Easily the best analytical piece of writing on China's economic problems I have come across. Its long but fun to read and contains a lot of investing nuggets. All you need to know about the next financial crisis, when ... it has already started, newsflow out of HK has it that Chinese mainland owners are busy selling their properties in HK (as they are most liquid), the squeeze is already beginning in China.
A Front-Row Seat
By Worth Wray
Before I teamed up with John last July, I worked as the
portfolio strategist for an $18 billion money manager in Houston, TX
that, among its other businesses, co-managed (with an elite team of
investors from the university endowment world) one of the largest
registered funds of funds in the United States.
For a bright-eyed kid from South Louisiana, it was a
life-changing experience. I had a front-row seat for every investment
decision in a multi-billion-dollar portfolio for almost five years; and
along with my colleagues and mentors in Texas, North Carolina, New York,
Shanghai, and Singapore, I had the chance to meet and interact with a
long list of the most sought-after hedge fund, private equity, and
venture capital teams. I often found myself in the same room with
honest-to-god legends like Kyle Bass, John Paulson, JC Flowers, and Ken
Griffin … and I forged lasting some friendships with their portfolio
managers and analysts.
As you can imagine, the information flow was addictive. I spent
thousands of hours poring over manager letters from six continents,
doing my best to connect the global macro dots ahead of the markets and
coming up with question after question for everyone who would return my
calls. That experience plugged me in to an enduring network of truly
independent thinkers, forced me to see the world from an entirely
different perspective, and put me in an ideal position to figure out
what it takes to navigate the unprecedented (not to say strange)
investment challenges posed by a “Code Red” world.
Sometimes, combing through a mountain of manager letters felt
like reading the newspaper years in advance. I remember watching with
amazement as a free-thinking global macro investor named Mark Hart made a
fortune for his investors by shorting US subprime mortgages and then
shifted his focus to what he argued would be the next shoe to drop – a
series of sovereign defaults across the Eurozone.
Mark explained how the launch of a common currency had allowed
historically riskier borrowers like Portugal, Ireland, Italy, Spain, and
France to issue sovereign debt for the same borrowing cost as Germany
did… without any kind of fiscal union to justify the common rates. The
resulting debt splurge led to a big increase in fiscal debts, drove an
unwarranted rise in unit labor costs across the southern Eurozone, and
essentially activated a ticking time bomb at the very foundations of the
euro system. It seemed obvious that rates would eventually diverge to
reflect the relative credit risks of the borrowers, but the market
didn’t seem to care until it got very bad news from Athens. We all know
what happened next.
Just as Mark and his team at Corriente Advisors had predicted,
spreads blew out in Greece, then in Ireland, then in Portugal, then in
Spain… and it now appears that Italy and France are veering toward a
similar fate. When the euro crisis finally broke out, my colleagues and I
were waiting for it, because Mark had already walked us through his
playbook for a multi-act global debt drama.
Instead of blowing up in spectacular fashion, the Eurozone
crisis has taken far longer to resolve than a lot of investors and
economists expected (Mark, John, and myself included); but the euro’s
survival thus far has been largely the result of extensive Realpolitik
and an increasingly hollow narrative from Mario Draghi and the ECB
laying claim to the wherewithal to “do whatever it takes” to preserve
the single-currency system. Meanwhile, as Corriente understood, the
likelihood of major defaults across the Eurozone rises every day that
the ECB does the bare minimum to resist France’s and Italy’s slide
toward deflation. It’s not over until the fat lady sings.
The point I am trying to make is that Mark saw the fundamental
imbalances behind the global financial crisis in time to launch a
dedicated fund in 2006, and he saw the root causes of the ongoing
European debt crisis in time to launch a dedicated fund in 2007…
precisely because he thinks of the global economy as one interconnected
system peppered with a series of unstable and still unresolved debt
bubbles. Mark is one of the most forward-thinking investors I have ever
met and one of the best in recent decades at spotting the big imbalances
that spell T-R-O-U-B-L-E.
I can’t tell you if he will be right about the next phase of the
global debt drama. Predicting the actions and reactions of elected and
unelected officials is next to impossible in a Code Red world, but some
people have an eye for fundamental imbalances. And since Mark has been
largely right in identifying the major debt bubbles that have plagued
the world since 2007, John and I can’t comfortably ignore his warning.
