Global banks issue alerts on China carry trade as Fed tightens, yuan falls

Half of this foreign lending is linked to China, where dollar loans have jumped by $620bn since 2009. Roughly 80pc are at maturities of less than one year. The report warned that higher rates might “erode bank’s willingness to roll over their cross-border loans to borrowers in China”.

^{Share of short-term loans globally. Source: Citigroup/BIS}

Speculators have been borrowing dollars to buy Chinese assets, a flow known as the "carry trade". They often do so with leverage and through convoluted means, some involving use of copper or iron ore as collateral. The bet is that the yuan will strengthen, generating a near certain profit on the exchange rate. This has gone badly wrong as the central bank intervenes to force down the exchange rate, causing the yuan to fall 2.5pc against the dollar since January.

Nomura issued a client note on Friday warning that the carry trade is “reversing gear”, describing a break-down of discipline in which almost everybody in China from investors, to manufacturers, exporters, and commercial banks have been playing the game. Most of the borrowing has been in dollars and yen on the Hong Kong market.

^{Dollar lending to Chinese businesses. Source: Citigroup/BIS}

Wendy Liu, Nomura’s China strategist, said investors are putting too much hope in the promise of fresh stimulus and infrastructure spending, ignoring the risks of a weak yuan.

She said devaluation is a double-edged sword. It helps cushion the shock of China’s economic slowdown, boosting “the razor-thin margins” on exporters along the Eastern seaboard. It may also mitigate the “coming wave of credit defaults”. But is also exposes the fragility of the system. A view is gaining credence that the weak yuan is an early warning sign that “China's credit bubble may implode imminently”, she said.

The Bank for International Settlements caught the attention of central banks across the world -- especially the Bank of England -- with a report last October warning that foreign loans to China are now large enough to risk a repeat of the 1998 financial crisis in Asia.

“They have more than tripled in four years, rising from $270bn to a conservatively estimated $880bn in March 2013. Foreign currency credit may give rise to substantial financial stability risks associated with dollar funding,” it said. Analysts say dollar loans -- to firms, not the Chinese state -- have since risen to $1.2 trillion. Almost a quarter come from British-based banks.

^{British banks make up a quarter of foreign loans to China. Source: BIS}

The BIS said the loan-to-deposit ratio for foreign currencies in China has doubled from 100pc in 2005 to 200pc today. Much of this has been through foreign exchange swaps and forms of credit that are hard to track.

China has $3.8 trillion of foreign reserves and ample monetary fire-power to shore up its financial system if need be. The banks are an arm of the state. The authorities can unleash $2 trillion of credit by slashing the reserve requirement ratio (RRR), currently 20pc. It was 6pc in the late 1990s. The question is whether President Xi Jinping wishes to do so.

The current monetary squeeze has been deliberately engineered to crush speculators and prick the bubble before it is too late. Mr Xi's "Third Plenum" reforms aim to break China's reliance on excess credit, and on a catch-up growth model beyond its sell-by date. The paradox is that western lenders may be as much at risk -- or more so -- than the Chinese themselves.

Credit Suisse says HSBC is heavily exposed, generating a large chunk of its profits from trades linked to China. The Swiss bank says the speculative part of the carry trade has reached $200bn and entails an intricate web of manoeuvres through Hong Kong. “Various indicators point to stress in the system. The risk of a mis-step is increasing,” it said.

Citigroup said dollar lending to Brazil, India, Indonesia and Turkey has also been enough to create “some threat to external stability”. Outflows will have the effect of squeezing domestic credit, and risk pushing these countries into deeper downturns.

The worry is different from last year's “taper tantrum” when the Fed's tough talk set off a 100 basis point rise in 10-year US bond yields, driving up global borrowing costs and triggering flight from emerging markets. Mr Lubin said the Fed's shift was the cause of China’s “nasty liquidity crunch” in June.

This time bond yields have been better behaved. Citigroup says investors may be taking false comfort, concluding prematurely that the emerging market stress is over. The Achilles Heel in 2014 may prove to be the Fed's short-term rates.

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