Bridgewater

Daily Observations
November 22, 2011 (203) 226-3030

2011 Bridgewater Associates, LP

Greg Jensen Erin Miles Jason Rotenberg Mac Steele Fred Post

An Update on Chinese Credit:

Chinese credit conditions make us nervous because: Growth and demand are coming from a leveraging up of the credit system, not from income growth as they did before. Credit creation is increasing by bypassing the formal credit system. Debt levels are low by developed world standards, but extremely high relative to economies in similar stages of development. There is preliminary evidence the Chinese credit cycle may be turning. The availability of capital is now being restricted in part by movements by Chinese authorities to regulate more of the sprawling system, and in part by the drying up of foreign capital that had been stimulative. China accounts for about 50% of all global credit creation, 26% of the worlds nominal growth and 31% of its real growth, so how Chinese credit growth plays out will be a large determinant in how the global economy plays out.

In summary, the Chinese economy is more dependent than ever on the booming credit cycle at the same time that global and domestic credit conditions have become less manageable and likely more volatile. Turns in credit cycles are dangerous and how this one is navigated will be one of the major drivers of both the Chinese and global economies. As the chart below shows, we may already be seeing the beginning of the turn. In response to the broadening of domestic tightening policy measures and worsening global credit conditions, quarterly credit growth fell significantly in the third quarter, to around 13% (annualized) from growth rates close to 40% in 2009 and 2010.
China Aggregate Non-Fin & Non-Central Govt Credit Grow th (3m Chg, AR) 45% 40% 35% 30% 25% 20% 15% 10% 5% 0% -5% 97 99 01 03 05 07 09 11 Some slow dow n in the third quarter, but still roughly keeping pace w ith nominal GDP grow th Stimulus during the crisis

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Over the past few years, the expansion in credit far exceeded the expansion in growth, suggesting that each marginal unit of growth was more and more dependent on expanding credit. In other words, the efficiency of credit has fallen substantially, consistent with the picture of uneconomic investment and overcapacity. Looking forward, continued credit growth at the pace we've seen since the crisis would be unsustainable. But without this underlying support, especially given the context of slowing global growth, there is a significant risk of a meaningful slowdown in Chinese growth. The slowdown in credit growth so far has only been moderate, but managing an orderly slowdown in credit growth going forward will likely be a difficult process.
China Aggregate Credit Relative to Trend China Nominal GDP Relative to Trend

50% 40% 30% 20% 10% 0% -10% -20% 00 02 04 06 Productivity-driven boom 08 10 12 Output expansion w ithout much credit expansion Credit expansion much larger than output expansion Debt-driven boom

As mentioned above, in recent months, there has been some flattening off in the level of credit relative to GDP, but the short story remains that going forward reliance on continued credit creation is stronger than ever. Debt levels rose by close to 60% of GDP since 2008 and are at extremes relative to history. Going forward, existing debts will need to be serviced through some combination of income and more credit. Given how fast credit was pumped out over the past three years, there are risks that there will be heavy reliance on the latter (e.g., investments may not yet be generating income). We have already seen marginal borrowers getting squeezed (e.g., Wenzhou lenders and small property developers, among others) and loan extensions / restructurings / subsidies are helping to keep many infrastructure-backed loans viable. If access to credit becomes more difficult, these borrowers will be in a tough spot.
China Aggregate Non-Fin & Non-Central Govt Credit Level (Est, % PGDP)
190% 180% 170% 160% 150% 140% 130% 120% 110% 100% 90% 97 99 01 03 05 07 09 11 Credit level remains at historical highs

