Market dislocations occur when financial markets, operating under stressful conditions, experience large widespread asset mispricing.
Welcome to this week’s edition of “World Out Of Whack” where every Wednesday we take time out of our day to laugh, poke fun at and present to you absurdity in global financial markets in all it’s glorious insanity.
While we enjoy a good laugh, the truth is that the first step to protecting ourselves from losses is to protect ourselves from ignorance. Think of the “World Out Of Whack” as your double thick armour plated side impact protection system in a financial world littered with drunk drivers.
Selfishly we also know that the biggest (and often the fastest) returns come from asymmetric market moves. But, in order to identify these moves we must first identify where they live.
Occasionally we find opportunities where we can buy (or sell) assets for mere cents on the dollar – because, after all, I’m a capitalist.
In this week’s edition of the WOW we’re covering that Black box that is China
Back in December of 2014 we pointed out obvious problems surfacing in the interbank lending market in China.
It was important for us since, as we mentioned:
“A rapid rise in a country’s interbank lending market is also a good predictor of the direction of a country’s currency, or at worst a confirming indicator.”
Gratefully at the time very few market participants were anything but massively bullish China and bullish the remnimbi. The renminbi was, after all, if one was to read the popular headlines, going to replace the USD as the world’s reserve currency.
To the real money managers and traders this concept was largely laughed at for obvious reasons. But it did make for sensationalistic news articles in a world driven by short-term soundbites where such titbits of trash are attention currency.
In any event, this meant that volatility in the renminbi was extremely low and options pricing as a consequence extremely cheap.
Never one to shy away from putting our money where our mouth was (because really, what’s the point?) I told readers exactly what we were doing:
“Over the last 6 months, we have been quietly gearing ourselves up for a dramatic move to the upside in the USD/renminbi. As interbank lending rates in emerging markets started to explode higher over the last 6 weeks we have picked up our pace of buying long term FX call options on the USD/renminbi. 12 months from now I suspect our only regret will be not being aggressive enough.”
Turns out we weren’t aggressive enough.
Bugger. That hurts.
Even more so when we mentioned we didn’t think that we would be aggressive enough which in itself really meant that we were being pretty aggressive. Hindsight, as they say, is 20/20.
It’s like going on a date with a gorgeous sexy girl, playing it cool all night, and being an absolute gentleman when you’re really just dying to get into her pants, and then getting a kiss at the end of the night – something you’re really not OK with. You leave disheartened, only to find out later from her best friend that she was dying to sleep with you. Bugger, bugger, bugger!
Such is life.
The question I’ve had since then from clients has been, “Is it still a good short?”
The cause of the problems which initially surfaced in the Chinese interbank lending market are to be found in the enormous credit-infused infrastructure boom which was needed in order for party officials in China to say, “Why, of course we’re meeting our self imposed GDP growth targets. Who says the market should determine such things?”
This gig worked for as long as real GDP growth was close enough to politically mandated targets. But when the growth began faltering, the government simply supplemented this “real” growth with artificial policy driven growth in the way of domestic infrastructure projects. Projects, I might add, which defy belief.
In order to finance these enormous projects the banks, flush with capital, lent and lent aggressively.
Hayman Capital’s Kyle Bass has, as far as I can tell, done more research on this topic than anyone else I know and so I’m going to reference him liberally. Kyle has called it, “The largest banking system experiment in world history,” and he explains it further.
“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.”
This is the largest credit expansion in history. It is (as are so many things in our financial system today are), in a word, unprecedented. I feel a little ridiculous using that word as it sounds sensationalistic but the facts are there for us to see and cannot be argued with.
“We must recognize that China is an emerging market. Emerging market banking systems should never be levered more or be larger than developed market banking systems for a variety of obvious reasons.
China’s system is even more precarious when we realize that, even at the biggest banks, loans are not made to borrowers based upon their ability to repay. Instead, loan decisions are political decisions made by the state.
Historically, booms and busts are typically driven by rapid credit expansion and then contraction. Credit has never grown faster or larger than it has in China over the past decade.
China’s banking system has grown from under $3 trillion to over $34.5 trillion in assets over the last 10 years alone. No credit system in history has ever attempted this rate of growth. There is no precedent.”
Thus far the PBOC has been defending the yuan, spending over $1 trillion doing so. If the intention was to hold the value of the currency then it surely isn’t working. They may as well burn the money because even though they have large dollar reserves they in no way will be sufficient to stem the outgoing tide.
Bass deals a death blow to the idea that China has sufficient reserves to deal with the impending losses in a banking system, undergoing the world’s largest ever non-performing loan cycle which is gathering momentum right now.
Yes, China has $3.2 trillion in reserves, or so they report, but within the context of the size of China, its existing money supply (and the fact that it is a massive import/export driven economy) of $3.2 trillion is not actually adequate to run their country given the liquidity requirements of running day to day operations for an economy of its size.
Bass goes on to say:
“China’s liquid reserve position is already below a critical level of minimum reserve adequacy. In other words, China is CURRENTLY out of the required level of reserves needed to safely operate its financial system.”
The PBOC have been spending roughly $100 billion a month in an attempt to contain the blaze and the blaze has only just really begun. In a short period of time it will be raging and the Chinese leadership will be forced to choose whether to save an imploding banking system or hold their currency. They cannot do both.
When you think about the fact that China has experienced a strengthening currency versus the euro, the dollar, and the yen for the last decade and then further consider that China as a country has grown wealthy from export. It’s relatively easy to understand that the politically appealing thing to do is to let the yuan fall.
It’s economically the thing to do, it’s politically the thing to do and it’s what’s going to happen.
A significant devaluation of the yuan will have reverberations globally. Markets are struggling to come to terms with Brexit and the repercussions of that, which I discussed in this week’s podcast. They are most certainly not ready for the kind of bonfire that lurks eerily on the horizon of the world’s second largest economy:
“The problems China faces have no precedent. They are so large that it will take every ounce of commitment by the Chinese government to rectify the imbalances. Risk assets will not be the place to be while all of this is happening.”
The question that I pose to you today is one of timing. In a recent interview on Real Vision TV where Grant Williams sat down with Kyle Bass, Kyle suggested that the crash will take place within the next 2 years.
I’m in full agreement with Mr. Bass. China, together with many of the other issues taking place globally which I’ll be discussing with you on this blog, has me and some of the smartest colleagues I know taking cover. I’d urge you to consider the implications and act accordingly.
“There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.” – Ludwig von Mises