It wasn't me... it was CHINA!
China is an interesting topic. We spent hundreds of hours to understand what China really is and we still do not understand. We think nobody, including the Chinese leaders, has a full grasp of its economy because it's big, growing and changing fast and not transparent. The availability of economic data is limited and not reliable.
Anyway, Shinya was traveling in New York and Boston last two weeks and he was asked about his opinion on China, particularly Chinese yuan, by almost everyone he met during the topic. His favorite answer was "I will disappoint you because I'm not as bearish as you are. I do not expect a hard landing in China. I do not expect a massive devaluation of Chinese yuan. But, the Chinese economy is slowing down and it will be painful for everyone." However, he was always confused because most people do not understand the question he was asking. What is the definition of an economic hard landing? What is the degree of a "massive" currency devaluation? What are they really worried about?
Hayman's Kyle Bass published his letter and it caught media's immediate attention. His argument is straight forward and convincing, but we thought it was misleading as well. Kyle understands China's problem very well and his analysis is interesting to understand what people are worried about (although most people have much less knowledge of China than Kyle has).
What We Agree:
China experienced massive growth of credit over the last decade and the credit standard was extremely poor. We discussed this issue in Crouching Bankers, Hidden Opportunities in 2013. Our views on China's credit condition hasn't changed much since then. The government, especially PBOC, tried hard to reform the banking system, but it was not enough as China's banking industry is very powerful.
We are worried about quickly diminishing foreign reserves. We know that not all foreign reserves can be used to support China's banking system. It is really the tool to manage a country's currency exchange policy, not to save the domestic system. And, we recently learned from Dimensions Capital's Bei Le-Si about the risk of the unwinding of the RMB carry trades (read). Yuan carry trades through LOC (letter of credit) was a common financial gimmick used by Chinese corporations to generate returns on the interest rate gap between China and the United States. Based on BIS data, the total amount of the carry trade could be as large as $1 trillion, or almost 1/3 of the foreign reserve. Of course, not all USD-denominated loans were used to buy the wealth management products in China as described in Dimensions' article, the potential size of this carry trade could be substantial enough to shake the current RMB exchange mechanism.
What We Disagree:
However, we disagree with Kyle on several important issues. The loss estimates for Chinese banks of $3.5 billion, or roughly 10% of assets or 30% of GDP, seem very high. We think that the non-performing loan ratio could reach as high as 20% of GDP (almost 2.5 years old, but Goldman Sachs'China credit conundrum: Risks, paths, and implications, is still a good piece to read).
Kyle also forgot that the epicenter of the US financial crisis was not the banking system itself, but so-called "shadow banking system', which was almost the same size as the traditional banking system, although the subprime short is still one of his best investments. The losses in the traditional banking system were shared by the government and the investors. Yes, China's shadow banking system is growing and quite toxic (e.g. recent implosion of one of the largest P2P lending platform called Ezubao, which cost investors $7.6 billion).
In contrast to the US in 2007, China's household balance sheet is still very healthy. The national saving rate is still close to 50% and Chinese people love saving as much as they love shopping. The reason we are seeing the reverse of migration is not only because of the economic slowdown but the changing landscape of the Chinese economy. Many factors are moving from the east to the west and the wage of inland China is rising.
Kyle also argues that China does not have enough foreign reserves because the current amount is almost the same as the required minimum foreign reserve. However, a country holds foreign currency as a reserve to protect her own currency if it is under severe devaluation pressure and IMF thinks that a country should have an adequate amount of reserve for this purpose, not a country should keep the amount all the time. We think China has enough foreign reserves and, potentially, more than enough, as we do not believe all Chinese people want to move all the cash away from the country. Given the current economic conditions, it is impossible. Kyle also forgot that the United States has the least amount of foreign reserve for the size. The total foreign reserve for the United States is $117 billion as of 2016, which is less than Turkey's $118 billion. IMF will be happy to give "F" to the United States for the foreign currency adequacy test.
We still believe that the Chinese government is fully aware of the problems despite the mistakes they have made so far and the banking reform is progressing as they planned. The fundamental economy is still doing ok as the household is healthy. The shift of resource allocation from the public sector to the private sector is painful, but this process is important for the longevity of the Chinese economy. As Kyle suggested, we passengers still need to fasten our seatbelts, but stay relaxed - our drivers know how to drive in the notorious heavy traffic of Beijing highways.
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