Bridgewater Daily Observations 11/22/2011

Policy Response As credit growth has slowed and marginal borrowers have gotten squeezed, policy makers have been forced to confront the challenges of managing the turn in the credit cycle. So far, they have initiated targeted easing steps while maintaining efforts to tighten unofficial credit creation. A series of measures has been rolled out, for example, to help ease the strain on small- and medium-sized enterprises that have been largely locked out of the official credit system. In contrast, policy makers have not yet eased conditions in the increasingly strained property market, as they continue to seek to increase affordability and ensure that home price appreciation does not re-accelerate. Broader policy measures remain consistent with continued restriction of unofficial lending, and they include plans to follow through on expanding reserve requirements to include margin deposits, enforcing the 75% loan-to-deposit ratio by the end of this year and increasing overall oversight of off-balance sheet activity in the banking sector. It is extremely challenging to try to manage who can and cannot get credit in this targeted fashion without creating either significantly increased economic volatility or inefficient allocations of capital.
Recent Chinese Policy Action since Q2 2011 Tightenings - 75% loan-to-deposit ratio grace period ending Dec 31st for all banks - Extend reserve requirements to most margin deposits over next 6 months - Increase oversight of banker's acceptance bills - Increase oversight of wealth management product sales - Bring informally-securitized trust loans back on balance sheet by EOY 2011 - Restrict bank lending to LGFVs unapproved by the banking regulator - Mortgage restrictions extended beyond Tier 1 cities

Easings

- 200bln MoF loan to Ministry of Railways to re-start stalled projects, ease funding squeeze - Tax deduction for SME loan loss provisions extended - Stamp duty on SME lending waived until 2014 - Loans <5mln RMB excluded from loan-to-deposit ratio restriction - Wenzhou loan quota increased to ease credit, 1.3x benchmark IR ceiling enforced - Pilot program for local government bond issuance with MoF guarantees - Tax break offered on Ministry of Railway bonds - Central Huijin purchased Big Four bank equities - Expand LGFV exemptions to include: road transport, land zoning and use, public housing and State Council approved infrastructure projects

In addition to managing domestic policy, policy makers will likely also have to deal with ongoing volatility in global capital flows. While capital inflows are not as important a source of funding in China as they are in the rest of the emerging world, they have been an additional source of domestic liquidity and have been negative in the third quarter based on reserve and trade balance figures.
China Capital Flows %GDP (3mma) Net Private Capital Inflows 20% 15% 10% 5% 0% -5% -10% -15% 00 02 04 06 08 10 Latest data showing capital outflows Calculated as reserve change (adjusted for FX) minus current account balance Current Account Reserve Change

Bridgewater Daily Observations 11/22/2011

The Chinese Shadow Banking System As we have described before, since 2010, there has been a significant shift in the Chinese credit system from official bank lending to off-balance sheet lending. The degree of expansion of lending outside of regulated and monitored channels will only make managing the turn in the credit cycle even more difficult. On both the supply and demand side, players have been incentivized to increasingly seek these channels - banks have looked to capitalize on inexpensive deposit funding costs and high unofficial market rates, depositers have moved their funds to alternative wealth management products to earn higher yield, and borrowers locked out of official channels have turned to alternative ways to obtain financing. So far, the efforts of policymakers to rein in the expansion of credit through unofficial channels are having some success. As the chart below shows, the flow of credit through off-balance sheet channels made up about 30% of total credit creation in the third quarter, down from 45% in the first quarter of 2011. Still this is a significant portion of total lending which remains largely outside of the purview of policymakers.
% Chinese Credit Creation by Type Bank Loans 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 00 Off-Balance Sheet Lending Bond Issuance

Recent reversal as regulators crack dow n on off-balance sheet credit channels, though still make up more than 1/4 all new credit

02

04

06

08

10

The flow chart below shows a simplified version of how this complex financial system has generally been operating. Not every linkage and dependency can be known or expressed in this framework, but we attempt to illustrate the major financing dynamics and the increasing dependencies and feedback loops across the economy. The red boxes illustrate where the recent strains have emerged, most notably less foreign capital coming into the economy and the highest interest rate borrowers (property developers and SMEs) having trouble either accessing enough credit or servicing it. What stands out is how interconnected the various channels are. Trying to stamp out or incentivize one or another channel will inevitably have knock-on effects, which may or may not be easy to understand and control.

