Risk Update – May 2020

We’ve written a fair bit about China’s prominent role in the build-up of endogenous risk during the global growth cycle since the GFC. There are any number of ways of trying to reflect it. A chart we used last month gives a clear impression of China’s importance in terms of credit creation over the last cycle.

Figure 1: Contribution to Global Credit Creation
Source: Citi Research, National Central Banks

In the March monthly, we used one of our regular views, China FX reserves to M2 money supply.

Figure 2: China FX Reserves / M2
Source: Bloomberg

Back in the December 2019 monthly, we showed some graphs from IMF and World Bank reports. This one shows the rates of change of Debt/GDP going into various end of cycle risk unwinds.

Figure 3: Rate of Change of Total Debt (EMDEs –Emerging Market Developing Economies)
Source: International Monetary Fund, World Bank

We have also updated an old favourite that represents historical and projected China Debt relative to Global GDP. Our past projections of this ratio hitting 100% around 2025 will be looking pretty conservative by the time 2020 numbers get rolled in.

Figure 4: Total China Debt vs Global GDP
Source: Bloomberg, Convex Strategies

Point being, there is a fair amount of endogenous risk in and around China, and that risk, more than ever, matters to the world. China has well and truly overtaken Japan as the number two contributor to Global GDP.

Figure 5: % Contribution to Global GDP: USA, China, Japan and USD/CNY
Source: Bloomberg

That’s the ground work for why China, in the midst of a very complicated world, has a decent amount of ‘fire risk’, aka fragility. In and amongst, or at least affiliated with, the complexity and fragility that is China, there is a particularly unique subset, better known as Hong Kong.

Most of you will be aware that HK and China have been going through a bit of a tricky patch, and China just fired the latest shot across the bow. The latest imposition of China Security Law, over the top of HK’s Legislature and Basic Law, strikes us as an imminent reescalation of impending end of “One Country, Two Systems” issues. What we might term the Judge Smail’s treatment towards the pro-Democracy movement requests – “you’ll get nothing and like it!” https://www.youtube.com/watch?v=FuNJq_wI1ns

Throw in the leap by the US to withdraw autonomous recognition of HK, in the midst of plenty of Pandemic finger pointing and trade friction (eg. repatriation of essential production) and you could have a recipe for real disruption. Of course, we should not ignore the economic implications of last year’s long run of protests, and this year’s virus shutdowns. Things are not good. Official GDP numbers through Q1 2020 are already at Asia Crisis and GFC levels.

Figure 6: Hong Kong GDP, %yoy
Source: Bloomberg

In the world of “fragility”, there are very few things with as much tail risk as HK. The universally accepted narrative of HK as an independent, global financial centre, with rule of law, free movement of people and capital, creates, in normal times, one of the least volatile, most efficient market environments in the world, but which is a part of China outside of her constraints. This allows HK some special status where it can run higher debt levels, a far bigger banking capacity relative to population and GDP than pretty much any other country in the world, and with an eyepopping, world leading, local Equity Market Cap to GDP. A breaking of this narrative, whether that be either a removal of its autonomy from China (ie. “One Country, One System) or, even worse, a defacto civil war with China, could result in some of the most significant tail events imaginable. Hong Kong has extreme fragility.

Figure 7: Bank Assets to GDP Top 10 Countries (as of 2017)
Source: theglobaleconomy.com
Figure 8: Equity Market Capitalization to GDP Top 10 Countries (as of 2017)
Source: theglobaleconomy.com

We saw this in the early ‘80s, which led to the creation of the currency Peg, and we saw it again in the midst of the Asian Crisis in the late ‘90s and the handover from the UK to China. The Peg, in a way, is an apt analogy for HK as a whole. Either there is no volatility, or there is massive volatility. As many readers may know, we are seasoned believers that the Peg, if allowed to function, has always been, and will ever be, defendable. The big risk, both in our minds and in memory of ‘97/’98, is not per se that the Peg breaks, but rather that the Peg works. Should rational concerns around either of the above two scenarios lead to capital outflows, and/or speculative attacks, the Peg mechanism will kick in and the HKMA will sell USD from their massive war chest of reserves, drain HKD out of the system, and allow interest rates to rise until the flow reverses. The risk, just like to the rest of the world but only more so, is to rising interest rates, and the implication that could have on asset prices and the stability of a massively levered system.

Figure 9: Debt Service Ratio: Private non-Financial Sector Top 10 Countries (as of 2019)
Source: theglobaleconomy.com
Figure 10: Economic Freedom Overall Index Top 9 Countries plus China (as of 2020)
Source: theglobaleconomy.com

A 20 year view of HKD forward points in Figure 11 (ie interest rate differentials) makes the latest move look extreme. A longer term view of 12 month FX forward points, however, gives an idea of what can truly happen to HKD interest rates if the Peg mechanism is allowed to function in the midst of a major capital outflow. The vertical line in Figure 12 is on July 1st 1997, day of the handover from UK to China, one day before the infamous devaluation of the Thai Baht.

