Legendary short seller Jim Chanos guests on Wall Street Week to discuss the art market, China and energy stocks, while guest S&P futures traders Larry Altman discusses the Flash Crash.
Jim Chanos on Wall Street Week – Text (via newsletter) and video below.
Economies and stock markets are not synonymous. However, with the Chinese economy grinding to a halt and Shanghai Stock Exchange Composite Index ripping higher, few times in history have we seen such stark contrast. So, what is the “reality” in China? The answer is complex and obscured by opaque reporting, but the trillion dollar question for investors is how a Chinese “hard landing” will impact fragile world economic recoveries and financial markets.
Starting in the 1980s, China recognized the need to put hundreds of millions of people to work and transition into a less agrarian, more manufacturing-based export economy. Free trade theory says that from 1990 from 2013, the value of the Yuan should have tripled, but instead, due to active suppression, the currency lost half of its value during that time. For the last decade, Chinese officials have allowed the Yuan to appreciate slightly to further transition to a more balanced and consumer-driven economy, but the credit-fueled experiment has largely failed.
To give some perspective, Jim Chanos stated on Wall Street Week that when his firm, Kynikos Associates, began digging deeper into China’s fundamentals in late 2009, it had 15% nominal GDP growth – 10% real, 5% inflation, while today it has 5% GDP growth – 7% real, 2% deflation. During those years of torrid economic growth, China’s stock market stagnated as little of the wealth accreted to equity investors. Now, the opposite is happening: China’s economy is the boulder that can’t be pushed up the hill, but more money is finding its way into shareholders’ pockets. Why?
First, you have to understand the problems in China are a credit story, not an equities story. Jim Chanos has been outspoken about shorting China over the last several years, but says his firm has never had an interest in betting against the Shanghai Index.
The country is suffering from a massive debt overhang that is a result of the “grow at all costs” mentality. Local debt, not federal debt, is the issue. Municipalities overdosed on debt to finance projects, like ghost cities, that have seen little return. Underperforming loans, especially in the housing sector, now weigh heavily on bank balance sheets. Chinese government debt is only around 65% of GDP, but when you factor in local, corporate, and household debt, the number looks at lot scarier at around 290%. Jim Chanos believes that in a few years, China’s debt-to-GDP could resemble the 400% levels seen in troubled Eurozone pariah Greece.
However, reasonable federal debt levels also mean Chinese policy makers have leeway for further stimulus measures. As we have seen over the past six years in the US, you don’t fight the Fed (or four Feds). Only a few years ago Chinese central bankers were using monetary policy tools to cool off growth and inflation, but now they are joining the low interest rate and QE party. The People’s Bank of China has slashed interest rates in three out of the last six months, and is now taking a page out of Europe’s book by swapping local-government bailout bonds for cash as a way to bolster liquidity and boost lending.
The second factor in China’s widening economy-vs.-markets imbalance has been the crackdown on corruption. The Chinese government moved to quell growing social unrest regarding income inequality (in a supposedly socialist society), but the crackdown has had adverse effects on China’s already-weakening economy. It has crimped spending on things like luxury goods and real estate and triggered a sharp downturn in gambling revenues in Macau. Financial risk-taking, which has deep roots in Chinese culture, has shifted from casinos to Asian capital markets. While decreased corruption has weighed on the economy, it has driven the growth of corporate earnings and share prices.
So, what are the global implications of China’s credit meltdown?
The commodities super-cycle has ended thanks to lower demand, and thus inflation has been subdued. Low inflation has led to the extension of American zero-interest rate policy (ZIRP) and new rounds of Europe/Japan/China QE. The can has been repeatedly kicked down the road since the financial crisis, and with China becoming an increasing headwind there is little to suggest central banks will be in a hurry to deviate from accommodative monetary policy. A Fed Funds rate hike in 2015 already seems like a coin flip at this point, and if the Chinese credit crunch intensifies it could further put the FOMC on hold. Interest rates could stay lower for longer.
And we haven’t even gotten to geo-political factors. Deep-seated cultural tensions between the Chinese and Japanese have bubbled up to surface over a dispute regarding a string of uninhabited islands. China is taking aim at the US dollar’s dominant reserve currency status with the Asian Infrastructure Investment Bank. George Soros takes it a step further, recently saying he believes the US and China are on the threshold of World War III.
Chinese policy makers have tools at their disposal to battle credit market woes, but it remains to be seen how deep the debt rabbit hole goes. While Europe has at times been a headwind and US data remains inconsistent, China has been, and will continue to be, by far the greatest macro risk, both because of its scale and uncertainty over the transparency of its data. If another financial crisis were to unfold, China would almost certainly be at its epicenter. However, in this new era of aggressive monetary policy activism, we could simply be entering a prolonged era of low interest rates and QE that would allow risk assets to remain richly-valued.