Bridgewater Daily Observations 11/22/2011

China has also become a major driver of global growth and credit creation. In the crisis, when most of the developed world was going through a period of deleveraging, China's massive credit expansion was roughly 80% the size of global credit creation. Since then, China's credit creation has slowed and elsewhere credit creation has picked up, but Chinese credit creation remains close to 50% the size of global credit creation. In part due to the support of China's massive credit expansion, Chinese growth now makes up roughly 26% of the world's nominal growth and 31% of its real growth.
Chinese Credit Creation / World Credit Creation 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 1/01/00

Post crisis, Chinese credit creation 80% the size of w orld credit creation, still at 50% over past year

1/01/02

1/01/04

1/01/06

1/01/08

1/01/10

1/01/12

Given the impact of Chinese growth on the rest of the world and the need to keep credit from growing at an unsustainable pace, the slowdown in Chinese credit creation is necessary, but presents a significant additional risk to the global economy going forward.

Bridgewater Daily Observations 11/22/2011

Other Countries
Korea Update
The Korean economy has clearly slowed over the last six months, but compared to the large contraction in 2008, the financial effects of the global pullback of capital have been moderate so far, with most of the impact on the economy coming from slower export growth due to weakening global demand. Korea is still operating slightly above capacity with some inflationary pressures, so some slowdown is desirable. And with the currency being very stimulative and real interest rates negative, further easing may not be necessary. Looking forward, the combination of slower global growth and financial tightness still poses risks to a Korean economy that has a lot of domestic debt, even if on net it is an external creditor county. In part due to recent developments and short-term risks we are short the Korean won relative to the US dollar. However, unlike 2008, with banks less reliant on short-term dollar liquidity, and with capital inflows and credit growth rates more muted, the risks are likely smaller for Korea than for debtor countries such as Brazil and Turkey. Growth Has Slowed Materially, Though Levels of Activity Remain Above Average Domestic growth in Korea has slowed recently as consumption measures continue to stagnate and export growth slows. While some slowing had been desirable given above-normal levels of activity and higher inflation rates, growth has been close to zero. Most of the recent slowdown can be attributed to slowing export growth due to slowing trading partner growth, and not due to financial disruptions.

Korea Growth (3m chg, AR)

20% 15% 10% 5% 0% -5% 2005 2010

Korea Economic Output Level

3% 2% 1% 0% -1% -2% -3% -4% 2005 2010 -5%

Although Korean exports have been a strong support to growth since the crisis, the slowdown in the developed world has started to flow through to slower export growth. EM Asia has continued to become a more significant export market for Korea; however developed world markets remain a significant source of end demand. The charts below highlight that slower trading partner growth has led to weaker export growth on a backward looking basis and that surveys point to continued weakness going forward. For an economy with 45% of GDP coming from exports (probably about one-third less than that after accounting for re-exports) continued weak developed world demand would create a significant drag on growth.

Bridgewater Daily Observations 11/22/2011

KOR Real Expo rt Index 6m chg, A R KOR Trading P artner Gro wth 6m Chg, A R 80% 60% 40% 20% 0% -2% -20% -40% -60% 00 02 04 06 08 1 0 1 2 1 3% 8% 3%

Korea Business Survey Index (Future Export Growth)

110 100 90 80 70 60 2005 2010

Slow ing global grow th flow s through to exports

-7% -1 2%

While most other EM Asian currencies are at or above their pre-crisis high, the won remains extremely competitive, giving Korean exporters an advantage that over time should mitigate the impact of slower growth. The chart below shows the major EM Asia exporters real exchange rates versus the dollar indexed to 2007. Koreas openness to global trade and capital flows left it severely exposed to a withdrawal of capital and collapse in trade, with the won depreciating in real terms more than 40% against a basket of trading partners in 2008. Since then, the central bank has leaned against the subsequent upward pressure on the won, accumulating reserves and maintaining Koreas competitive position.