Figure 11: USD/HKD 12mth FX Forward Points – Shorter View
Source: Bloomberg
Figure 12: USD/HKD 12mth FX Forward Points – Long View
Source: Bloomberg

We can create similar visuals using HKD interest rates, for example with HKD 3 month HIBOR. We’ve added in a distribution of historical realizations. Some might consider it “fat tailed”, more Pareto than Normal distribution.

Figure 13: HKD 3mth HIBOR
Source: Bloomberg

Again, 3 month HIBOR overlaid with HSI Index on a logged basis.

Figure 14: HKD 3mth HIBOR and HSI Index (logged)
Source: Bloomberg

As ever, our point is not that we have ‘a view’ that we think any of this is going to happen, but rather the fragility if it does, and even if it does so just moderately. Back to the above point about the unique status afforded to HK; the status that allows it to have 3x banking assets/liabilities to GDP, to have a stock market cap at 10x of GDP. It is easy to argue that those ratios, which would seem crazy in any normal economy, make sense in the unique construct that is HK, but a change in the accepted narrative of HK could have significant tail implications. Again, fragility. The place is uniquely susceptible to capital outflows and the interest rate implications of the Peg mechanism. The unique status gets challenged if the unique narrative comes under question.

As discussed at the opening of this piece, we have long noted China as the most relevant build-up of endogenous risk through this long cycle, given its unprecedented contribution to credit creation post 2008. We wrote about this issue, yet again, in the Dec 2019 Monthly Update https://convex-strategies.com/2020/01/26/risk-update-december-2019/. Further, HK is dangerously placed as the go-between in the largest overriding flaw in the whole global system, that being the fiat currency based global reserve system and the two dominant powers on either side of the imbalance it has created, namely the US and China. HK could very well be ground zero if everything goes ‘bang’. Of course, all of the above is well known to China and they have every reason to want to avoid any of the unforeseen tail events that might emanate from these scenarios. They won’t want to fritter away the ~$500bn of FX Reserves. They won’t want to see interest rates move to levels that devastate the local economy and banking system. They won’t want to see a currency devaluation of epic proportion by letting the Peg go. Yet, those wants will be very hard to achieve while removing HK’s autonomy. History tells us that the answer to this problem, particularly by authoritarian governments principally focused on maintaining power and control, is capital controls. One need look no further than China for an example. Again, we’re not saying this is or isn’t what is going to happen, simply discussing the tails.

Like we said above, the Peg is a good analogy for HK as a whole. Markets, asset prices, interest rates, the economy, business, social and political factors, all function on a belief in a long held narrative: “One Country, Two Systems”. The scale of being a conduit into the “One Country”, but the freedom of being an open, rule-of-law, system, is how the world sees and operates in Hong Kong. All of the above factors, potentially, have very fat tails. For perspective, we show histograms of monthly percent changes of the USD/HKD exchange rate for the 36 years post the Peg, and then again including the preceding 3 years.

Figure 15: USD / HKD 1984-2020, monthly change %
Source: Bloomberg, Convex Strategies
Figure 16: USD / HKD 1980-2020, monthly change %
Source: Bloomberg, Convex Strategies

As we often say, it is uncanny how the biggest build-ups of dry brush have a knack of finding a spark. As you would expect, underlying the generally accepted narrative that all is normal in HK/China, there persists an absolute plethora of yield seeking structured product volatility supply. We pulled the below chart out of an article that was in Bloomberg about Structured Product volumes in China. Not easy to see, but that last bar in Figure 17 is approaching the region of $2trillion. Some may recall, as reported, it was something in the region of just $3bio of oil linked Structured Products bought by Bank of China’s local retail customers that garnered some of the blame for oil’s brief visit to negative $37/barrel. One can only postulate what other unimaginable contingent triggers lurk underneath the below bars.

Figure 17: Outstanding volume of Structured Products in PRC, RMBtn
Source: Bloomberg, People’s Bank of China

Regular readers know that we have absolutely no belief in “timing it” when it comes to hedging and convexity, just construct your book to optimize geometric compounding, but with one caveat; the time to do it is when you can. Right now, for reasons that we can only speculate upon, despite being in the midst of a global economic shock of unprecedented scale (you can see our thoughts on the “cycle” in the March ’20 Monthly Update https://convex-strategies.com/2020/04/25/risk-update-march-2020/) , and all of the above discussed geopolitical and local economy specific implications, we can still construct quality hedging asymmetry.

Figure 18: Volatility ‘Comet’
Source: JP Morgan, Convex Strategies
Figure 19: SGD/JPY Cyclical/Seasonal Indicator
Source: JP Morgan, Convex Strategies

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