22.04.2019 reading time: 10min
A huge domestic debt is an issue for which Beijing pays special attention, but the growing leverage of foreign debt denominated in US dollars is underestimated and may lead to a serious financial crisis. This is what Kevin Lai, Asia’s chief economist excluding Japan in the Japanese investment bank Daiwa Capital Markets, claims. “… The $ 3 trillion Chinese debt makes it particularly vulnerable to liquidity in US dollars, the weakness of the yuan and the ongoing trade war between the US and China,” said Lai.
Is China intending to let the yuan weaken below seven to the dollar?
Global debt denominated in US dollars outside of America rose to 12 trillion dollars today from $ 9 trillion in 2013, According to Lai 25 percent of this amount, or USD 3 trillion, was borrowed by China Inc and its subsidiaries in Hong Kong, Singapore and the Caribbean. Chinese cross-border liabilities in denominated in US dollars increased faster than any liabilities of other economies, despite a partially closed capital account. In response to two challenges related to the financial market – “taper tantrum” in 2013, when the US Federal Reserve began tightening monetary policy (the term “taper tantrum” specifies the situation of a sharp increase in US Treasury yields in 2013, which resulted from the fact that Federal Reserve used less and less resources to gradually reduce the amount of money in the economy. Investors panicked in response to news of this reduction and quickly drew their money from the bond market, which drastically increased their profitability) and the People’s Bank of China attempt to reform the exchange rate in August 2015 – China has incurred even more dollar debt instead of paying it back and solving basic problems with corporate efficiency and management.
Can this trade war push the world dollar debt to $ 13 trillion or $ 14 trillion?
The amount of the dollar debt in the world probably reached the highest level after the US dollar tightened. This would mean that investors would sell their assets to recover their dollars and pay off the dollar debt. “We will talk about a serious financial crisis – a debt crisis in dollars.” The amount of dollar debt acquired by China in offshore centers that entered the Chinese banking system is worrying, given the prospect of further depreciation pressure on the yuan exchange rate, Lai said. It has long been an unspoken rule in the corridors of Chinese power is that the value of the national currency of the yuan should never fall below seven to the US dollar. Often in the past, when it seemed to be going, the central bank intervened and lifted it back to the next level.
Will it be this way this time?
US debt owned by China is USD 1.13 trillion from January 2019. It is 28% from USD 3.97 trillion Treasury bills, banknotes and bonds held by foreign countries. The rest of the $ 22 trillion national debt is owned by either Americans or the US government itself.
China has the largest amount of US debt from foreign investors. Japan ranks second with USD 1.07 trillion, followed by Brazil – USD 305 billion. Ireland has 270 billion dollars, and the United Kingdom (England, Wales, Scotland and Northern Ireland) – 272 billion dollars.
Why do government spending in the US grow?
Before the recession, the government kept federal spending below 20% of GDP. The rate of expenditure growth was not faster than the growth rate of the economy, around 2% to 3% per annum. During the recession, expenses increased to a record level of 24.3% of GDP in the budget year 2012. This increase resulted from economic incentives and two foreign wars.
At the same time, growth slowed down. It reduced tax revenues. Congress was worried about the growing US debt. No one could agree how to reduce it. As a result, Congress introduced a 10% reduction in the budget called sequestration. This eventually reduced spending to 20.7% of GDP in 2015.
Since then, spending has risen again despite the sequestration. Congress and the President rely on deficit spending to stimulate economic growth. But deficit spending is getting out of control. They grow every year, even if the economy is doing well.
Almost two-thirds of federal spending goes to paying for the services required by Social Security, Medicare and Medicaid. They are part of the mandatory expenses. These are the programs established by earlier congressional acts.
Interest on national debt absorbs 10% of the budget. They are also required to maintain faith in the US government.
The remaining 30% of expenditure goes to discretionary expenses. These expenditures finance the activities of all federal government agencies. The largest of them is the army.
