Hyaman Capital’s Kyle Bass on the $34 trillion experiment: China’s banking system & the world’s largest macro imbalance. ValueWalk has obtained the full letter of Kyle Bass’ latest big (gigantic) macro bet against China. This is a hot trade as we have noted before, but no one has spelled it out in as much depth as Kyle Bass. The content of the letter was first reported by Julia La Roche of Business Insider earlier this morning.

See the full letter below (please credit if you found it here).

All,

Over the past decade, we have worked diligently to identify anomalies in financial systems, governments, and companies around the world. We have been vigorously studying China over the last year, with the view that the rapid credit expansion in the Chinese banking system will result in significant credit losses that will require the recapitalization of Chinese banks and materially pressure the Chinese currency. This outcome will have many near-term and long-term effects on countries and markets around the world. In other words, what happens in China will not stay in China.

The unwavering faith that the Chinese will somehow be able to successfully avoid anything more severe than a moderate economic slowdown by continuing to rely on the perpetual expansion of credit reminds us of the belief in 2006 that US home prices would never decline. Similar to the US banking system in its approach to the Global Financial Crisis (“GFC”), China’s banking system has increasingly pursued excessive leverage, regulatory arbitrage, and irresponsible risk taking. Recently, we have had numerous discussions with various Wall Street firms, consultants, and other respected China experts, and they almost all share the view that China will pull through without a reset of its economic conditions. What we have come to realize through these discussions is that many have come to their conclusion without fully appreciating the size of the Chinese banking system and the composition of assets at individual banks. More importantly, banking system losses – which could exceed 400% of the US banking losses incurred during the subprime crisis – are starting to accelerate.

Our research suggests that China does not have the financial arsenal to continue on without restructuring many of its banks and undergoing a large devaluation of its currency. It is normal for economies and markets to experience cycles, and a near-term downturn that works to correct the current economic imbalance does not qualitatively change China’s longer-term growth outlook and transition to a service economy. However, credit in China has reached its near-term limit, and the Chinese banking system will experience a loss cycle that will have profound implications for the rest of the world. What we are witnessing is the resetting of the largest macro imbalance the world has ever seen.

So how did we get here? Since 2004, China’s real effective exchange rate has appreciated 60%. The majority of this appreciation occurred in the last few years as the ECB and BOJ both actively targeted weaker exchange rates to stimulate Europe’s and Japan’s large export sectors, respectively. While the markets seem solely focused on China’s exchange rate versus the US dollar, this fixation misses the point that many other manufacturing economies and currencies, including those belonging to Japan, Europe, Russia, and several Southeast Asian countries, have gained significant price advantages at China’s expense. If China is to achieve the required clawback of its real effective exchange rate, the renminbi will need to devalue against a trade-weighted basket of currencies and not just the dollar. In effect, the required devaluation against the dollar will need to be multiplied to achieve the necessary result.

As the renminbi appreciated over the last decade, China undertook a massive infrastructure spending program in order to maintain politically-determined GDP growth targets in the face of these headwinds. This policy action created a system of distorted incentives (not to mention a dramatic misallocation of capital) whereby local officials were promoted to higher office by exceeding those targets without regard to the return on investment of the projects they supported. 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.

Today China is at a point where its banking system can no longer support such massive growth, and the strong renminbi has effectively undermined the competitiveness of China’s export economy. A dramatic devaluation of the renminbi is warranted to regain export competitiveness; however, the Chinese authorities have errantly fought against this so far, spending around $1 trillion to defend their currency. The continued capital outflows and emerging need to deal with losses in the banking sector will eventually force China to change tack and allow (or enable) a devaluation that resets growth as many countries have done over the past eight years.

China: Divergence in Bank Asset Growth and GDP

Kyle Bass - China

China’s current situation reminds us of Ireland and Spain, where construction, real estate, and infrastructure investment activity constituted a disproportionate share of economic activity, government revenue, and bank lending. A cyclical downturn in these sectors will have a profound impact on the Chinese economy just as it did in Spain. In fact, Chinese residential real estate investment as a percentage of GDP, which peaked in 2013, was the second highest in global history, only after Spain in 2006, and 60% higher than the US peak in 2005.

“Consider the past quarter century: a credit boom in Japan that collapsed after 1990; a credit boom in Asian emerging economies that collapsed in 1997; a credit boom in the north Atlantic economies that collapsed after 2007; and finally in China. Each is greeted as a new era of prosperity, to collapse into crisis and post-crisis malaise.” – Martin Wolf, Financial Times

China’s Hard Landing

No matter how one analyzes the available data, China’s economy has already started to experience a hard landing. Consider that China’s National Bureau of Statistics reported that China’s migrant population (defined as Chinese people that have left their hometown to seek employment or education elsewhere in the country) decreased by 5.7 million people in 2015. This was the first reported decrease in 30 years. This abrupt reverse migration is noteworthy because it signals a slowdown in urban labor opportunities for Chinese workers and could undermine the Chinese urbanization process that has been one of the key pillars of China’s economic growth over the past few decades. The following charts illustrate additional evidence of China’s hard landing.

China hasn’t seen it this bad in the last 40 years… Yet Yellen doesn’t see a “significant downturn” in China…

Chinese Nominal GDP Growth – Y-o-Y % Change

Kyle Bass - China

Chinese industrial sales and profits both declined in 2015 with sales falling for the first time in over 30 years…

China: Industrial Enterprise Sales and Profits – Y-o-Y % Change

Kyle Bass - China

Chinese exports are tanking because of China’s high real effective

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