As Carmen Reinhart and Kenneth Rogoff argued in their
still-authoritative history of financial boom and bust over the past
eight hundred years, “When an accident is waiting to happen, it
eventually does. When countries become too deeply indebted, they are
headed for trouble. When debt-fueled asset price explosions seem too
good to be true, they probably are.”
The Bubble That Is China
Following his prescient calls on the subprime debacle and the
European debt crisis, Mark identified in 2010 another source of
instability that he warned could shake the global economy. And it took
me by surprise. He warned that China was in the “late stages of an
enormous credit bubble,” and he projected that the economic fallout when
that bubble burst could be “as extraordinary as China’s economic
outperformance over the last decade.”
To my knowledge, Mark Hart and his team at Corriente were the
first of many global macro managers to anticipate a hard landing in the
People’s Republic of China. Mark argued that the Middle Kingdom would
land very hard indeed, popping speculative bubbles in the property and
stock markets, sending foreign capital flying out the door, and
triggering a rapid collapse in the renminbi … and even if the Chinese
government could manage its economy away from a deflationary
bust, they would be forced to devalue the renminbi to do so. In other
words, Mark saw a much lower renminbi under almost every outcome.
It was a mind-blowing concept to me that the main driver of
global growth (at the time) could not only implode but even drag the
rest of the world down with it.
I can’t share the original Corriente China presentation with you
for legal reasons, but here are a few public notes published by the Telegraph’s
Louise Armistead after she attended one of Mark’s presentations in
November 2010.
These may look like obvious observations today, the sort
you can find plastered all across the internet, but very few people were
actually paying attention four years ago. And the data has only gotten
worse since 2010 as rampant credit growth and insidious shadow lending
have continued to fuel greater and greater capital misallocation.
In the presentation, which amounts to a devastating attack on
the prevailing belief that China is an engine for growth, the financier
argues that ‘inappropriately low interest rates and an artificially
suppressed exchange rate’ have created dangerous bubbles in sectors
including:
Raw materials: Corriente says China has
consumed just 65pc of the cement it has produced in the past five years,
after exports. The country is currently outputting more steel than the
next seven largest producers combined – it now has 200m tons of excess
capacity, more that the EU and Japan's total production so far this
year.
Property construction: Corriente reckons
there is currently an excess of 3.3bn square meters of floor space in
the country – yet 200m square metres of new space is being constructed
each year.
Property prices: The average
price-to-rent ratio of China's eight key cities is 39.4 times – this
figure was 22.8 times in America just before its housing crisis.
Corriente argues: “Lacking alternative investment options, Chinese
corporates, households and government entities have invested excess
liquidity in the property markets, driving home prices to unsustainable
levels.” The result is that the property is out of reach for the
majority of ordinary Chinese.
Banking: As with the credit crisis in
the West, the banks’ exposure to the infrastructure credit bubbles isn’t
obvious because the debt is held in Local Investment Companies – shell
entities which borrow from Chinese banks and invest in fixed assets. Mr
Hart reckons that ‘bad loans will equal 98pc of total bank equity if
LIC-owned, non-cashflow-producing assets are recognised as
non-performing.’
The result is that, rather than being the ‘key engine for global growth’, China is an ‘enormous tail-risk’.
The markets may damn well prove Mark right, along with a host of
other managers who either jumped on his bandwagon or reached the same
conclusions independently; but it seemed downright crazy in 2010 to
think that the main driver of global growth could abruptly become its
biggest threat within a few short years.
On a personal note, I obsessed over China’s culture, economy,
and political system for years in college and then witnessed the
country’s transformation firsthand during my time at Shanghai’s Fudan
University in the summer of 2007.
Then and later, I marveled at China’s
strength relative to the developed world and the seemingly invincible
central government’s ability to keep the economy chugging along with
credit growth and fixed investment while it hoped for the return of its
developed-world customers then mired in the Great Recession.
It wasn’t what I wanted to hear … but I had to accept that Mark
could be right. He had clearly identified a major imbalance which has
continued to worsen over the last few years, and now we are just waiting
for the next shoe to drop.
