Re(N)member What's Really Important

| About: SPDR S&P (SPY)


It's a bad time to be an Italian bank.

Or a systemically critical German lender called Deutsche Bank.

Or a London property fund.

Or a Chinese financial institution.

The Italian banking sector is imploding, Deutsche Bank may be headed for single digits, and the Brexit fallout is beginning to be felt in earnest in the UK where multiple property funds have gated investors, citing illiquidity amid rising redemption requests.

But I don't want to talk about any of that. However, I'd be remiss if I didn't survey the damage. Have a look below.

The "Italian Job":

(Charts: BofAML, my addition)

"Zee Germans":


(Chart: Citi, my addition)

The market's fixation on the three admittedly important stories mentioned above has diverted attention from the "main event," so to speak. While everyone's eyes were focused squarely on Europe, the offshore yuan quietly logged its third straight week of losses against the dollar:

This is cause for concern. As Capital Economics' Chief China Economist Mark Williams wrote in a note last month, the yuan's persistent decline over the last few months may indicate "that the PBOC was banking on market interest being focused elsewhere."

Well, they were right. No one was paying attention and the CNY (NYSEARCA:CYB) continued its grind lower against the trade-weighted basket:

(Chart: Credit Suisse)

For their part, Credit Suisse thinks the economic outlook is deteriorating for China which makes more FX depreciation a virtual certainty. Here's more:

We forecast USDCNY to rise to about 6.84 by end-2016 and 7.11 by end-2017. However, our perception is that the government judges the August 2015 devaluation was a mistake that it does not want to repeat. We expect it to draw down on FX reserves to maintain a gradual, almost predictable, pace of depreciation. We estimate FX reserves have fallen every month this year on a valuation-adjusted basis, even if the pace has fallen to less than $10bn per month since April. We expect FX reserves to fall to $2.74tn by the end of 2017. This implies a continued fall in the CNY on a nominal and real effective exchange rate basis.

Of course that will lead to more pressure on CNH and a wider gap between the onshore and offshore spots. The wider that gap, the more pressure on risk assets, including US stocks (NYSEARCA:SPY). CNY's decline vs USD and CFETS "makes a mockery" of the central bank's suggestion that it wants to keep its currency stable, Capital Econ's Williams notes. Here's a bit from Commerzbank's Zhou Hao via Bloomberg:

  • PBOC probably won't allow much upside on USD/CNY after it passes 6.70, a level that would intensify bearish sentiment
  • Central bank is releasing some pent-up depreciation pressure by weakening currency now while market environment is favorable
  • Overall capital outflows could be easing, which is "somewhat inconsistent" with USD/CNY spot rate movement
  • FX forwards market quiet, which hints that market doesn't see it as worthwhile to speculate on large CNY depreciation

Once again, no one knows quite what to think. This is a juggling act for China. It's a matter of guessing when they finally drop one (or more) of the many balls they have in the air.

Recall that selling FX reserves to control the pace of the devaluation saps liquidity from the system. That necessitates RRR cuts. Here's Credit Suisse again (emphasis mine):

We expect China's reserve requirement ratios (NYSE:RRR) to be cut by 100bps, but stress that this is more likely to be simply to manage liquidity levels for the current interest rate structure rather than to lower rates. We see a chance that the PBoC could cut its policy guidance rates by another 25bps later this year if the US Fed remains dovish. However, we believe continuing pressure on the CNY greatly limits the scope for lower interest rates.

Right. That's exactly the dynamic I discussed a few days ago. Here's how I put it:

Consider also that efforts to prop up the yuan and control the pace of the devaluation add fuel to the fire. Think about what happens when the PBoC intervenes in the spot market. They sell dollars. They're effectively sucking RMB liquidity out of the system. In order to offset that, they need to cut RRR (which is what you saw on numerous occasions last year). Of course RRR cuts are an easing measure. And easing is currency negative. The pressure builds anew. China intervenes. Liquidity dries up. And around we go.

With that in mind, let's take another look at China's options for recapitalizing its banks which, you're reminded, will be necessary once the myriad "zombie" state owned enterprises are closed and their bad debt booked.

Here's an overview of where the debt is:

(Chart: SocGen)

As you can see, SOE debt is a real problem. And SOEs have grown in size while their profitability has only declined:

(Charts: SocGen)

Here's a look at NPLs at Chinese banks:

(Chart: SocGen)

The thinking is that understates the case by a mile. There are two possibilities for disposing of these things. First, they can be sold to asset management companies. Here's the problem with that:

Notwithstanding new rules which could be in the works, we understand that Chinese commercial banks supposedly still sell off their NPLs to state owned/designated AMCs. Chinese banks are allowed to bulk-sell NPLs to the 'Big Four' AMCs or to the other local AMCs at a discount, with the AMCs subsequently attempting to recover the debt or sell them on to onshore distressed debt investors. That the PBOC is now contemplating a debt/equity swap would suggest that: (1) there are too many NPLs; and/or, (2) there might not be enough appetite/capacity on the part of the AMCs to buy the NPLs. As AMCs are increasingly transacting their purchases on "commercial" basis (i.e. viable market prices), banks are forced to take bigger MTM losses as and when the sale of the NPLs to the AMCs are recognised.

Got it. So what about a debt-for-equity swap? No. That's not a long-term solution. Here's why (again, via SocGen):

And while the end game for lenders is unclear (one would think there would be minimal, if any, equity upside from the debt swapped for the lenders), it could also serve to only "postpone" the entire NPL/"Special mention" loans crisis until further down the road. Should nothing improve on the part of the borrowers (which is likely to be the case), we could expect the state to bail out the state-owned lenders in the (inevitable) event of lenders having to recognise significant impairments on these equity stakes. For banks, the simplest of logic is that the conversion of debt to equity would reduce commercial banks' NPL ratios, free up capital requirements, which are tied up currently to provide for the NPLs, and subsequently allow fresh lending for investment in the many new fiscal projects to help revive the economy. And while this move frees up loss reserves, it essentially strips banks of their security and asset protection which they enjoyed as secured lenders.

Keep in mind, this doesn't include the credit risk that's carried on the balance sheet as something other than traditional loans.

You can see why Kyle Bass thinks a massive recapitalization is inevitable. So let's look at how that might work. Here's a flow chart:

(Chart: SocGen)

The thing to note here is the currency impact of the two options (fiscal and FX reserves) Beijing could pursue for the recap. SocGen makes a crucial point. Public debt is low as a percentage of GDP, but issuing more debt to fund the recap will drive up rates (i.e. tighten financial conditions). Additionally, it will likely force the PBoC to monetize a portion of the debt, which would put depreciation pressure on the yuan. Alternatively, if China uses its FX reserves for the recap, the banks will have to convert dollars to renminbi, thus putting upward pressure on the currency and derailing the managed devaluation. Further, the FX reserve depletion leaves the PBoC with less ammo to fight future depreciation pressure.

In other words, what China needs to do is figure out the exact right mix of QE and FX reserve injection that results in a balance between the depreciation pressure PBoC bond buying would exert and the appreciation pressure FX reserve conversion by the receiving banks would entail.

Needless to say, the most likely outcome would be that QE would take precedence in the market's mind and pressure on the yuan would mount just as the central bank burns through its reserves in the recap effort.

We'd all better hope they figure out how to get this right, because re(n)member...

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.

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