China is facing a veritable "yuan-pocalypse" and the mechanics behind why aren't well understood. At all.
For instance, it's not as simple as saying "well, they can just set the yuan fixing anywhere they want." Actually, they can't. Well, they can - if they want to watch the export-driven economy crash and burn.
The point is, there are other moving parts here. Namely China's other trading partners. That's why they devalued in the first place: the dollar peg was making the yuan (NYSEARCA:CYB) more expensive vis-a-vis the currencies of countries other than the US. Here's a short excerpt from Deutsche Bank which explains what's going on now that the new trade-weighted index is in place (this is a bit dated, but it does the trick):
Taking the hypothetical case of a uniform drop of 5% in all world currencies against the dollar, this implies USD/CNY has to rise by around 15% to keep the yuan stable at current levels. This of course implies that the currency is indeed kept stable rather than actively weakened. Put simply, if China allows USD/CNY to appreciate in line with dollar strength against other currencies, the broad trade-weighted dollar will appreciate by even more.
(Chart: Deutsche Bank)
See what I'm saying? This isn't necessarily easy to manage. Here's how Soc Gen explained it in December: "The PBOC is clearly preparing the market to interpret a weaker yuan versus the dollar not being devaluation."
Think about it in terms of what we saw during the risk-on mood that prevailed after the February lows on the S&P (NYSEARCA:SPY). Here's the yuan versus the trade-weighted basket:
And here's the CNY versus the dollar during the same period:
Now think about what stocks did during that stretch. As Citi's Stephen Englander put it, "they're much better off depreciating against other EM currencies in a risk-on environment than they are depreciating against the dollar in a risk-off environment."
I would perhaps add that we're all better off when they go that route.
Note that more recently we've seen that dynamic reverse. See in the charts above how CNY has weakened to its lowest levels since January in the last few days and also started to turn the opposite direction (i.e. strengthen) against peers late last month. And guess what we've seen? A five-day sell-off in US stocks through Wednesday.
Then we got an uber-dovish Fed statement. And you'll never guess what happened with Wednesday night's fix. That's right, the PBoC strengthened the fixing by the most in more than a week:
- CHINA SETS YUAN FIXING AT 6.5739 VS. 6.6001 DAY EARLIER
In any event, take what you will from the above about the give and take between the yuan, the dollar (NYSEARCA:UUP), the fix, and the new basket. I started with that because it's indicative of a kind of overarching theme for Chinese policymakers. Essentially, they are everywhere and always trying to pull off an impossible juggling act. That's certainly the case in the banking sector and it's to that point I'll turn next.
More specifically, I'd like to draw your attention not to non-performing loans, but to credit risk that's carried on banks' balance sheets as "investments."
As I mentioned on Tuesday, an eye-watering array of investment vehicles including wealth management products and trusts are used by banks in conjunction with the country's vast shadow banking complex, to channel credit to the sagging economy. Chinese authorities are well aware of the risks, but at the same time, they know that curtailing shadow banking would mean cutting off the spigots entirely because banks aren't willing to loan money through traditional channels (i.e. plain vanilla loans). Those have to be carried on the balance sheet and sooner or later, losses there will have to be recognized as NPLs.
In many cases, shadow banking credit is carried as "investments" or "investments classified as receivables." My favorite example is this one, from Reuters:
At China's mid-tier lender Industrial Bank Co., for example, the volume of investment receivables doubled over the first nine months of 2015 to 1.76 trillion yuan ($267 billion).
This is equivalent to its entire loan book - and to the total assets in the Philippine banking system, filings showed.
Here's how Fitch describes the business:
Banks work with non-bank financial institutions (i.e. trust companies, securities firms, other financial subsidiaries and/or affiliates to the banks) to channel credit to sectors that have restricted access to traditional banks loans. This is usually called "channel" business in China. The banks may put together these transactions themselves, in which case the borrower could be an existing bank customer, or the non-bank financial institution may help the bank identify profitable lending opportunities. Some of this credit is sold to investors as WMPs, but banks are increasingly holding it on their own books as "financial assets held under repurchase agreements" or "investments classified as receivables..."
The amount of informal loans channeled through non-bank financial institutions and accounted as "investments classified as receivables" has increased from close to zero in 2010 to CNY4.4trn at end-2014 for Fitch-rated commercial banks, equivalent to 8% of total loans.
Now obviously, this is a problem. It creates a situation wherein a very substantial chunk of credit risk is effectively carried off balance sheet through largely opaque vehicles that are funneling credit to inherently risky sectors of the Chinese economy. Bloomberg has had some good (if hopelessly late) commentary on the subject recently. Here are a few excerpts:
As many as 15 publicly traded Chinese lenders, large and small, report roughly $500 billion of such debt between them, which they hold not as loans but as receivables from shadow banking products. While the traditional credit business of these banks is 16 times bigger, receivables have jumped sixfold in three years. Explosive growth of this type usually ends badly. It's hard to see why it'll be different for the People's Republic.