Asian Real FX vs USD (indexed to Jan 07)

Korea
20% 10% 0% -10% -20% -30% -40% -50% 2007 2008 2009 2010 2011

Taiwan

Philippines

Malaysia

Singapore

High Domestic Credit Levels Pose Risks, but Credit Expansion has been More Moderate and Less Reliant on External Capital than in 2008 Sudden global pullbacks of capital typically affect debtor countries materially more than creditor ones, however creditor countries can be affected materially when a) they have a lot of domestic leverage that is expanding at a fast rate, b) highly leveraged financial institutions face pullbacks of short-term funding while sustaining losses. These conditions can lead to a disruption in domestic credit creation, as was the case for Korea in 2008. These risks look smaller to Korea this time around, because domestic credit has largely grown at the same pace as incomes since the financial crisis. While these high debt levels do increase Koreas sensitivity to a tightening of liquidity, they have not significantly increased their leverage now relative to 2008. Additionally, domestic credit creation over the past year and a half has been less dependent on foreign debt inflows, which have not been as strong as in the pre-crisis period. This is

Bridgewater Daily Observations 11/22/2011

partly the result of capital controls implemented after the crisis that made it more difficult for banks to borrow in FX and discouraged capital inflows.

Korean Credit Flows (6mma, AR, % GDP)

Bank and Other + Debt Inflows
25% 20% 15% 10% 5% 0% -5% -10% 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

Non-Fin Pvt Credit Creation

Throughout 2010 and 2011, capital inflows to Korea have been smaller than in some of the other booming EM economies, creating less sensitivity to a further pullback. The chart below compares total capital inflows into Korea, versus Turkey and Brazil.

Capital Inflows % GDP, 6mma

Korea Turkey Brazil 15% 10% 5% 0% -5% -10% 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

The lower reliance on short-term capital inflows has occurred at the same time as Korea has maintained a significant current account surplus. This stands in contrast with a number of major emerging countries that have seen a deterioration in their deficits, and makes Korea less affected by the pullback in global credit.

Bridgewater Daily Observations 11/22/2011

Current Account % PGDP, 6mma

Korea Turkey Brazil

5% 2% 0% -2% -5% -8% -10% 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

The Financial System Seems Less Exposed to the Pull back in Global Capital Korean banks do look less exposed to the drying up of global liquidity than in 2008. While there has been a increased demand for dollars relative to Korean won, the stress this has placed on Korean borrowers has been significantly lower than in the 2008 crisis, as short term foreign currency debts have declined since the crisis. The chart below shows the KRW/USD basis swap, which is a measure of strain on foreign currency funding conditions. It blew out in September as global credit was withdrawn, but remained well below the levels seen in 2008. The basis has since fallen back to more normal levels as capital inflows have returned to the emerging world. For comparisons sake, we include the euro basis swap, to show that the improvement in global liquidity conditions has not been universal. Short-term external debts have also been stable in recent years, compared to sharp increases (largely by banks) prior to the financial crisis.
USD Basis Swap (1Y)
KRW Euro
0.0% -1% -2% -0.5% -3% -0.8% -4% -5% -6% 2005 2010 -1.0% -1.2% -0.3%

Korea Short Term External Debt, USD Bln

175B

150B

125B

100B

75B

2010

The table below shows South Koreas banking system relative to other emerging Asian economies along with Brazil and Turkey. Foreign claims on Korea make up a smaller proportion of domestic credit than in any other EM Asia economy (ex China), suggesting that Koreas economy is less susceptible to a pullback in foreign credit than its regional peers. The difference is starker with Turkey and Brazil, where domestic banking systems have forced a greater reliance on external financing. However, as is also clear in the table, private sector debt levels in South Korea are the highest in the emerging world, which may over time limit the domestic expansion while also creating risks for the domestic financial sector.