Four years later, Chinese production is slowing in the shadow of
a massive credit bubble and in the face of aggressive reforms.
Disappointing investment returns are revealing broad-based
capital misallocation; property prices are cooling (relative to other
countries); and commodity stockpiles are mounting.
With China’s new policy of allowing defaults (historically,
China’s default rate has been 0%), there is a real risk that follow-on
events could spin out of control, raising nonperforming loan ratios and
sparking a panic as bank capital is significantly eroded.
In the meantime, the renminbi is trading down, most likely due
to an intentional effort by the People’s Bank of China to aid in the
slow unwinding of leveraged trade finance.
Now the signs of a Chinese slowdown (and thus a global one, as
the world is geared to 8% Chinese growth) are clear, and people around
the world are meeting uncertainty with emotion. With that in mind, let’s
dig into the data that really matters and try to get to the heart of
China’s dilemma.
China’s Minsky Moment?
“China is like an elephant riding a bicycle. If it slows down,
it could fall off, and then the earth might quake.” – James Kynge, China Shakes the World
After 30 years of sustained economic growth topping 8% and a
successful bank cleanup in 2000, the People’s Republic was well on its
way to blowing through the “middle income trap” and transitioning to a
more advanced consumption-based economy. But then in 2008 the banking
crisis in the United States abruptly ushered in a painful era of balance
sheet repair across the developed world and delivered a demand shock to
emerging markets. Rather than allow the Chinese economy to fall into
recession at such an inconvenient time, the Party leadership sprang into
action to stimulate demand with its largest fiscal deficit in more than
60 years and to mobilize bank lending with historically low interest
rates and enormous liquidity injections.
As you can see in the charts above, China’s total debt-to-GDP
(including estimates for shadow banks) grew by roughly 20% per year,
from just under 150% in 2008 to nearly than 210% at the end of 2012 …
and continued rising in 2013. Even more ominous, corporate debt has
soared from 92% in 2008 to 150% today against the expectation that
China’s government would always backstop defaults. That makes Chinese
corporates the most highly levered in the world and more than twice as
levered as US corporates, just as corporate defaults are happening for
the very first time in more than 60 years.
By another measure, China has accounted for more than $15
trillion of the $30 trillion in worldwide credit growth over the last
five years, bringing Chinese bank assets to roughly $24 trillion (2.5x
Chinese GDP) and prompting London Telegraph columnist Ambrose
Evans-Pritchard to tweet John and me a short message: “China riding tail
of $24 trillion credit tiger. Tiger will eat Maoists.” And to that, I
would respond that I hope the tiger doesn’t find its way to France.
Looking further into the debt problem, China is steadily
incurring more and more credit for less and less growth – suggesting
that the newer debt is less productive because it is being put to
unproductive uses – as you can see in Chart 2 above. That explains why
many analysts believe China’s official reported nonperforming loan ratio
of 1% is more like 11% – or more than 20% of GDP.
Furthermore, China’s incremental capital/output ratio rose from
2.5x in 2007 to almost 5.5x in 2012. That means it takes more than twice
as much debt to generate a given improvement in growth as it did before
the debt binge began; and as an aside, the interest burden on China’s
total debt, at 9.2%, is higher than in the US in 1929 and near the peak
interest burden in 2008. Moreover, debt-service costs in China are more
than double the total interest burden seen at any time in the last 100
years of US history.
China’s massive debt build-up since 2008 looks like the perfect
recipe for a particularly destructive banking crisis; but as George
Soros explains, “There are some eerie resemblances with the financial
conditions that prevailed in the US in the years preceding the crash of
2008. But there is a significant difference, too. In the US, financial
markets tend to dominate politics; in China, the state owns the banks
and the bulk of the economy, and the Communist Party controls the
state-owned enterprises.”
It will be a difficult balancing act, but China’s ruling elite
doesn’t appear to be in denial about its debt problem, as we have come
to expect from the United States and the Japan of old. In fact, it seems
the new government under President Xi Jinping is intent on popping the
domestic debt bubble and allowing widespread defaults rather than
continuing to leverage the system into an unmanageable crisis or a
Japanese-style stagnation. The trouble is, their efforts may be too
little too late to manage a gradual deleveraging from a massive debt
bubble. They are about to perform a dive off the high board that has
never been attempted, with the whole world watching.