The names keep changing, from "investment management products under trust scheme" and "investment management products managed by securities companies" to "trust beneficiary rights" and "wealth management products." The latter has swelled to the equivalent of 35 percent of GDP, and account for 3 trillion yuan of interbank holdings. The common thread to these products is that they're all exposed to corporate credit and designed to get around lenders' minimum capital requirements and maximum loan-to-deposit norms, with scant loss provisioning in case things go wrong.
So you can see why this is a problem in terms of sheer scope and credit risk, right?
But it's not just that. You also have to understand that some of these products are inherently risky for another reason. Many suffer from maturity mismatch. Here's how the RBA put it in a report out last summer:
A key risk of unguaranteed bank WMPs is the maturity mismatch between most WMPs sold to investors and the assets they ultimately fund. Many WMPs are, at least partly, invested in illiquid assets with maturities in excess of one year, while the products themselves tend to have much shorter maturities; around 60 per cent of WMPs issued have a maturity of less than three months."
In other words, whether or not investors get paid back depends entirely on whether the paper rolls. If existing investors don't roll their exposure, then new buyers have to be found to pay those investors back because the assets their money was invested in by the WMP don't mature for years. This was precisely what happened in Canada in 2007 when the ABCP market suffered a meltdown.
What should stick out here is that it's a Ponzi scheme. The model is basically this: 1) I take your money and promise to pay you back in a month with 2% interest; 2) I invest your money in something that matures in a year that yields 4%; 3) I pocket the spread and get another you to invest with me and use his/her money to pay you back at the end of the month.
Note also that this is precisely the dynamic that fractional reserve banking is based on. Only these are Chinese banks. Investing in things like the beleaguered industrial sector or worse, margin lending for Chinese housewives speculating on stocks or commodities futures. With opaque products. In an environment where the regulatory regime is sorely lacking.
But it gets better. These products are now investing in each other, in what amounts to the Chinese equivalent of the CDO-squared. Here's Bloomberg:
Interbank holdings of WMPs swelled to 3 trillion yuan as of December from 496 billion yuan a year earlier, according to figures released by the clearing agency last month. As much as 85 percent of those products may have been bought by other WMPs, according to Autonomous Research, which based its estimate on lenders' public disclosures and data on interbank transactions. The firm speculates that in some cases the products are being "churned" to generate fees for banks.
"My concern is that bond defaults might trigger some losses that will lead to WMP impairments or WMP investors being unwilling or unable to roll over the funding, which then leads the bank to take some of these assets back onto the balance sheet," said Matthew Phan, credit analyst at CreditSights in Singapore. "If this happens in a large scale, it could cause some issues, given the mismatch between the duration of the WMPs and the bonds."
As if all of that weren't enough, also consider that these channels are impairing the extent to which new credit gets to the real economy. In short, bank credit growth isn't translating to M2 growth. Have a look at the following two charts from Deutsche Bank:
(Charts: Deutsche Bank)
See a problem there? Here's Deutsche to explain:
How could M2 growth be so much weaker than credit? The answer is that a large part of bank credit is circulated back to the banking system via non-deposit channels. We believe the root cause is the structural slowdown of China's economic growth, and its implication is several-fold.
There is a similar pattern in the US before the subprime crisis, but the picture is less clear. Credit grew faster than M2 persistently from 2002 to 2005, but the gap closed by early 2006.
And can you guess what the picture looks like when we look at the share of bank credit extended to non-bank financial institutions versus credit extended to the real economy? Have a look:
(Charts: Deutsche Bank)
They're just pyramiding risk on top of risk. Just like US banks did with mortgage-backed paper.
And by the way, these things have defaulted before. See the case of Fanya Metals, for instance.
At the end of the day, it will all come down to whether or not the state wants to make investors whole when the paper issued by banks and NBFIs one day stops rolling. And it will. Just like it did in Canada. It starts with a small case (something like Fanya) and then, when the market gets spooked, investors won't want to roll their 60-day paper into the next month. Banks and NBFIs will then need to pay investors and sit on the underlying assets. Needless to say, that really won't be feasible given the size of this market and the nature of the underlying.
We now come full circle to Kyle Bass and the yuan short. When this thing implodes and the contagion spreads through the banking sector, the government will really have no choice but to backstop it. If they don't, everyday Chinese who invested and were fed the lie that these products are as safe as deposits will take to the streets (this has happened on several occasions including the Fanya debacle).
And remember, this is just the off-balance-sheet stuff. That is, it doesn't count the 6%-10% of banks' traditional loans that are probably bad.
China doesn't have the reserves to plug the hole. Well, they do - almost. But they won't by the time this train wreck plays out, especially if the capital outflows pick up in the coming months, which seems likely.
To be sure, the story of the yuan short is rather complex and that is precisely what leads investors to ignore the possibility (and the likelihood) of a crisis in China. But make no mistake, it is decipherable. You just have to be willing to look under the hood and have the intestinal fortitude not to run away ostrich-style and bury your head in the sand once you get a peek at how truly precarious things are.
Finally, note that this isn't a case where the pain will be contained to China. This will spill over immediately. As in virtually overnight. That's what happened in August on Black Monday and that's what happened in January when US stocks very nearly got off to their worst start to a year in history.
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.