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USB sees risks in the mainland's level of unhedged foreign debt. Photo: Reuters

UBS flags China's US$1tr debt risk

Mainland economy more exposed to shifts in currency and interest rates as international trade expands and foreign-exchange rules are eased

China debt

UBS is flagging risks from the mainland's US$1 trillion worth of unhedged foreign debt as forecasters see bets against the greenback unwinding next year.

Stephen Andrews, head of Asia banks research at UBS in Hong Kong, said the world's second-largest economy was exposed to shifts in currency and interest rates as never before because of expanding international trade and easing foreign-exchange regulations.

Daiwa Capital Markets estimates carry-trade inflows - bets on the difference between yields on the mainland and overseas - since 2008 at US$1 trillion. It forecasts the yuan will drop 5.7 per cent against the US dollar next year.

It is heading for a 2.8 per cent loss this year as the US dollar gains on Federal Reserve plans to raise interest rates and the People's Bank of China cuts borrowing costs to support a flagging economy. Capital controls and record foreign-exchange reserves would help the mainland's central bank cope with any situation similar to 1997's Asian financial crisis, when firms struggled to repay debt as currencies slumped, Andrews said.

"This could get very uncomfortable very quickly," he said. "I boil it down to its basics. You've borrowed unhedged and leveraged: you're at risk."

Andrews said mainland companies had been depositing 20 per cent to get a letter of credit from an onshore lender. They then used that to get a low-interest US dollar loan from a Hong Kong bank, which treated it like a no-risk cheque fully backed by the guarantor.

The companies then flipped those US dollars back to the mainland, Andrews said, using them as collateral to get even more letters of credit, leveraging even further. That money was then used to invest in high-yield and often risky trust products on the mainland or in its booming stock market, with the profits used to pay off US dollar borrowings.

Hong Kong banks' mainland-related lending stood at HK$3.06 trillion at the end of September, 14.7 per cent of total assets, according to the Hong Kong Monetary Authority. Andrews said his estimate was higher because he included trade bills and other forms of lending not captured by the data, such as between sister companies in intergroup corporate transfers or letters of credit between onshore and offshore bank branches.

Hong Kong-based Daiwa economist Kevin Lai said: "There were too many cheap dollars in the market for everyone to borrow. If you just put the money in China, the carry plus appreciation is about 5 per cent."

Lai estimates US$1 trillion of carry-trade inflows since the first round of US quantitative easing in 2008, of which US$380 billion entered the mainland disguised as commerce flows.

Global markets became flooded with cash after the Fed started the bond-purchase programme. Meanwhile, steady growth and tighter monetary conditions pushed up yields in the mainland, widening their premium to similar US securities. The gap between 10-year Chinese and US sovereign yields rose to a record 235 basis points in 2011. It has since shrunk to 140 basis points.

Mainland companies issued a record US$5.4 billion of bonds offshore that were supported by standby letters of credit from national banks this year. The 18 securities compare with only four last year and two before 2013 in data going back to 1999. They sold a total of US$224.8 billion of notes offshore this year.

Andrews said the similarities between pre-Asian financial crisis Thailand and the mainland today were limited. The amount involved was still small relative to the mainland's US$9.2 trillion gross domestic product, its overall loan to deposit ratio was healthy and its foreign-exchange reserves peaked at US$4 trillion in June.

Chen Long, Beijing-based China economist at research consultancy Gavekal Dragonomics, said the mainland's overseas debt had been growing in line with the economy and banks were healthy enough to absorb changes in rates or currencies.

Sabine Bauer, an analyst at Fitch Ratings in Hong Kong, said that while lending to mainland firms with letters of credit shielded the city's banks from corporate risks, it left them exposed to the mainland's financial system.

"If there are problems in the Chinese banking system, either real or perceived, that could spill over to the Hong Kong banks and their liquidity may tighten as well," Bauer said.

 

This article appeared in the South China Morning Post print edition as: UBS flags China's US$1 tr debt risk
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