Among the various reforms set forth in last November’s Communist
Party Third Plenum, ranging from financial liberalization to a
crackdown on corruption and pollution, the greatest challenge will be
gradually deleveraging the Chinese economy without throwing growth into a
tailspin. Wei Yao and Claire Huang at Societe Generale argue that the
Chinese government must approach the deleveraging process in three
steps:
The first step is to stall credit growth –
especially the growth of risky lending – so that overall leverage rises
at a slower pace. In order to achieve this, Beijing has to stick to
stringent monetary policy. The market has got a bitter taste of this.
Since the beginning of the year, the People’s Bank of China (PBoC) and
financial regulators have issued a slew of policy-tightening measures on
local government off-budget borrowing, cross-border arbitrage flows,
bank WMPs and the interbank bond market.
These measures were intended to
limit the supply of easy liquidity – mostly from the interbank market –
for speculative uses and risky shadow bank lending. In early June,
interbank liquidity conditions started to tense up as these measures
took effect. The PBoC at first adopted a surprisingly tough stance and
held off on liquidity injections, which resulted in unprecedented
interest rates spikes. We would agree that this app
roach
lacks elegance and the central bank could have been more communicative,
but it was a strong signal that policymakers disapproved of all the
risky lending behaviour plaguing the system. This is nonetheless a
difficult stance to maintain when economic growth slows, given that
credit growth has been used as a policy tool by the Chinese government
to stabilize short-term economic growth.
The second step is to keep rolling over (a majority of) bad debt.
This may be a necessary evil. If stalling credit growth caps the upside
on economic growth, rolling bad debt should limit the downside, at
least in the near term. The purpose is to avoid sparking a series of
corporate bankruptcies, and economic growth can also do its part in
deleveraging. Particularly in the case of infrastructure debt, keeping
existing projects going can help manufacturers’ supply glut from going
wider, and some projects, once completed, may eventually generate cash
flow.
In addition, an improving global economy is likely to invite a return of export demand.
The third step is to start NPL disposals bit by bit.
Many companies in China are probably unable to even support interest
payments on their debt. If the financial system were to keep all of them
alive, the percentage of financial resources that goes into the
efficient part of the economy would only decline. This is essentially
the lesson we can learn from Japan’s lost decades – the economy
struggled to grow due to the large number of zombie companies in the
system. Therefore, China needs to let bad projects fail and failing
companies disappear to make space for efficient ones.
(Wei Yao & Claire Huang, “Asian Themes: Deflating China’s credit bubbles.” Societe Generale; September 19, 2013)
If President Xi Jinping, his Politburo comrades, and the
People’s Bank of China can work together to slow credit growth, roll
over the majority of bad debts, and gradually start disposing of the
worst nonperforming loans, they may have a small, but not hopeless,
chance of avoiding the difficult choice between a forceful deleveraging
and footing the bill to backstop defaults and/or bank failures that
could pile up toward 20% of GDP. That increasingly likely scenario would
seriously disrupt real GDP growth along with China’s annual budget.
Trouble is, the People’s Bank of China has allowed some pretty
wicked cash crunches over the past year. Some say it was an intentional
move to discipline the shadow banking system. That scenario scares the
hell out of me, because that kind of behavior suggests the Chinese are
playing a dangerous game – and not just with their own economy.
Interbank rates do not normally bounce from 2% to 12% in a healthy
economy.
In the chart below from Bloomberg, it appears that fluctuations
in FX flows may explain a lot of the easing and tightening happening in
the interbank market. I suspect this is a clear sign that the PBoC may
already be losing control.
For all practical purposes, with China’s corporate debt above
150% and total debt above 210%, history suggests that China’s Minsky
Moment is quickly approaching. Investors should prepare for the
inevitable demand shocks and fall in global growth regardless of the
specific outcome. The Chinese government may have the assets to backstop
a truly horrific crisis and maintain slow growth in the 2-3% range; but
then again, Mark Hart may have the final word.
Four years on, the denouement has clearly taken longer to arrive
than Mark expected, but he is still in the market with his Corriente
China Opportunities Fund. And he is still betting big against the yuan,
which continues to surprise and slide.
