He was right about subprime, right about gold, and early in his call for a Japanese crisis. Is Texan investor Kyle Bass too early in his call for a China banking crisis and currency devaluation within the next two years?
“It’s a foregone conclusion but we don’t know about the timing; it feels like it’s happening as we speak,” he told Grant Williams of RealVisionTV in an interview. Bass had first stated his pessimistic view of China in late 2015 when the currency was under pressure and the country was bleeding capital to the tune of $100 billion per month.
Since February of this year and the so-called Shanghai Accord or the G20 finance ministers, outflows have abated, although the currency has declined to a multiyear low of 6.66 per U.S. dollar.
So why does Bass think the situation in China is intensifying? Everybody knows China has too much debt, especially corporate debt. As a result, the country’s total debt-to-GDP ratio is higher than 250 percent according to a range of different estimates. This is not much higher than Japan’s government debt ratio of 245 percent of GDP, so why focus on China now?
“The Chinese corporate bond market is freezing up. Since April 11th the Chinese corporate bond markets had 150 cancellations out of 210 announced deals,” says Bass. And indeed, the Chinese corporate bond market, which has helped keep unsustainable corporate debt afloat and also backs trillions in repackaged loans called Wealth Management Products (WMP), is in trouble in 2016.
According to Bloomberg, Chinese companies raised 1.85 trillion yuan ($280 billion) of onshore bonds between April and July this year, 30 percent less compared to the three preceding months.
Bankruptcies are also on the rise. Although corporate defaults are still in the low double digits, Chinese courts handled 1,028 bankruptcy cases in the first quarter of 2016, up 52.5 percent compared to a year earlier.
“There are so many perfect parallels to the U.S. mortgage credit system or the European banking system and the Chinese banking system. There are things that go on in those systems that show you there are problems,” says Bass, emphasizing the acuteness of these problems. “We see it starting now.”
While there are clear parallels to what happened in the United States in 2008 and Europe in 2010, Bass says that China’s problems are a magnitude larger. “They have asset liability mismatches in wealth management products that are more than 10 percent of their system. Our mismatches were 2.5 percent of the system and you know what they did,” he says.
According to Bass, the bad loans will first hit the banking system and then lead to a sharp devaluation of the Chinese yuan.
“How they deal with this, it’s not Armageddon. They are going to recap the banks, they are going to expand the People’s Bank of China’s (PBOC) balance sheet, they are going to slash the reserve requirement, they are going to drop their deposit rate to zero, they are going to do everything the United States did in our crisis,” he said.
All of these policy measures would lead to a depreciating currency, all other things being equal. But China’s currency is already under pressure as mostly Chinese citizens are taking their money out of the country because they don’t trust the banking system any longer. Bass estimates that bad loans could lead to losses of up to $3 trillion or 30 percent of GDP. Chinese citizens’ savings are backing these loans, and they don’t want to wait around to find out whether Bass’s number is correct or not. “In China, the credit excesses are already built in,” says Bass.
Goldman Sachs estimated that net capital outflows from China in the first quarter of 2016 were around $123 billion according to a report, 70 percent of which came from Chinese citizens funneling money out of the country. They do this in spite of harsher capital controls in 2016 and use either illicit methods like smuggling or legal ones like buying up Vancouver and New York real estate.
According to Bass, there is no way out for the regime, which is trying to manage the devaluation as much as it can. “The Chinese government wants a devaluation, they just want it on their terms.”
Reuters had previously reported that the Chinese central bank would not mind seeing the currency slip to 6.80 against the dollar, a target it will likely overshoot if things don’t change materially.
Bass also shines light on why the regime would not be opposed to devaluing the currency, albeit measuredly. He says that one of Chairman Xi Jinping’s closest aides, Vice Premier Wang Yang, thinks the Japanese made a mistake by not devaluing in the mid-1980s, right when they were blowing up their own credit bubble.
“Wang has said that he thinks Japan’s critical error was agreeing to the Plaza Accord. Japan decided to be submissive to the United States once again, to sacrifice their economic growth for that of the United States.” As the dollar devalued and the Japanese yen strengthened, the United States finally emerged out of a decade of stagflation. What happened to Japan at the beginning of the 1990s was less flattering. According to Bass, however, this time will be different: “They are going to do what’s best for China. And what’s best for China is to materially devalue their currency.”
After the devaluation and the recapitalization of the banking system, however, it’s time to buy again: “If you have any money left, it will be the best time in the world to invest. It will be the greatest time ever to invest in Asia.”