China’s $16 Trillion Problem Collides With ‘Taper Tantrum’

As emerging markets brace for another giant “taper tantrum,” not enough attention is being paid to how China might fare.

Admittedly, Asia’s biggest economy navigated the turmoil of 2013 with flying colors. What’s more, investors who’ve bet against Beijing since the late 1990s haven’t done particularly well. China, for example, didn’t devalue its currency in 1997 as feared along with Indonesia, South Korean and Thailand.

In 2008, then-President Hu Jintao’s government stimulated its way around the worst of the global financial crisis. In 2013, as hints of Federal Reserve tightening sparked the above-mentioned taper tantrum, it was Xi Jinping’s turn to confound the naysayers. As governments from Brasilia to Jakarta faced the wrath of markets, President Xi’s was largely unscathed. 

And Xi’s is the first major economic power to recover from the Covid-19 crisis still ravaging the Group of Seven nations world.

But the next tantrum could be something very different for China thanks to its so-called $16 trillion problem. The reference here is to China’s government bond market, one that Xi’s team is steadily opening to the outside world. And for good reason. A liquid and trusted debt infrastructure is vital to undergirding any economy with big global ambitions.

Hence, China’s efforts to get mainland debt added to top fixed-income indexes, most recently the FTSE Russell. But China represents a blind spot unprecedented in modern economics: a colossus with a decidedly underdeveloped financial system.

A few things China’s debt arena lacks: basic transparency; a credible credit-rating system; press freedom that facilitates lively analysis; a range of hedging tools; a roster of independent bond dealers to make markets; a fully convertible currency; level playing fields for state and non-state issuers.

China will surely figure all this out. But if emerging markets hit a wall in 2021, the absence of these basic stabilizers and others could trip up the second-biggest economy at the worst possible moment.

The most likely catalyst of the next market-shaking tantrum is less the Fed than skittish bond traders. Over the last 30 days, the U.S. Treasury Department hosted two disturbingly mediocre auctions of seven-year notes. Demand at last week’s sale wasn’t as disastrous as February’s, but still rather disappointing.

The worry is that global investors doubt Washington’s ability to finance Covid-19 rescue packages—and President Joe Biden’s $3 trillion infrastructure extravaganza to come. This remains to be seen, of course. A modest spike in U.S. yields, though, has been enough to send waves of panic through global markets.

It’s also been enough to drive international capital China’s way. China’s 10-year bonds yield 3.22% versus 1.64% for comparable U.S. debt. In a world in which zero interest rates are the norm, China’s appeal is obvious. Nor does it hurt that China grew 2.3% in 2020, the only major trading power to emerge from the coronavirus. It did so without adding trillions of dollars to the national debt load or resorting to quantitative easing.

China, meantime, is clamping down on leverage. Efforts to reduce systemic risks extend far beyond the $10 trillion-plus shadow banking system to municipal government lending programs far beyond Beijing. Yet more attention must be on the explosion of local government financing vehicles (LGFVs) in recent years. They can make it hard to discern where the cracks lie.

Ma Jun, an external adviser to China’s central bank, warns that excessive regional government borrowing could set off a “chain reaction” of defaults and other stumbles. These LGFVs, after all, have been the fuel powering China’s post-2008 infrastructure boom. In 20 nascent metropolises around the nation, they’ve been employed to build countless six-lane highways, international airports and white-elephant stadiums.

Deleveraging is a work in progress. For all the chatter about Xi’s market-friendly reforms, he’s also making China’s economy more of a black box. When China does stumble, as every industrializing nation does, it could come as quite a surprise. This opacity that comes with the Xi era means credit spreads, yield-trading dynamics and price discovery in secondary trading are anything but state of the art. 

There are other idiosyncrasies that might unnerve investors funneling into Chinese government debt and domestic punters alike. Beijing even reportedly is scrubbing the words “stock market” from social media.

Internet censorship and Xi’s moves to snuff out investigative journalism is anathema to global debt trading norms. So are government policies that silences researchers asking too many questions. Or prodding analysts at international investment banks to engage in self-censorship.

Again, China may indeed find a balance between Beijing’s obsession with control and global market norms. But if emerging markets stumble anew, China’s ginormous debt market might not be ready for prime time. It may be giving investors 16 trillion reasons to worry things could go awry.