With so much of the market expecting one-way appreciation in the
RMB/USD – despite a crescendo of warnings of currency volatility from
the PBoC – such moves represent a big surprise and may simply be the
first steps down.
China’s government finds itself on the exact opposite side of
the carry trade now, and it appears they have a lot to gain by
unwinding it – on the order of $200 billion for every 10% devaluation in
the CNY/USD. It’s essentially a way to join the currency war and boost
exports without appearing to circumvent the free market.
Contrary to what many onlookers believe, the People’s Bank of
China and China’s top leadership are probably not willing and possibly
not able to defend the currency while also supporting growth in a
deleveraging economy. They will have to make a choice, and frankly, they
already have an incentive to let the renminbi fall as they attempt to
put the right reforms in place to support long-term growth – or face a
deflationary nightmare in the uncomfortably near future.
Not many people realize that China has lost a great deal of
competitiveness as its real effective exchange rate has risen in recent
years.
Source: OECD
This is the same kind of dynamic that made Ireland, Spain,
Greece, Italy, France, and others so uncompetitive relative to Germany
in the easy-money years leading up to the euro crisis.
Source: JPMorgan, “Guide to the Markets”
American, European, and Japanese politicians will have a hard
time making the case for a downward-trending RMB as long as it floats
freely. And honestly, the flip side will be difficult to defend.
Although many economists believe that China’s abundant reserves, near
50% of GDP, will be enough to stem the tide in the event of capital
flight, I don’t believe they are looking at the right data. In light of
clearly wasted spending and widespread capital misallocation, GDP is
artificially inflated … not to mention that a substantial portion of
Chinese reserves may have already been locked up in loans to foreign
borrowers.
M2 is a far better proxy for the capital that can rush out of an
economy without warning … and Chinese M2 is now nearly twice the size
of GDP. Since outstanding reserves cover less than 35% of M2, capital
outflows place more pressure on the currency than most people realize. I
wholeheartedly believe the renminbi will fall further over time, albeit
with some serious volatility.
The Bigger They Come…
Over the last 50 years, every investment boom coupled with
excessive credit growth has ended in a hard landing, from the Latin
American debt crisis of the 1980s, to Japan in 1989, East Asia in 1997,
and the United States after both the late-1990s internet bubble and the
mid-2000s housing bubble.
The lesson is always the same, and it is hard to avoid. Economic
miracles are almost always too good to be true. Broad-based,
debt-fueled overinvestment (misallocation of capital) may appear to kick
economic growth into overdrive for a while; but eventually
disappointing returns and consequent selling lead to investment losses,
defaults, and banking panics. And in the cases where foreign capital
seeking strong growth in already highly valued assets drives the
investment boom, the miracle often ends with capital flight and currency
collapse.
John and I talk about China constantly and always reach the same
conclusion. We really have no way of knowing whether the country will
suffer a modest slowdown or a hard landing, but we both agree with
George Soros that “The major uncertainty facing the world today is not
the euro but the future direction of China.”
To be clear, China doesn’t have to experience a deep
recession in order to disrupt global growth. A slowdown to 2-3% real GDP
growth and a corresponding decline in China’s import demand could fire
demand shocks across emerging Asian economies like India and Indonesia,
commodity producers like Australia and South Africa, and even
deteriorating economies in the Eurozone like France and Italy.
The investor’s dilemma is that there is really no way to know what is happening in China today, much less what will happen tomorrow.
The primary data is flawed at best, manipulated at worst, and there
seem to be a lot of inconsistencies when we compare official data to
more concrete measures of economic activity.
Even China’s new premier, Li Keqiang, believes China’s GDP
numbers are “man-made” and therefore unreliable, according to a US
diplomatic cable released by WikiLeaks in 2010. For what it’s worth,
that same cable suggests the premier is more interested in measurements
like electricity consumption (officially expected to rise by 7% in
2014), rail cargo volumes (officially expected to rise by 2% in 2014),
and bank loans (officially expected to stall in 2014) ... which are all
showing potential signs of fatigue.
From an investment perspective, China’s predicament can teach us
one valuable lesson. The most important risks are often the ones you
cannot easily anticipate, and thorough diversification may be your only
defense. As the Chinese say, “Precaution averts perils.”
