China has never ceased to both amaze and mystify investors. It has transgressed all possible barriers, and has positioned itself as a global economic and industrial superpower over the past few decades. Once brimming with both supply and demand, it seems the country is grinding to a halt. A rout in Chinese equity markets wrought havoc across global markets, with investors flocking to "safe" global government credit securities. Amid the rout, the 10-Year T-Bond yield dropped about 0.7 percentage points, signaling further risk-averse sentiment.
Both individual and institutional investors have largely been at a loss of ideas, some even sticking with cash. China's transitioning economy, rapidly depleting foreign exchange reserves, and a growing credit crisis point to a collapse in the powerhouse.
Traditionally well known for being a prominent export-driven nation, China has recently dedicated to transition itself to a consumer-driven one. In this transition, it is imperative that China boosts individual's discretionary income and provide additional services for its citizens in order to drive spending. Following suit with their goals, the PBoC slashed SLF rates to lift bank liquidity. In addition to slashing key rates, reserve requirements were lowered by 0.5%, freeing up about $107 billion, with which banks will be able to issue additional loans. The following chart outlines China's reserve ratios for large banks, and shows how they have recently been significantly decreased.
Source: The Wall Street Journal
The country is having a difficult time balancing the nation's desires of both monetary easing and a stable yuan. On the one hand, the nation's equity markets have suffered myriad corrections and are desperate for stimulus. However, stimulus in the form of QE comes with a hefty price tag: additional downward pressure on the renminbi. China's internal demand for dollars has already suppressed the yuan's value, and additional downward pressure from QE would force the nation to further use its foreign exchange reserves to stabilize the currency.
China's rating on the Human Development Index stands at 0.727, placing it in the "High Human Development" category and showing that the nation has significant potential. However, unemployment is likely to become another problem for the country. As urbanization becomes more prevalent, and the supply of labor in large cities continues to grow, demand is shrinking.
The problem with China's employment, though, is that a significant portion of jobs rest in the hands of foreign corporations, which are rapidly pulling out of the nation. Along with them go their capital and jobs. With this pullout of foreign enterprises, unemployment currently rests at 4.05%. However, this figure is widely known to be manipulated by the Chinese government, and Fortune recently wrote that "there is no statistic less credible than the nation's official unemployment rate." With the Chinese government attempting to boost wages, foreign corporations can no longer exploit the opportunity as much they were once able to: cheap labor. As the government continues to aim to transition, rising wages are inevitable, and therefore pullouts are as well.
Recent data released by the PBoC indicates that exports slowed 25.4% year-on-year in February, showing just how quick this transition may be occurring and how rapidly the Chinese government wants it to occur. For China to have even a miniscule chance at a "soft landing" during this transition, it is imperative that fiscal and monetary policies are synchronized. Unfortunately, many investors don't feel this is possible. George Soros, the man who "broke the BoE," says that "a hard landing is practically unavoidable."
Foreign Exchange Reserves
China's once-gargantuan currency reserves had always been a source of both pride and safety for the nation, being described as the "blood and sweat of the workers." In the early 2000s, boosted with an influx of FDIs and a growing trade surplus, foreign reserves began to soar. In mid-2014, they stood tall at approximately $4 trillion. This surplus of foreign reserves proved to be a significant "safety net" for the country, allowing it the luxury of keeping the renminbi at sustainable and competitive levels. This has been a key factor in the ability of the nation to keep GDP at above 6% levels since the early 1990s.
Now, China is being faced with a problem: its foreign reserves are shrinking, and fast. An analysis conducted by the New York Times pegs the number at about $3.23 trillion, nearly a fifth lower than its mid-2014 levels. Last month alone, reserves saw an exodus of $99.5 billion. These rapidly depleting reserves present a less controllable currency for Chinese policymakers, and therefore a smaller "war chest" with which to preside over both the yuan and other domestic markets. Mr. Rajiv Biswas, a prominent chief economist, states that "the mathematics around this rapid pace of depletion in recent months is simply unsustainable for any length of time." Mr. Biswas' view is certainly not unique. In fact, some U.S. hedge funds have initiated short positions in the yuan, many calling it the "trade of the year."
China's currency reserves have mainly acted as a sort of "shock absorber," helping shield the nation from global economic volatility many times in the past. Although $3.23 trillion seems to still be a massive sum, many believe the number to be only superficial. Kyle Bass, a prominent HF manager and principal of Hayman Capital Management, estimates that of the $3.23 trillion, approximately $2.7 trillion is tied up.
What does this mean? Well, many see much of this capital locked up in illiquid foreign investments and loans. Further analysis into this thesis proves correct, a seemingly notable example being China's loans to Venezuela between 2005 and 2015, amounting to approximately $45 billion. Another notable example of illiquid investments on the part of the nation includes its presiding over a mountain of T-Bonds totaling $1.25 trillion.
