Bass tells Fortune he expects a ‘hard landing’ for China and the global economy, but that it won’t be as bad as the 2007-09 financial crisis.
Kyle Bass, head of Dallas-based hedge-fund Hayman Capital Management, rose to prominence in 2007 for being one of the few investors to spot the U.S. financial crisis early, and to profit from it by betting against subprime mortgages. He successfully called Japan’s banking problems (and bold monetary stimulus) a few years later, and now he’s saying China will be next.
In an interview with Fortune prior to his appearance at this week’s Ira Sohn investing conference in San Francisco, Bass offered reasons why China’s impending banking crisis, though far bigger than the U.S. crisis in terms of the assets at risk, will have a smaller impact on the global economy. He also explained why the hedge fund business is less forgiving than it has ever been. Edited excerpts of the conversation follow.
Fortune: You have said the banking system in China is under-capitalized, and the country could blow through foreign reserves quickly. What does China’s banking system look like?
Kyle Bass: It’s not a mono-variable equation. Foreign reserves aren’t China’s only access to capital – they can sell bonds and they can actually print more money. But when you are thinking about their [foreign-exchange] reserve pile, and investor solace that they have so much money – a $3.5 trillion rainy day fund that they can weather any storm – the point is that their banking system used to be 41 trillion RMB only eight years ago and now it’s 184 trillion RMB. They have $31 trillion of assets in their banking system. Their economy is $10 trillion.
What does that look like relative to the U.S. in 2008?
When the U.S. was entering the financial crisis, the US banking system was [equivalent to] 100% of GDP, with $16 trillion of assets on the balance sheet. We had $1 trillion of equity, meaning we were, in essence, levered 16 times. Loan losses then were about 7.6%. China has three times its GDP in bank assets.
Their reserves imply they could cover about 10% in loan losses, right? They have a $3.5 trillion fund and about $31 trillion of assets. Isn’t that reasonable?
It’s hard to make a blanket statement like that. When you look at other non-performing loan cycles, it varies. When you get to emerging markets like Malaysia in 1999, losses got to 11%. The Philippines in 2002 lost 18%. Indonesia and Thailand, hit in 1999 and 1998 [respectively], hit 47% and 58%.
Loan losses in developed markets end up from 5% to 10% and emerging markets go anywhere from 10% to 40%. But emerging markets should never have 300% of GDP on their books.
My view is that China is an emerging market. Last time it had a non-performing loan crisis in 2001 to 2002, their losses got to over 30% of assets across entire banking system. My view this time, since they have grown 400% in eight years, is that they are going to have some loan losses. And emerging markets should never be higher than developed markets in [ratio of] bank assets to GDP. That is my conservative assumption.
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