Kyle Bass Takes On China

by: Shareholders Unite

Summary

Kyle Bass is arguing that China's debt situation is much worse than that in the US before the 2008 financial crisis and is about to get very dangerous.

There are reasons to believe the situation is not as dire as Bass argues.

However, what is dire and immediate is the policy dilemma that is facing the Chinese authorities as a result of all that debt.

We've argued in a previous article that the world is awash in debt, and that this is having effects on the real economy. Simply said, high debts moderate borrowing and spending, therefore tend to slow growth and inflation, which makes it more difficult to reduce the debt ratios.

It also affects the effectiveness of monetary policy, whose main transmission mechanism is fomenting credit demand. Too many households and companies all over the world prefer to reduce debt, rather than taking on new debt, despite record low interest rates.

Also, the risk of a more acute debt crisis increases when some debtors fail and cause a chain reaction through the financial system. One of the more likely places such debt crisis might happen is China, at least according to Kyle Bass from Hayman Capital. He's even betting on it.

It's undoubtedly true that debt in China has ratcheted up, in staggering amounts in nominal terms, but, more importantly, also as a percentage of GDP.

Click to enlarge

Kyle Bass predicts some kind of meltdown:

A Chinese credit crisis would see the country's banks rack up losses 400 percent larger than the hit U.S. banks took during the subprime mortgage crisis, storied hedge fund manager Kyle Bass has warned in a letter to investors.

Bass is certainly right when he argues that Chinese banks often don't lend on economic criteria, but give (or rollover) credit because of relationships or political imperative.

He's also right that in order to circumvent lending restrictions, credit growth got a second wind from the growth of the shadowbank system.

But the government has come down on that. For instance, it allowed local governments to tap the bond markets, which took the wind out of local government finance vehicles, important players in the shadowbank sector.

This provides at least some clues that the government is aware of problems and has the capacity to intervene successfully even if the shadowbank system was instrumental in the creation of the stock market bubble.

The shadowbank system, like the banking system overall, is more symbiotic with the authorities. Banks often favor sectors upon instructions, whilst the shadowbank system is allowed to grow out of convenience, or reined in when it is no longer convenient.

So the Chinese have experience in dealing with deflating bubbles, in real estate, shadow banking system, and lately the stock market. No guarantee things won't go wrong, but at least there is something of a track record to underpin some confidence.

Not everybody agrees with Kyle Bass, like Deutsche Bank (NYSE:DB). According to DB, Bass is basically talking about a hard Chinese landing scenario, which is far from certain and not very likely according to them (DB assigns just a 20% chance to that).

Evans-Pritchard actually argues for a pickup in Chinese growth in The Telegraph, with rebounds in the car market and the housing sector as a result of a fairly drastic change of policy. Nouriel Roubini agrees.

A rebound in the housing sector is especially important as home ownership is 80% in China.

Deutsche Bank also thinks Bass is overestimating the problem:

Deutsche Bank said the note overestimated problematic credit and didn't capture "buffers" against non-performing loans (NPLs), such as previously written off NPLs, excess provisions and the banks' around $1.1 trillion in pre-provision profits.

Rather than China's banks potentially needing $3.5 trillion in recapitalization, "our analysis suggests high-risk credit of US$1.6 trillion (11 trillion yuan) with recap needs of $500 billion (3.2 trillion yuan) under a hard-landing scenario," It even noted that the figures cited for China banks' balance sheets needed to be taken with a grain of salt. While Bass correctly noted that China's banking sector had total assets of around $34 trillion at the end of 2015, only around 60 percent, or $20.5 trillion, were credit-type assets

They also point out that some 43% of the outstanding loans are collateralized.

The policy dilemma

While opinions differ about the seriousness or immediacy of the Chinese debt problem, what's certain is that Chinese debt poses some awkward policy dilemmas. Here is McKinsey:

Three developments are potentially worrisome: half of all loans are linked, directly or indirectly, to China's overheated real-estate market; unregulated shadow banking accounts for nearly half of new lending; and the debt of many local governments is probably unsustainable. However, MGI calculates that China's government has the capacity to bail out the financial sector should a property-related debt crisis develop. The challenge will be to contain future debt increases and reduce the risks of such a crisis, without putting the brakes on economic growth.

The emphasis is ours. There simply is a nasty trade-off between growth and deleveraging. The Chinese authorities are already very much aware of this.

Last year, they chose deleveraging by cracking down on the shadowbank system and real estate, but they had to quickly reverse course as the economy started to slow down.

What seemed like a clever plan to sidestep the policy trade-off, to turn much debt into equity by inflating the stock market has backfired badly, and authorities had to pull out all the stops (and then some) in order to backstop the latter.

This year, the government clearly went for stimulus:

There have been six reductions in benchmark interest rates since November 2014 and five reductions of the bank reserve-requirement ratio since last February, but this monetary stimulus has had no noticeable effect, largely because there is a lack of demand for money. [The Daily Beast]

And here is The Telegraph:

Spending contracted 19.9pc in January [2015] as local government reform went horribly wrong. It did not recover fully until May and June, when the new bond market took off. The fiscal stimulus will feed through over the next six months.

That new bond market is also something of a safety valve for the Chinese debt. If it turns sour, it's good old-fashioned proportional hit to the creditor's balance sheet, the chances for wider ramifications, like bank collapses, are smaller.

And the latest figure are even more clear cut:

Under the plan to juice infrastructure spending, the National Development and Reform Commission plans to offer 400 billion yuan this quarter under a special bond program so local authorities can finance infrastructure, people familiar with the matter said. Making 400 billion yuan available in each of the next three quarters would mark a doubling in the pace of funding under the bond program. Economic planners offered 800 billion yuan in bonds last year. The NDRC unveiled the special bond program last year as part of efforts to boost spending. [Bloomberg]

This was part of a wider initiative and credit, once again, is ratcheting up in January, with an unprecedented $520 billion in new yuan credit (although part of this might reflect declining dollar credit or even repayments of these).

However, the policy trade-off is further complicated by large capital outflows, which automatically tightens Chinese monetary conditions.

Now that the authorities seem to go all in for another round of credit infused stimulus, are there any guarantees that a reverse logic, in which easing of monetary conditions exacerbates the capital outflows, does not apply?

We're not the only ones who see this danger, here is George Magnus in FTAlphaville, arguing about the stock and the flow problem of the Chinese forex reserves.

The flow problem emanates from the fact that money and credit growth in China are generating far too much excess liquidity which can leak abroad, especially through porous restrictions. The money stock amounts to about $21tn, and growth has picked up in the last year from about 10 to about 15 per cent per annum. As a proportion of the money stock, reserves have fallen to just 15.5 per cent, half of what it was in 2007-08, for example. As nominal GDP is growing at best by 6.5 per cent per year, excess money growth may running close to $2tn a year.

The problem would perhaps be eased if the credit flows manage to boost growth, but not everybody is convinced about that anymore.

As Deutsche Bank argued, the Chinese banks and authorities still have significant buffers in case of a debt crisis. Also, the Chinese central bank (the PBOC) could recapitulate banks if necessary. It's balance sheet isn't bloated by years of QE.

They could also force through restructurings and write-offs basically unopposed given that the banking system is still largely state owned.

However, by once again opening the floodgates of credit the immediate day of reckoning is postponed, but the reckoning itself can be considerably more complicated. Perhaps Bass has a point after all.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.