China is the Global Economic Engine. Its Financial Markets do not Match Up
February 13, 2015
Asian risky debt is largely driven most strongly by JGB yields on one hand and S&P 500 levels on the other. However, Chinese debt doesn’t care much about either one. The impact of a Chinese debt crisis will impact global markets unfavorably in a big way. The impact will unfold through depressed corporate profitability, not through instantaneous financial market linkages.
Debt is borrowing from the future. China has borrowed too much. China will eventually experience a debt crisis, and I believe that time is coming very soon. Debt crises are nothing like equity bubbles because they completely blow-up balance sheets. Debt bubbles contain fixed or floating payment obligations that remain despite asset value collapses. The only way to reduce them is to pay them down or to default. Paying them down is a slow grinding process. Default is the corporate equivalent of death.
As much as I love Chinese culture and its friendly, respectful, lovely people: history shows this will lead to a disaster. It will be a big one. The Global McKinsey Institute has tallied up the growth in Chinese debt since 2000, and it is clear that the coming crash will be epic.
The associated defaults and retrenchment it will dampen confidence, spending, production, and growth. No doubt a China slowdown will be unfavorable to credit all over the place.
The key for an investor is to either avoid the train-wreck, or capitalize on it. However, the channels through which global credit and financial markets will be impacted are not clearly understood. Here’s some information that sheds some light on the matter.
Below is a standard correlation matrix that isolates the relationships the between the interconnected web of the Asian financial universe. It shows you on a scale from -1 to 1 the nature of the relationship, where -1 means it is a completely linear inverse relationship and 1 means a completely linear positive relationship. An inverse relationship means one goes up and the other goes down. Completely linear means that a move in one factor implies the other moves in lockstep. Below the Pearson correlation measures are an indication of the statistical strength of these relationships given some technical assumptions hold, the smaller the better. I believe the assumptions are not valid, so reporting them is somewhat meaningless but not particularly dangerous once forewarned. The relationships do not identify causation in any sense.
Since February 2010 to present:
Sorry if you have to squint. Drop me a note and I’ll send you something larger.
Chinese corporate debt yields have little linear relationship to anything except Chinese sovereigns.This makes sense as govvie yields serve as the reference rate for risky Chinese local currency debt.
A drop in the S&P 500, a measure of US corporate profitability, strongly drives all South Korean debt to sell off (yields go up).
A drop in the S&P 500, a measure of US corporate profitability, strongly drives Japanese corporate and bank debt to sell off (yields go up).
The broad Japanese equity market, the Nikkei 400, doesn’t impact credit much.
Taiwan government debt is completely uncorrelated to everything else.This makes it a potentially important portfolio diversification tool.
South Korean, Taiwanese, and Japanese Corporate bond yields are tightly connected, indicating they are integrated parts of the Asian financial universe.
Moves in JGB yields anchor Taiwanese, South Korean, and Japanese risky debt.
This covers Asian credit. I’ll look at the connection between US debt markets and China in a separate post with a tight little model.