How Can Evergrande’s Contagion Occur? 3
As the Evergrande contagion spreads via the Chinese banking system to the rest of the economy, the uncertainty will lead to a squeeze on USD funding across the board. Which is when, and how, the contagion has the potential to spread across the world, not forgetting that Chinese real estate developers would have at this point already defaulted on a good chunk of their Dollar borrowings.
As Dollar lenders hold back from lending in light of the unfolding economic chaos, Chinese companies reliant on Dollar funding face a mad scramble to raise Dollar liquidity in order to avoid defaulting on their own Dollar based obligations. While Dollar denominated bonds, and the amounts issued, and at risk of default will dominate narratives and news flow at this juncture, it is important to remember that Dollar payments due to suppliers, i.e. accounts payable will also be affected.
The most obvious result of this Dollar funding squeeze will be a sharp and significant spike in the USD/CNY exchange rate, which provides a real time indicator of just how dire the Dollar liquidity situation is. Note that the exchange rate will have begun to spike in the earliest stages of the contagion, way before Chinese banks join the pile of falling dominos, as the FX market attempts to anticipate just how far the Evergrande contagion can spread.
It is important to remember that at this point, what matters isn’t really the size of USD creditors’ exposure to Chinese companies, but the lack of confidence in them which quickly morphs into fear. This fear, can, in turn, lead to the global Dollar funding market seizing up as the Evergrande contagion, now a full blown economic crisis, directly affects its global trading partners.
That is, the countries that export the prodigious amounts of commodities and other raw materials to feed the Chinese manufacturing juggernaut suddenly find themselves selling much less to their biggest customer. As global USD banks and other USD lenders react to this uncertainty by further pulling back their provision of Dollar liquidity, and hoarding their Dollars for use in their own worst case scenarios, the entire market freezes.
The quickest and easiest way of observing if the crisis has reached such proportions is by simply looking at how the USD trades against its peers. If the USD spikes against all currencies, especially those of emerging markets, then it is a pretty clear indication that the Evergrande contagion has gone global.
Since the repo market is a crucial component of the global USD funding market, stresses in repo and collateral indicators also serve as good warning signs. For instance, a sharp fall in UST Bill yields coinciding with worsening economic contagion in China probably indicates tightening collateral conditions in repo. This means that repo market participants have begun to require collateral of the highest quality in order to transact, causing a mad rush for T Bills which drives down their yields.
Tightening repo conditions in turn increase liquidation pressures as investors and traders who are unable to meet higher collateral requirements frantically dump their most liquid assets in order to raise cash. This indiscriminate selling leads to more selling and further margin/collateral calls, sending global markets into a tailspin. Given today’s very high levels of indebtedness due to public policy measures against Covid lockdowns, all of this might even precipitate an emerging market debt crisis!
To be concluded…
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