Another factor that played a substantial role in the decreasing of foreign reserves was the exodus of capital into foreign investments. Both Chinese state-owned institutions and wealthy individuals have been rapidly moving capital out of the country, further depressing the currency's value and leaving its equity and credit markets suffering major corrections. In fact, since early 2014, capital outflow charts show a significant increase in an exodus of capital. The following chart, compiled by Bloomberg, shows how capital outflow has affected the "redback."
As the FER chart on the left side clearly shows, propping up the renminbi cost reserves to return to 2013 levels, a figure that stunted China's economic growth and weakened their "defenses." In terms of how these capital outflows occur, many citizens use a technique known as "smurfing," which entails citizens bypassing capital controls by using friends and family to transfer money offshore as well. In such desperation for dollars, some Chinese have even decided to start buying up U.S. real estate.
From capital outflow charts, it is evident that Chinese citizens are desperate to move capital out of the nation for fears of a collapsing yuan. Therefore, demand for foreign currencies, the U.S. dollar in particular, has dramatically increased. This means that China must spend a significant amount of its reserves to prop up the currency. Although China's foreign reserves are still large, illiquid assets severely diminish the amount of free capital that the nation has, and therefore limit the ability of the nation to support the yuan.
As demand for foreign currency increases in the nation, China will be faced with a choice: spend more of its reserves to keep the renminbi stable, or let it devalue. Looking at the past, China generally hasn't had much of a problem letting it depreciate. However, the circumstances are a bit different now. In the past few years, Chinese banks and corporations have been adding massive amounts of dollar-denominated credit to their balance sheets. If the renminbi were to further devalue, these banks would be struck with colossal losses. Add to that the fact that many of these banks and corporations are state-owned, and it appears a crisis will soon be on our hands.
Perhaps China's greatest problem is its credit crisis. Individuals, corporations, and nations all require credit, and China is no exception. In fact, China's debt totals about $30 trillion, accounting for nearly a seventh of the world's debt. From 2009 onwards, China racked up massive amounts of dollar-denominated credit in an effort to boost and stimulate their economies, which were feeling the reverberations of the 2008 credit crunch. Much of this borrowed capital was in turn "given" to Chinese state-owned banks, which in turn issued more loans to corporations. Now, many state-owned banks are realizing that much of this credit may be defaulted upon. According to Kyle Bass, if NPLs are the cause of Chinese banks taking losses, these losses could total north of $3.5 trillion.
China's government credit rating was recently lowered by rating agency Moody's to negative, a move that further adds to suspicion that Chinese government credit may not be as safe as many investors suspect. With government debt securities around the globe yielding such low percentages, and in some cases negative percentages, investors have once again been forced to join the perennial "hunt for yield."
This hunt has seen many, in a very surprising move, flock to Chinese government credit. Although this may seem either inconsequential or even favorable at first glance, the truth is far different. Due to China's already massive amounts of debt, adding additional credit is not a smart move. Although this will be enough to fulfill short-term coupon payments, the long-term result will be catastrophic.
Aside from Chinese state-owned banks being burdened with all of this credit, many corporations are under significant duress themselves. This is due to the fact that they as well have borrowed heavily in dollar-denominated debt markets, and many are now rushing to repay the principals on these bonds early. Even Chinese corporations are uncomfortable with the colossal downward pressure upon the yuan, a clear sign that foreign investors should be even more wary.
China is a very unique nation in equally unique economic circumstances. Its transition from an export-driven to consumer-driven economy is one that the government has tried to excel at a pace too rapid, and what appears to be in the wrong direction. This transition has crushed equity markets, with the PBoC forced to implement QE measures that add extra downward pressure on the renminbi. With its foreign reserves quickly depleting, the nation is losing control over its currency, and therefore its monetary maneuverability.
To top it all, China's credit market is a ticking time bomb that can only be defused through what Ray Dalio famously calls a "beautiful deleveraging." Unfortunately, the deleveraging that will soon ensure will be far from beautiful. It will suffocate Chinese banks through NPLs and continue to force rapid foreign currency-denominated credit, which will lead to additional unemployment and therefore lower discretionary incomes.
Short the Yuan - Marked by banks as the "Trade of the Year" and being executed by some of the most prominent fund managers in the industry including George Soros, Stanley Druckenmiller, and David Tepper, this directly capitalizes on the PBoC's inability to prop up the currency.
Short Chinese Equities - Chinese equities are prepared to undergo a major correction, mostly due to mounting credit and an unavoidable deleveraging that will most likely end in some sort of a debt restructuring.
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. I have no business relationship with any company whose stock is mentioned in this article.