extent of Chinese financial opening. Because ultimately, in order for policy makers and regulators to continue tackling financial imbalances, policy makers need to be cautious with how much control they see to the private sector or non-resident investors.

Art Woo:

Steven, I'm completely on side with your point on financial liberalization. It hasn't progressed that much in recent years, other than [Metin 00:05:23] foreign banks enter into the market.

Greg Anderson:

Hey, if I could ask the next question, and probably the last, just back to the issues of spill over from Evergrande, one of the things that has happened over the last couple of weeks that this has been a theme, is that copper has fallen about 6% or so. And, [ozzie 00:12:42] has fallen, I'll call it 3%. So Art, do you think these moves seem about right? Or, is there a chance that they're overdone? And I guess, how much do you think the Evergrande situation will impact Chinese metals demand over the next six months or so?

Art Woo:

Hard to say, whether the correction is overdone. It's not surprising to see metals sell off a bit, given how important Chinese demand, particularly, property related demand, is to global metals. In our view, a temporary cooling in the housing market should lend support to our forecast, that prices of base metals should ease off next year, compared to this year. The more critical factor we think that will impact prices, which have performed exceptionally well over the past year, still revolve around the pandemic and how it unfolds. And what I mean by that, is that if the pandemic driven spike in demand for durable goods, supply chain shortages, and bottlenecks, and global logistics, and transportation networks, if these eventually reverse course, it should reduce demand for metals, and will lead to average lower prices in 2022, whether this is for copper, nickel, aluminum, or steel.

Stephen Gallo:

Thanks for that, Art. Great comments there. We're going to wrap up the podcast now. Art, I want to personally thank you for sharing your insights and being patient with us, as we attempt to navigate the complex economic backdrop in China.

Greg Anderson:

Hey, Art. I also want to thank you for coming on our show.

Art Woo:

Thank you for having me come on board. It's been a pleasure joining you.

Stephen Gallo:

Thanks, Art. So, this brings us to the end of episode 19 of Global Exchanges. Thanks listeners for joining us as always, bye for now.

Greg Anderson:

Thanks for listening to global exchanges, listen to past episodes and find transcripts at B-M-O-C-M.com/globalexchanges.

Stephen Gallo:

We'd love to hear what you thought of today's episode. You can send us an email or reach out to us on Bloomberg. You can listen to this show and subscribe on Apple Podcasts, Spotify, or your favorite podcast provider.

Greg Anderson:

This show and resources are supported by our team here at BMO, including the Ficc Macro Strategy Group and BMO's marketing team. This show is produced and edited by Puddle Creative.

Speaker 3:

This podcast has been repaired with the assistance of employees of bank of Montreal. BMO knows that burned incorporated, and BMO Capital Markets Corporation. Together, BMO, who are involved in fixed income, and foreign exchange sales, and marketing efforts. Accordingly, it should be considered to be a product of the fixed income and foreign exchange businesses generally. And not a research report that reflects the views of disinterested research analysts. Not withstanding the foregoing, this podcast should not be construed as an offer, or the solicitation of an offer to sell, or to buy, or subscribe for any particular product or services, including, without limitation, any commodities, securities, or other financial instruments. We are not soliciting any specific action based on this podcast. It is for the general information of our clients. It does not constitute a recommendation, or a suggestion that any investment or strategy referenced herein may be suitable for you.

Speaker 3:

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Speaker 3:

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Greg Anderson Global Head of FX Strategy
Stephen Gallo European Head of FX Strategy
Art Woo Director and Senior Economist

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