Some investors have been spooked by the recent liquidity issues in the US repo market and the Federal Reserve’s subsequent attitude. As a brief explanation, a repo agreement or repurchase agreement is essentially a transaction between two entities, where the one in need of liquidity (the dealer) gives assets that it owns such as bonds to an entity that sends it the required money, with the dealer promising to buy the assets back at a higher price later on, usually rather quickly (for example the next day).
It is similar to a loan but unlike with loans, assets actually change hands. These transactions are fairly frequent in the bank to bank world and whenever issues occur which make gaining access to short-term liquidity difficult, investors become frightened because the financial system is far more fragile than it seems.
This is precisely what happened in the United States recently, with the Federal Reserve (the central bank of the United States) stepping in. The bottom line is this: for one reason or another (anything from market participants simply holding on to liquidity due to fear to more complex reasons), the straightforward flow of liquidity within the financial system can… well, stop. We call such a situation a liquidity crunch, with the name pretty much speaking for itself.
What are the implications when it comes to China? Not stellar, unfortunately.
In an ideal scenario for China, investors who are spooked by other markets would simply flock toward China and Chinese assets. In other words, they would see fires burning in the West and quickly move toward China as a safe haven jurisdiction. However, there is a problem with this scenario: it isn’t realistic, for the simple reason that China is not yet perceived as a safe haven (risk off) jurisdiction but rather as a riskier (risk on) one.
To put it differently, investors develop an appetite toward jurisdictions such as China when times are good and prosperity seems abundant. In a climate of let’s say overall optimism. When things turn sour with the economy and/or financial system, money quickly flows from risk on to risk off assets and this is a situation that hardly works in China’s favor.
In fact, the exact opposite is true, as the Global Financial Crisis of ’07-’08 made clear. If liquidity problems persist in the US in particular and let’s say the West in general, not only are investors not going to flock to China, they will do the exact opposite: they will limit their exposure to this jurisdiction, despite the liquidity crunch situation having its origins in the US rather than China.
But hasn’t a lot changed since the Global Financial Crisis days?
Indeed, China is in a lot more robust position at this point, with its economy having grown tremendously since the ’07-’08 days. Therefore, a valid case could be made that a liquidity crunch in the US would pose less problems for China now than 10-11 years ago. However, make no mistake, China is still perceived as a risky jurisdiction and the positive developments that have taken place over the past decade are not quite enough.
Is this situation set in stone?
As always when it comes to markets, the answer is that nobody knows and time will tell. A lot of times, markets move on a whim and there is no telling when (or even if) the market will have an “Aha!” moment with respect to China. It may very well happen this time around, with the market considering that it’s time to shift to the East in terms of safe haven assets. But while this scenario is definitely not impossible, it isn’t very probable.
Probabilistically speaking, it is quite likely that China’s economy still has a fair bit of growing up to do before investors feel comfortable enough with it and being the #2 worldwide player in terms of nominal GDP is just not enough. Investors need more than that to feel comfortable enough to consider China a safe haven jurisdiction. From legislative predictability to executive competence and even political issues such as human rights-related ones, the path toward becoming a safe haven destination is challenging to say the least.
As a conclusion, it is fairly safe to say that those greedily rubbing their hands in anticipation of the major capital exodus from West to East that will take place due to problems such as liquidity crunches are most likely early to the proverbial party at best. Instead, those who own Chinese assets should consider them a warning signal which should perhaps bring about some portfolio changes, whereas those who are interested in acquiring Chinese assets can see such scenarios as buying opportunity facilitators.
Whether we are talking about China, the United States or any other jurisdiction, it is vital to understand that even problematic situations such as anything from liquidity crunches to credit crunches or full-fledged financial calamities bring about both problems and opportunities. Here at ChinaFund.com, we do our best to help clients avoid the former and embrace the latter, something easier said than done but hardly impossible, especially when you have chosen experts with their finger firmly placed on the pulse of China’s economy as well as financial system. To find out how we can help, simply visit the Consulting section of ChinaFund.com.