The U.S. trade war with China and China’s daunting debt problems are well understood by most investors. Coming U.S. sanctions on Iran and Iran’s internal economic problems are also well understood.
What is not understood is how these two bilateral confrontations are intimately linked in a three-way tangle that could throw the global economy into complete turmoil and possibly escalate into war. Untangling and understanding these connections is one of the most important tasks for investors today.
Let’s begin with the China debt bomb. As is apparent from the chart below, China has the largest volume of dollar-denominated debt coming due in the next 15 months.
The chart shows China with almost $100 billion of external dollar-denominated liabilities maturing before the end of 2019. But this debt wall is just the tip of the iceberg. This chart does not include amounts owed by financial institutions nor does it include intercompany payables and receivables. China’s total dollar debt burden is over $200 billion and towers over other emerging-market economy debt burdens.
This wall of maturing debt might not matter if China had easy access to new finance with which to pay the debt and if its economy were growing at a healthy clip. Neither condition is true.
China has entered a trade war with the U.S., which will reduce the prospects of many Chinese companies and hurt their ability to refinance dollar debt. At the same time, China is trying to get its debt problems under control by restricting credit and tightening lending standards.
But this monetary tightening also hurts growth. Selective defaults have already emerged among some large Chinese companies and certain regional governments. The overall effect is tighter monetary conditions, reduced access to foreign markets and slower growth all coming at the worst possible time.
The situation in Iran is even more fraught. The U.S. waged a financial war on Iran from 2011–13. The first step was to impose sanctions on Iranian individuals and entities. Then Iran was banned from using the U.S.-controlled Fedwire system to send or receive U.S. dollars.
Iran responded by switching its oil shipments to payment in euros cleared through the SWIFT system, based in Belgium. Next the U.S. leaned on its SWIFT partners to ban Iran from using that system, a process known as “de-SWIFTing.”
This move effectively cut Iran off from receiving hard currency for its oil. Iranians smuggled dollars into Iran from Iraq and ran a black market to get dollars to pay Dubai-based smugglers to bring in consumer goods. There was a run on the Iranian banks, interest rates were moved to 20% to stop the run and the Iranian rial collapsed. Inflation soared and anti-government demonstrations emerged. Iran was halfway to regime change without a shot being fired.
Obama declared a truce in the financial war at the end of 2013 in exchange for negotiations on the Iranian nuclear program. This resulted in the 2015 Joint Comprehensive Plan of Action, JCPOA, a multilateral agreement on Iran’s pledge to stop uranium enrichment. Obama paid billions of dollars in cash and gold to Iran as a bribe to secure this agreement.
After the agreement, Obama ended many economic sanctions on Iran. Direct foreign investment, mostly from Europe, started up again.
Last May, Trump tore up the JCPOA and resumed sanctions under a doctrine of “maximum pressure.” The difference now is that Iran wasted the Obama bribe money on foreign adventures and terrorism in Iraq, Yemen, Syria, Lebanon, Gaza and Sinai. The situation in Iran today is even worse that it was in 2013.
A new round of severe sanctions is set to go into place on Nov. 4, 2018. These new sanctions will result in a near complete shutdown of Iranian oil sales and an end of direct investment in Iran. Trump is on the path to regime change in Iran unless a new agreement is reached that is much stronger from the U.S. perspective than the JCPOA.
Here’s where the China and Iran stories converge. Iran has one and only one lifeline to keep its economy going — oil sales to China. And China desperately needs the Iranian oil to keep its own economy growing so it can pay or roll over its debts. The chart below tells the story:
Iran’s oil sales to South Korea, Italy, Japan, the UAE, Spain, France and Greece are likely to be shut down or greatly curtailed by the new Trump sanctions. That leaves China, India and Turkey as Iran’s only large customers. Turkey and India are facing financial crises of their own and may not have the hard currency to pay Iran. That leaves China as Iran’s only source of hard currency going forward.
China will not stop buying Iranian oil; they need the oil desperately. Iran will not stop selling oil to China; they need the hard currency desperately. Still, Trump’s sanctions will force China and Iran into financial and logistical gymnastics to avoid interdiction by Trump.
Iran will use its own tanker fleet to ship the oil because third-party countries won’t allow their tankers to violate the sanctions. China will have to cheat on SWIFT message traffic notices to avoid appearing to credit Iran with hard currency.
Even with these workaround methods in place, the two-way flow of oil and currency will become more difficult. The impact on China and Iran will be to slow both economies even if the oil and currency keep flowing.
China is between a rock and a hard place because it’s trying to control the increase in debt while trying to borrow more and pay its debts at the same time. Iran is in even worse condition because its foreign investment currency lifelines are being cut one by one even as the government struggles with hyperinflation, bank runs and social unrest.
Both of these situations could be alleviated if China would give Trump the trade deal he wants and if Iran would give Trump the nuclear deal he wants. Both outcomes are unlikely in the near term because of the confrontational geopolitics standing in the way.
Markets have been notably docile lately despite crises in Argentina, Turkey, Indonesia, Iran, China, Venezuela and elsewhere. Political crises related to Brexit and U.S. political dysfunction have not roiled global markets so far. The calm and low volatility are about to end.