New paper, ‘Dollar Funding Stresses in China,’ weighs implications of China’s use of dollar debt
Authors point to possible spillover effects if China can’t get dollars in times of financial stress
China’s increasing reliance on debt issued in U.S. dollars poses an often-overlooked risk to global financial stability that policymakers must better understand, according to Federal Reserve Bank of Boston economist Leslie Shen.
Last month, the Boston Fed released a working paper, “Dollar Funding Stresses in China,” that Shen co-authored with Laura E. Kodres from the MIT Golub Center for Finance and Policy and Darrell Duffie from Stanford University. The paper aims to shed light on the extent and implications of China’s use of dollar debt.
Using available data, which are incomplete, the paper points to a large and increasing use of dollar debt by Chinese banks and companies. The paper says this phenomenon increases the likelihood of default during times of financial stress when dollars become scarce, which could negatively impact the rest of the world.
The Chinese banking system and nonfinancial firms are two sources of dollar demand
The paper notes that China’s banking system, the world’s largest, relies heavily on the dollar for foreign borrowing and lending. It highlights one driver of China’s rising dollar exposure – the Belt and Road Initiative (or BRI), which includes multi-trillion-dollar global infrastructure projects.
Chinese nonfinancial firms also have large holdings in dollar-denominated bonds – they hold 36% of the total issued by emerging market economies, as of the end of 2019. Shen added that a significant share of these holdings is issued by Chinese property developers and local government financing vehicles, entities with no natural dollar-based revenues, so they have no guaranteed access to dollars, if needed.
Shen said it’s tough to precisely pin down how large China’s dollar debt is, or when its various components will mature, because the available data is incomplete. To get as clear a picture as possible, the paper’s authors had to scour numerous sources on debt held by Chinese banks and nonfinancial corporations.
Shen added that even though China’s total dollar debt is still small compared to advanced economies like Europe and Japan, it’s become large enough to really matter. According to the paper, “While the information that we have provided about dollar-based exposures of Chinese entities is far from complete, we believe that the available data imply that China has significant dollar exposures that could strain the ability of Chinese banks and corporations to source sufficient dollar funding during a period of stress.”
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“Rollover risk” is one result of China’s reliance on dollar debt
One key area of exposure highlighted in the paper is “rollover risk.”
Dollars become scarcer during a crisis because people feel safer with cash in hand and liquidate their dollar-denominated holdings. This can become a problem for the many Chinese entities that use short-term debt to finance longer-term projects.
When that short-term debt matures, it needs to be “rolled over” into new debt. The risk of default – and global spillover effects – increases if a scarcity of dollars makes it difficult or impossible for Chinese firms and institutions to roll over their dollar debt.
“If (Chinese firms) default, then the counterparties, which are usually entities in the U.S. or in other economies around the world, would be impacted,” Shen said.
China has avenues to get dollars, but they may not be sufficient or reliable
The paper reviews ways China could get dollars when needed, including its large foreign exchange reserve base. But Shen said it’s not clear that China would be willing to liquidate significant amounts of its dollar-denominated reserves, because of possible losses and increased exposure if dollars again became scarce.
The Foreign and International Monetary Authorities (or FIMA) Repo Facility, which the Federal Reserve established during the pandemic, is another potential avenue to dollars, though an account with the New York Fed is required to use the facility, and the identities of account holders are confidential. If China does have an account, it could post its U.S. treasuries as collateral to obtain dollar funding there, then lend it to banks in China, Shen said. But she added China might not be willing to do that, as it may still be wary of the reputational risk of using the facility.
Shen said not only might these avenues and others listed in the paper be unreliable, the amount of dollars available might not be enough to help China in times of need.
“We're pointing out the potential economic and financial stability risks based on what we see in existing data,” Shen said. “But this is intertwined with many other issues, including political factors, so the overall situation is complex.”
Read the full paper here.