Kyle Bass is famous for his doomsday predictions regarding the third largest economy in the world, Japan. Now, as reported first by Rob Copeland of Absolute Return (partialview only) yesterday, Kyle Bass is betting against the world’s second largest economy, China. ValueWalk has obtained the full letter, which can be found below.
Kyle Bass Big Trouble in Little China
We have become significantly more cautious regarding global growth and the potential for asset price appreciation in the second half of this year. China’s growth appears to be stumbling dramatically. This has significant ramifications for individual markets and the world economy.
The scale and pace of credit expansion in China over the last 5 years is truly staggering. The compounded annual growth of bank assets as measured by the China Banking Regulatory Commission has been 30.8%. More recently, the Chinese authorities started publishing data that includes non?bank credit growth to capture the way in which the credit creation machine has moved beyond traditional methods. “Total Social Financing” is now growing at 21.7% year over year as of April. The total size of the Chinese credit system is now approximately 256% of total Chinese GDP. To give some perspective, a 30.8% compounded annual growth of credit in the U.S. equivalent over 5 years would be an expansion of $33 trillion. This rate of credit growth is 3 times the total credit system growth experienced in the U.S. at the peak of the bubble in 2006.
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This massive credit growth has been the irresistible force that has driven growth and asset pricing in China throughout the global financial crisis and maintained robust (and by world standards, incredible) GDP growth during a period of global economic crisis and anemic recovery. The Chinese authorities share the faith of Bernanke and the Fed that liquidity and credit expansion are the ultimate cure?alls and that sufficient expansion is the tide that will lift all boats above the threatening rocks of structural inefficiencies and accumulated macroeconomic imbalances. They have relied time and time again on using reserve requirements and their influence over the major banks to encourage lending and then to slow it down as they deem necessary to avoid overheating. The resilience in the Chinese economy for the last 5 years is a testament to this model.
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The story, however, is never that simple and eventually, as we have seen in major economies around the world, the inescapable law of diminishing marginal returns presents itself. As in the U.S. in the lead up to the credit crisis, the marginal utility of an extra unit of credit dropped dramatically. Initially small increases in nominal terms were enough to spur real GDP growth, but then ever increasing amounts were required to generate slowly shrinking amounts of growth. Eventually massive levels of credit expansion were required just to keep the economy on track. We believe an important limit has been reached in the capacity of Chinese credit expansion to deliver real economic activity growth and wealth creation.
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From the beginning of the year to March, it took almost 18 trillion RMB to generate 5 trillion RMB of GDP growth. This ratio is the lowest it has been since the depth of the global crisis. So where has all the new money gone? The data available from the Chinese corporate sector indicates that a huge proportion has been used to fill operational shortfalls and to supply working capital. The debt?to?equity ratios of Chinese companies are exploding as they funnel new capital, not into yield returning investments, but into the black holes on their balance sheets that have been created by a slowing growth environment. In the industrial sector, there is even outright deflation as overcapacity finally takes its toll.
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The speed and depth of the Chinese policy response will help determine the severity and duration of this crisis. If the Chinese address the issue quickly and move decisively to rein in credit expansion and accept a period of much lower growth, they may be able to use the government and People’s Bank of China’s balance sheet to cushion the adjustment in the economy. If, however, they continue on the current path and allow this deterioration to reach its natural and logical limit, we will likely see a full-scale recession as well as a collapse in asset and real estate prices sometime next year.
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China’s direct contribution to global growth is enormous, but perhaps equally as important is its role in generating growth in developed and emerging economies. A slowdown, whether significant or extreme, in the Chinese economy heralds very bad news for asset prices around the world. A growth crisis centered in Asia will further exacerbate the instability and volatility in Japan and have a devastating impact on second derivative marketplaces such as Australia, Brazil and developing markets in South East Asia. The combination of rich valuations and further threats to growth has led us to dramatically reduce risk in the portfolio and actively position ourselves to withstand the uncertainty and instability ahead.
