Crescat Capital letter to investors for the first quarter of 2016.
We are pleased to announce that Crescat Global Macro Fund was recently named 2015 Global Macro Fund of the Year in the HedgeFund Intelligence Absolute Return Awards for its absolute and risk-adjusted performance among hedge funds less than $500 million.
All three Crescat Capital strategies posted gains through the first two months of 2016 while the S&P 500 index declined 5.1%. Crescat Global Macro Fund returned 7.2% net through February and Crescat Long/Short Fund was up 6.3% net. Crescat Large Cap Composite gained 1.7% net, significant for a long-only strategy in a down market. Performance across all three strategies was driven by a range of our global macroeconomic themes. Crescat’s best performing theme year to date has been Global Fiat Currency Debasement, as our long precious metals positions have been bid up amidst rising global credit risks and ongoing expansionary monetary policies. Our Biotech Bubble theme was a strong performer in both hedge funds as overvalued biotech companies continued to sell off benefitting our short positions as the SPDR S&P Biotech ETF (XBI) had its worst month ever in January. Another big gainer in both hedge funds was our China Currency & Credit Bubble theme, which is the focus of the majority of our outlook in this letter.
Crescat Capital – A Twin Crisis Brewing in China
Many believe that if China were to devalue its currency, it would be in an effort to wage a currency war, or a competitive devaluation to boost exports. The idea of a mere currency war represents a misunderstanding of China’s economic imbalances. In our opinion, China is not on the verge of a currency war; it’s on the verge of a currency crisis. And it is not just facing a currency crisis, but rather a twin crisis: a combined currency and credit crisis.
For the past two years, we have been writing about the growing credit problems in China, its illicit capital outflows, and the extreme overvaluation of the yuan. Through a combination of money printing and new debt, the People’s Bank of China (PBOC) has created the largest money supply and total banking system assets of any country in the world. Over the last fifteen years, China’s M2 money supply has grown at a 17% compounded annual rate to $21.7 trillion. To put the absurdity of the yuan overvaluation into perspective, China’s M2 is now valued 75% greater than the entire US M2 at the current USDCNY exchange rate. But China’s GDP is 57% smaller than the US.
According to prominent banking analyst Charlene Chu of Autonomous Research, China’s total banking system assets have grown by $21 trillion over the last seven years and now stand at $31 trillion. The rampant money and credit creation have been responsible for excessive domestic capital investment with diminishing returns. As a result, China’s GDP growth has been lagging its debt growth, and in fact has been decelerating rapidly. Moreover, China has a non-performing loan problem that threatens the largest banking system collapse in history. Chu estimates that based on return on assets, China’s non-performing loan ratio stands at 22%, while Chinese official estimates report that ratio to be just 1.6%!
China’s current monetary policy has inherent conflicts in its attempts to fend off the twin crisis. In order to defend its currency peg while preventing a banking system collapse, China’s tightening decisions have been simultaneously turning into more quantitative easing. As the PBOC has been supporting the yuan by selling foreign reserves, it has also been sterilizing this deflationary force by injecting even more stimulus into its domestic banking system. For instance, since June of 2014, the Chinese central bank sold over $791 billion of foreign reserves. Defending the currency in this way is a monetary tightening policy, but it would have triggered debt defaults given China’s non-performing loan problem. So, to prevent such defaults, the PBOC injected $1.1 trillion into the banks through the repo market over the same time, more than reversing the tightening effect.
This new liquidity, accompanied by several required reserve ratio reductions, continued to promote unhealthy credit expansion. For example, in 2015, China’s M2 money supply grew by $1.7 trillion. Over the same time, Total Social Finance (the Chinese version of M3 money supply) also known as TSF increased by $2.9 trillion. TSF increased by another half-trillion dollars in January of this year alone, revealing recent accelerating debt growth through China’s shadow banking channels. Consequently, rather than fixing China’s bad debt problem to support the yuan, the current policy of printing money and extending more credit will ultimately exert even more downward pressure on the currency by creating the incentive for greater net capital outflows. China is in the midst of a self-defeating policy spiral that only makes a twin currency and credit crisis more inevitable.
The PBOC has pegged the yuan exchange rate to the dollar rather than allowing it to depreciate meaningfully in the face of China’s economic imbalances, and has been drawing down foreign reserves at a rapid pace. China’s currency bulls remain focused on the still significant size of foreign reserves, $3.2 trillion. But one must also consider that China has a significant amount of foreign debt. Therefore, we believe that Net International Investment Position (NIIP) is a better measure of the true level of reserves available to defend a currency from the pressure of capital outflows. This figure, last reported in September of 2015, is close to $1.5 trillion. If you adjust for the amount of foreign reserves sold from September of 2015 to January of 2016, the number is now close to $1.2 trillion.
In 2011, Glick and Hutchison1 studied the macro-empirical regularities that precede currency crises. They featured a number of important crisis precursors that include increasing M2 to foreign reserve levels, drawdowns in foreign reserve levels, increasing real exchange rates, high and increasing levels of domestic credit to GDP, and a slowdown in output growth. We highlight every one of these factors in this paper with respect to China today.
NIIP, which we believe to be a more precise measure of foreign reserves, relative to M2 has fallen from over 15% to just 6% of China’s M2 over the last five years. China policy makers are reaching the end of their runway. As the PBOC strives to maintain the currency peg by depleting foreign reserves, while earning negligible GDP growth from its ongoing credit expansion, the country has little ammunition left to keep its twin currency and credit bubbles aloft.
A yuan crisis could certainly act as a contagion and trigger a domino effect with other Asian-Pacific currencies. In our opinion, New Zealand and Australian currencies are the most exposed candidates to a Chinese contagion. The circumstances in Australia and New Zealand are eerily similar to the 1997 Asian Financial Crisis