Why Investors Can't Ignore China

| About: iShares MSCI (EEM)

Summary

How China could represent the largest macro imbalance in world history.

How China compares to Japan in terms of its debt bubble.

How to tell if a country has met its maximum debt capacity.

What are the investment implications of China's deleveraging.

Click to enlarge

Throughout my investment career, I have learned much from meeting with hedge fund managers and other renown investors.

I find it valuable to listen to their investment philosophy, process and current views. Managing a hedge fund is challenging, stressful, time consuming and humbling.

Investors are not very patient.

In 2010, I was in New York and met with Brian Kelly who ran the Asian focused hedge fund Asian Century Quest. At the time, the firm had approximately $2 billion in assets.

By early 2014, investors had pulled 95% of the firm's assets, forcing it to close most of its operations.

Had the fund lost money? No. It gained 5.5% net of fees in 2013 according to CNBC. Unfortunately, the Japanese stock market gained 57% that year and the MSCI All Country Asian Index rose 14%.

Kyle Bass, an American hedge fund manager who runs the firm Hayman Capital, said in a recent interview on Real Vision, "It's easier to maintain a conviction. It's harder to maintain investors."

In 2007, Bass' fund gained 212% after successfully positioning for the U.S. subprime mortgage crisis.

The Largest Macro Imbalance In History

Now Bass has positioned his fund to profit from the unwinding of what he calls "the largest macro imbalance in world history."

He said, "All my money is where my mouth is…There's one thing that I am as close to 100% certain of than I have ever been."

How does Bass develop such certainty? He said, "We check and recheck our thesis all the time. It's a constant endeavor. 24-7. Seven days a week."

What is Bass so certain about? That debt in China has gotten too big and grown too fast and indiscriminately. As a result, there will be massive write-offs, requiring China to recapitalize its banks.

When a bank's losses get too great, the bank becomes insolvent, harming both the depositors and the shareholders.

In 2003, the Chinese government injected $45 billion into the Bank of China and the China Construction Bank to recapitalize the banks to offset losses.

Bass believes the current loss cycle will require the Chinese government to inject $2 to $3 trillion to cover losses.

Chinese Devaluation

In order to mitigate the negative economic impact of these massive losses, Bass believes the Chinese government and central bank will take steps that will cause the Chinese yuan to depreciate significantly against other currencies such as the U.S. dollar and the euro.

"They're going to do what is best for China. And what's best for China is to materially devalue their currency," said Bass.

What does this mean for investors?

Bass said, "It's not Armageddon. They're going to have a loss cycle. They'll recap their banks. Their currency will depreciate, pretty materially. It will export deflation to the world one last time, and if you have any money left, it will be the best time in the world to invest. It will be the greatest time ever to invest in Asia."

That's good news for investors in the Vanguard FTSE Pacific ETF (NYSEARCA:VPL), the iShares MSCI China ETF (NYSEARCA:MCHI) or the iShares Emerging Market ETF (NYSEARCA:EEM).

Hedge fund managers don't position for Armageddon. They develop a thesis and then take investment positions that let them profit if the thesis comes to fruition.

At the same time, they are always mindful how much they can lose if their thesis is wrong or their timing is off.

To date, Bass' timing is off. He admits his fund has had "two years of bad performance."

In my 2010 visit with Brian Kelly, he said investors forget that China as a communist country owns most of the banks. He implied that China could assist the banks in rolling over the bad loans for an indefinite amount of time.

A Different View

Michael Pettis, a Beijing-based economic and investment strategist who I have followed for years, believes there is a serious bad debt situation in China.

He wrote in a recent blog post that, "As far as I can tell there is not a single case in modern history in which the reforming country was able to grow its way out of its debt burden. Instead the debt burden has always increased until the country either engineers or is forced into explicit or implicit debt forgiveness."

Where Pettis differs from Bass is he doesn't believe China will have a banking collapse.

He wrote, "While it is possible, and the risk of its happening should not be dismissed out of hand, I do not think China is likely to have a banking collapse, any more than Japan in the late 1980s and early 1990s was ever likely to have a banking collapse. This doesn't mean however that China's debt burden is irrelevant."

Japan's Debt Bubble

Similar to China's current situation, in the 1980s Japan experienced a huge run up in debt that spurred economic growth and a stock market and real estate bubble.

Yet, Japan did not have a financial crisis or a banking collapse. In many ways, what Japan has experienced since 1990 is much worse: over two decades of subpar economic growth as businesses and households have paid down debt.

During the 1980's, Japan's private non-financial debt as a percent of its economic output as measured by gross domestic product ("GDP") climbed from approximately 140% to over 210%. After 25 years of deleveraging, Japan's non-financial debt to GDP is 167%.

China's debt burden has grown even faster. In 2006, right before the great financial crisis, China's non-financial debt to GDP was approximately 120%. It is now over 210%, the same level where Japan's debt burden peaked.

Maximum Debt Capacity

Does that mean China has reached its maximum debt capacity? Michael Pettis points out that debt capacity limits are reached when debt can no longer grow fast enough to roll over old bad debt, cover new bad debts and invest in new projects that allow the economy to expand.

Bass believes China has reached its maximum debt capacity and the negative ramifications have begun. Pettis thinks China at its current rate of debt growth will reach its maximum debt capacity in two to three years, at which point Chinese economic growth will slow materially.

Investment Implications

What remains unclear is if the Chinese economy, the world's second largest and the primary driver of global economic growth over the past decade, slows materially or even contracts, how will that impact the rest of the world, particularly the U.S. stock market as represented by holdings such as Spyder S&P 500 Trust ETF (NYSEARCA:SPY)?

Bass subtlety states, "He doesn't see it as an equity positive event." He's not forecasting a crash, but he doesn't see stocks going up either.

A Chinese debt crisis of uncertain magnitude and timing is one of the many investment risks that needs to be acknowledged but at the end of the day investors cannot specifically prepare for, other than to make sure they are diversified with many different asset types in their portfolios.

Podcast

For more discussion on the debt situation in China and the potential impact to investors, listen to Episode 116 of Money For the Rest of Us.

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.

Additional disclosure: The Information and opinions contained in this article are for educational purposes only. The Information does not consider the economic status or risk profile of any specific person. The Information and opinions expressed should not be construed as investment/trading advice and does not constitute an offer, or an invitation to make an offer, to buy and sell securities. Any return expectations provided are not intended as, and must not be regarded as, a representation, warranty or predication that an investment will achieve any particular rate of return over any particular time-period or those investors will not incur losses. I have a business relationship with Real Vision who conducted the video interview with Kyle Bass mentioned in the article.