If EM/China credit growth decelerates, it will not only cap inflation but also cause a growth scare.
Given China’s onshore corporate bonds rallied dramatically in 2015-16 on the back of massive investor-buying, a further drop in these bond prices might trigger an exodus of funds and a meaningful push-up in corporate bond yields. In fact, the price of onshore corporate bonds continues to make new lows, and is already down 8% from its peak in November 2015. This could cause corporate bond issuance and other non-bank financing to slump at time when bank loan growth is already decelerating.
Ultimately, higher borrowing costs along with regulatory tightening of banks’ off-balance-sheet operations may cause a slowdown in China’s domestic credit flows in the second half of 2017. This could spill over to other EM economies due to lower mainland imports and declining commodities prices.
In addition, the banking systems in many EMs have not adjusted following the credit boom of the preceding years. Unhealthy banking systems and higher global interest rates will cause further retrenchment in domestic credit creation.
Bottom Line: A renewed slump in China/EM growth later this year will warrant an underweight position in EM risk assets across equities, credit and currencies according to our EM strategists.