The mandatory budget will cost USD 2.841 trillion in the budget year 2020. Compulsory expenditure is growing exorbitantly, as more and more people are reaching the retirement age. By 2030, one in five Americans will be over the age of 65. Social insurance costs the most – 1.102 trillion dollars. Current payroll taxes provide income of USD 949 billion. Interest from the Social Security Trust fund finances the remainder. However, the costs will exceed interest and income by 2034. At that time, Social Security benefits will begin to drain the general fund. It also means that Congress can no longer “borrow” from the Social Insurance Trust Fund to other federal programs. Medicare (USD 679 billion) and Medicaid (USD 418 billion) are the next largest expenses. Medicare taxes are another $ 289 billion in costs. The rest comes from the general fund.
The following compulsory programs cost 642 billion dollars:
• Income support programs, such as food stamps, unemployment compensation, child feeding, child tax credits, additional security income and student loans. Unemployment insurance costs cover $ 46 billion in costs. Contrary to popular opinion, welfare programs are not the biggest reason for government spending.
• Pension and disability programs for civil servants, coast guards and the army.
• In 2020, interest payments on domestic debt are estimated at USD 479 billion. That’s enough to pay for 10 Justice Departments. It is also one of the fastest growing expenses. It is forecasted that by 2029, interest on debt will double, to USD 823 billion, becoming the third largest budget item after social insurance and Medicare. This is not a compulsory program, but it must be financed to avoid insolvency of US debt. These estimates will increase as interest rates rise.
The budget is to amount to USD 4.7 trillion.
According to the assumptions of the administration of President Donald Trump, the budget deficit is to amount to USD 1.1 trillion. It would be the highest deficit of the decade. The government also assumes a rapid economic growth, which in 2019 would amount to 3.2 percent. GDP, and in 2020 – 3.1%; the media considered this to be an optimistic assumption.
The Fed estimates that the US economy will slow down this year and the rise will be 2.3 percent. The International Monetary Fund forecasts that it will be at the level of 2.5 percent.
The White House is demanding $ 8.6 billion. for the construction of the wall on the US-Mexico border, which – as the agencies emphasize – will be the source of further conflicts with the Congress, which decides on the allocation of federal funds. This autumn the rate will be higher than the shutdown, October 1 is the deadline in which you can raise the US debt limit. If this does not happen, the government will be in a state of technical insolvency.
Why China has so much US debt?
It is unlikely that China would call for the repayment of debt denominated in USD. If that happened, the demand for the dollar would fall sharply. This dollar collapse would disrupt international markets even more than the 2008 financial crisis. The Chinese economy would suffer along with others.
It is more likely that China will slowly start selling its shares in the US external debt. It happens that they warn about their plans in the situation of increased demand for USD. This causes a drop in demand for the dollar, which is detrimental to the competitiveness of the Chinese economy. As US export prices increased, US consumers would buy American products. China can only start this process if it extends exports to other Asian countries and increases domestic demand.
Owning US Treasury bonds helps the Chinese economy grow. It maintains a weak yuan exchange rate against the dollar. As a result, Chinese exports are cheaper than American products. China’s highest priority is to create a sufficient number of jobs for 1.4 billion people.
The United States has allowed China to become one of the largest bankers because the Americans enjoy low consumer prices. Debt sales to China finance federal spending that stimulates US economic growth. It also maintains low interest rates in the US. But the Chinese ownership of American debt shifts the economic balance in favor of China.
The current US government spending is $ 4.746 trillion. This is the federal budget for the fiscal year 2020 covering the period from October 1, 2019 to September 30, 2020. It is 21% of the gross national product according to the Office of Management and Budget Report for the financial year 2020.
In the US, we see that inflation is rising. We see this in the so-called wage inflation. We observe an increase in transport costs. And we see it thanks to tariffs. Let’s look at the market of household goods: washing machines are more expensive after the introduction of steel tariffs than after the introduction of tariffs. Do American companies have price control? If this is the case, they can maintain record high margins. If not, the margins will show a downward trend, which will significantly affect the rate of profit growth. The price power is extremely important, and many American companies have forgotten what it is like to raise prices because they did not have to do it for a long time. The most worrying sector is the retail business, which has a huge number of employees with low earnings. If a remuneration of USD 15 per hour is implemented in the country, this will put real pressure on the margin for most retailers. Why cannot all companies increase the prices of their products? Because there are several large consolidated retailers on the market controlling the blocking of consumption by companies by raising prices. Giants like Amazon, Walmart, Target and Kroger can refuse a company that does not have too many alternatives to distribute their products.