Bridgewater Daily Observations 11/22/2011

Foreign Bank Funding Of Domestic Domestic Credit Summary

Foreign Bank Claims Outstanding June 09 EM Asia ex-China Taiwan Malaysia South Korea India Thailand Philippines Indonesia Brazil Turkey USD Bln 1,277 186 155 371 316 96 38 115 561 226 % GDP 29% 41% 55% 33% 18% 27% 17% 14% 22.70% 27.30% Private Sector Domestic Credit Outstanding June 11 USD Bln 4,042 596 327 1,733 846 377 62 102 1,186 163 % GDP 83% 129% 112% 149% 49% 102% 26% 13% 46% 21% Foreign Bank Claims % Domestic Credit Level 48% 31% 47% 21% 37% 25% 62% 112% 47% 138%

Korean banks do have more exposure to European banks than they did years ago, though recently that exposure has declined. This exposure may still create risks, and more broadly speaking it is very hard to know what exposures banks may have. However, as pointed out above, it does seem that risks to the financial system are smaller than before, and the strains visible in market pricing are so far consistent with this.

Korean European Bank Claims as % of GDP

23% 20% 18% 15% 12% 10% 8% 2005 2010

Cyclical Conditions Reduce the Likelihood of Monetary Easing in the Near Term As described earlier, while growth has slowed, Korea is still experiencing some modest late cycle pressures that should mitigate the need for as much easing as is necessary in the developed world. Low unemployment rates and output levels above potential have driven both headline and core inflation rates to near the upper bound of the BoKs target. Additionally, the 10% decline in the won since the summer will also create some modest inflationary pressure and should achieve some easing.

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Korea CPI (6m chg, AR)

Headline Core Lower Target Upper Target 7% 6% 5% 4% 3% 2% 1% 0% -1% 2005 2010

Beyond just goods prices, inflation in asset prices has also not slowed significantly since the crisis, with home prices continuing to rise across Korea to all-time highs. The Seoul market, which saw a sharper run-up in prices, has remained relatively flat since the crisis, but broader housing inflation has continued through this year. Rising home prices both create some growth prospects going forward (via the wealth effect or rekindling the domestic construction industry which had been a drag to growth since the crisis) and highlight the risks to easing too quickly given low real interest rates and the attractiveness of assets that can be purchased on credit. While both goods and asset price inflation are likely to be less of a concern for Korea going forward should the global slowdown continue, the central bank does not yet have much pressure to ease yet.

Korea Home Prices (% pre-crisis peak)

Total Seoul
10.0% 0.0% -10.0% -20.0% -30.0% -40.0%
Aug 2008

-50.0% 2010

2005

Interest Rates Remain Accommodative, so Less Relative Pressure to Ease Although Korea was one of the first countries to hike interest rates coming out of the crisis, its tightening cycle of only 125bps has left the policy rate well below pre-crisis averages and the rate of inflation. The real policy rate (i.e. minus inflation expectations for the next 12 months from the BoK survey) is only 100bps above the crisis low and remains negative. While a continued contraction in global and domestic growth could necessitate further easing at some point, the current easing pressures are far lower than in developed or more exposed emerging economies.

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Korea Real Policy Rate (BoK Policy Rate - Inflation Expectations)

4% 3% 2% 1% 0% -1% -2%

2005

2010

Korea remains extremely competitive and has a banking system that is less exposed to foreign capital withdrawals than before the crisis. Although Korean growth will likely remain slow with slower global growth given its dependence on exports, it is in a much better position to handle the slowdown in foreign investment than it was in 2008 or than other emerging economies (i.e. Brazil and Turkey) that have been more dependent on foreign capital to fuel their credit expansion and growth. Moreover, the persistent current account surplus and high level of output suggest that Korea faces less need for easing, either through rates or FX, than much of the emerging world.

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