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By Chris at www.CapitalistExploits.at
Market dislocations occur when financial markets, operating under
stressful conditions, experience large widespread asset mispricing.
Welcome to this week's edition of “World Out Of Whack” where
every Wednesday we take time out of our day to laugh, poke fun at
and present to you absurdity in global financial markets in all
it's glorious insanity.
While we enjoy a good laugh, the truth is that the first step to
protecting ourselves from losses is to protect ourselves from ignorance.
Think of the "World Out Of Whack" as
your double thick armour plated side impact protection system in a
financial world littered with drunk drivers.
Selfishly we also know that the biggest (and often the fastest) returns
come from asymmetric market moves. But, in order to identify these moves we
must first identify where they live.
Occasionally we find opportunities where we can buy (or sell)
assets for mere cents on the dollar - because, after all, I'm
a capitalist.
In this week's edition of the WOW we're covering that Black box that
is China
Back in December of 2014 we pointed out obvious problems surfacing in the interbank lending
market in China.
It was important for us since, as we mentioned:
"A rapid rise in a country’s interbank lending market is also a
good predictor of the direction of a country’s currency, or at worst a
confirming indicator."
Gratefully at the time very few market participants were anything but
massively bullish China and bullish the remnimbi. The renminbi was, after
all, if one was to read the popular headlines, going to replace the USD as
the world's reserve currency.
To the real money managers and traders this concept was largely laughed at
for obvious reasons. But it did make for sensationalistic news articles in a
world driven by short-term soundbites where such titbits of trash
are attention currency.
In any event, this meant that volatility in the renminbi was extremely low
and options pricing as a consequence extremely cheap.
Never one to shy away from putting our money where our mouth was (because
really, what's the point?) I told readers exactly what we were
doing:
"Over the last 6 months, we have been quietly gearing ourselves
up for a dramatic move to the upside in the USD/renminbi. As interbank lending
rates in emerging markets started to explode higher over the last 6 weeks we
have picked up our pace of buying long term FX call options on the
USD/renminbi. 12 months from now I suspect our only regret will be not being
aggressive enough."
Turns out we weren't aggressive enough.
Bugger. That hurts.
Even more so when we mentioned we didn't think that we would be aggressive
enough which in itself really meant that we were being pretty aggressive.
Hindsight, as they say, is 20/20.
It's like going on a date with a gorgeous sexy girl, playing it cool all
night, and being an absolute gentleman when you're really just dying to get
into her pants, and then getting a kiss at the end of the night -
something you're really not OK with. You leave disheartened, only
to find out later from her best friend that she was dying to sleep with you.
Bugger, bugger, bugger!
Such is life.
The question I've had since then from clients has been, "Is
it still a good short?"
The cause of the problems which initially surfaced in the Chinese
interbank lending market are to be found in the enormous credit-infused
infrastructure boom which was needed in order for party officials in China to
say, "Why, of course we're meeting our self imposed GDP growth
targets. Who says the market should determine such things?"
This gig worked for as long as real GDP growth was close enough to
politically mandated targets. But when the growth began faltering, the government
simply supplemented this "real" growth with artificial policy
driven growth in the way of domestic infrastructure projects. Projects, I
might add, which defy belief.
In order to finance these enormous projects the banks, flush with capital,
lent and lent aggressively.
Hayman Capital's Kyle Bass has, as far as I can tell, done more
research on this topic than anyone else I know and so I'm going to
reference him liberally. Kyle has called it, "The
largest banking system experiment in world history," and
he explains it further.
"In 2005, exports and investment constituted 34% and 42% of
China’s GDP respectively. By 2014, exports had fallen to 23% and investment
had grown to 46%. This growth in investment was funded by rapid credit
expansion in China’s banking system, which grew from $3 trillion in 2006 to
$34 trillion in 2015."
This is the largest credit expansion in history. It is (as are so many
things in our financial system today are), in a word, unprecedented. I feel a
little ridiculous using that word as it sounds sensationalistic but the facts
are there for us to see and cannot be argued with.
"We must recognize that China is an emerging market. Emerging
market banking systems should never be levered more or be larger than
developed market banking systems for a variety of obvious reasons.
China’s system is even more precarious when we realize that,
even at the biggest banks, loans are not made to borrowers based upon their
ability to repay. Instead, loan decisions are political decisions made by the
state.
Historically, booms and busts are typically driven by rapid
credit expansion and then contraction. Credit has never grown faster or
larger than it has in China over the past decade.
China’s banking system has grown from under $3 trillion to over
$34.5 trillion in assets over the last 10 years alone. No credit system in
history has ever attempted this rate of growth. There is no precedent."
Thus far the PBOC has been defending the yuan, spending over $1 trillion
doing so. If the intention was to hold the value of the currency then it
surely isn't working. They may as well burn the money because even though
they have large dollar reserves they in no way will be sufficient to stem the
outgoing tide.
Bass deals a death blow to the idea that China has sufficient
reserves to deal with the impending losses in a banking system,
undergoing the world's largest ever non-performing loan cycle which is
gathering momentum right now.
Yes, China has $3.2 trillion in reserves, or so they report, but within
the context of the size of China, its existing money supply (and the fact
that it is a massive import/export driven economy) of $3.2 trillion is not
actually adequate to run their country given the liquidity requirements of
running day to day operations for an economy of its size.
Bass goes on to say:
"China’s liquid reserve position is already below a critical
level of minimum reserve adequacy. In other words, China is CURRENTLY out of
the required level of reserves needed to safely operate its financial
system."
The PBOC have been spending roughly $100 billion a month in an attempt to
contain the blaze and the blaze has only just really begun. In a short period
of time it will be raging and the Chinese leadership will
be forced to choose whether to save an imploding banking system or hold their
currency. They cannot do both.
When you think about the fact that China has experienced a strengthening
currency versus the euro, the dollar, and the yen for the last decade and
then further consider that China as a country has grown wealthy
from export. It's relatively easy to understand that the politically
appealing thing to do is to let the yuan fall.
It's economically the thing to do, it's politically the thing to do and
it's what's going to happen.
A significant devaluation of the yuan will have reverberations globally.
Markets are struggling to come to terms with Brexit and the repercussions of
that, which I discussed in this
week's podcast. They are most certainly not ready for the kind of
bonfire that lurks eerily on the horizon of the world's second largest
economy:
"The problems China faces have no precedent. They are so large
that it will take every ounce of commitment by the Chinese government to
rectify the imbalances. Risk assets will not be the
place to be while all of this is happening."
The question that I pose to you today is one of timing. In a recent
interview on Real Vision TV where Grant Williams sat down with Kyle
Bass, Kyle suggested that the crash will take place within the next 2 years.
So...
Cast
your vote here and also see what others think
I'm in full agreement with Mr. Bass. China, together with many of the
other issues taking place globally which I'll be discussing with you on this
blog, has me and some of the smartest colleagues I know taking cover.
I'd urge you to consider the implications and act accordingly.
- Chris
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