The American economy in January 2019 created 304,000 new jobs. This is a larger than expected growth, even considering the large downward correction of the December number of jobs. Recent employment increases remain impressive, even after almost a decade of steady progress. The maintenance of the dynamics of the last few months will probably be difficult, but even the rolling 12-month change in employment in the non-farm sector is the highest in more than two years. Given the strong labor market and the shrinking ranks of the unemployed (4%, the lowest in almost 20 years), it is not surprising that wages have risen. As the pool of available employees decreases, competing for them requires higher wages – and a higher remuneration is an incentive for more employees to look for a job. The US economy is still in the high wages cycle, and the most credible leading indicators suggest that the increases are likely to continue.
A strong US consumer is good news for the economy and markets. The net effect of all this: household budgets are still growing. In fact, they grow faster than at any time from the global financial crisis. Financial markets seem to have big concerns about slowing down the economy, but the strong labor market suggests the opposite: the consumer is in good shape for now. Consumption is responsible for almost two-thirds of the American economy and as long as the foundations of consumers remain good, the recession is unlikely.
The Chinese debt strategy works
The strategy of creating a low-cost competitive advantage of China has been working for the moment. The economy of China grew on average 10% per annum for three decades before the recession. From 2018, it grows by almost 7%, which is a more balanced rate. China has become the largest economy in the world, overtaking the United States and the European Union. China has also become the largest exporter in the world in 2010. They need growth to raise the low standard of living of citizens. Despite the threats, China will continue to be one of the largest US debt holders in the world. Traders, investors and their clients have in the past benefited from a lucrative spread between US and Chinese interest rates to borrow cheap dollar debt and convert it into assets with high Yuan-denominated profitability. If the yuan continues to depreciate, it is very likely that we will see a debt crisis in dollars. As a result, loans in dollars will become even more unmanageable, which will lead to more sales of the yuan and a possible negative spiral, because $ 3 trillion “carry trade” in dollar debt will be resolved. In this situation, we can have a very strong and unpleasant effect, a crisis of debt denominated in dollar. At this point, I suggest you look at the USD 1M LIBOR rate, which at the time of writing the article is 2.49% and is the highest in the last 10 years.
Another interesting issue is the indebtedness of Chinese housing developers. Shimao China announced on January 13 that it is issuing RMB 2 billion in 3-year bonds with an interest rate of 4.65% per annum, while Sunac China on January 10 conducted a bond offer worth USD 600 million in the amount of 8.375 percent. On January 17, the R & F Group completed the issue of 1.3 billion RMB short-term bonds (with a repayment term of 270 days) at 5.28%. While the China SCE group sold a $ 500 million seniority on January 15, a senior notebook with a coupon of 8.75%. and maturity in 2021. In December last year, the National Development and Reform Commission (Chinese government agency) published a notice on support for direct fundraising initiatives by “high-quality enterprises” to further strengthen the capacity of corporate bonds to service the real economy. The central planning authority said it would support fund raising by Chinese developers with assets of RMB 150 billion and more, sales revenue of over RMB 30 billion and a debt ratio below 85 percent. This movement was perceived as a signal for some relaxation of the Chinese government’s policy of financing Chinese developers. Chinese developers face increased refinancing requirements, as USD 34.8 billion in inland bonds and USD 17.9 billion in offshore bonds in the next 12 months can be reported by buyers for redemption.
We understand that the increase in debt at the corporate level and at the level of governments is a global phenomenon, a function of the economic situation, which should be observed and analyzed over a longer time horizon. The question arises of the implications of the increase in debt, especially in the context of further growth prospects. From the corporate and governmental point of view, borrowers try to stimulate short-term growth, usually at the expense of long-term growth. Another important factor in the context of the analysis of debt growth is the demographic factor, i.e. how much the working-age population will grow in the future. Who or what would have to maintain the current growth dynamics in the future. We are looking at the development of AI, the phenomenon of progressive automation of processes and the concentration of data in the hands of the largest e-commerce platforms. Maybe we’ll write about it. We are also looking at the competition on the China-US line for the title of hegemon, and this article should be treated as an introduction to further analysis of this phenomenon.
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The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all RCieSolution management teams. Are subject to revision over time.