Earlier this month, Kyle Bass asked a funny question in a discussion with CNBC’s David Faber. To wit: “If some fund manager in Texas is saying that your currency is dramatically overvalued, you shouldn’t care on a $10 trillion economy with $34 trillion in your banks. I have, call it a billion – it’s so small it should be irrelevant and yet somehow it’s really relevant.”
Bass was referring to China’s penchant for firing off hilariously absurd “Op-Eds” in response to anyone who suggests that the country may indeed be experiencing the dreaded “hard landing” or that a much larger yuan devaluation is a virtual certainty. The People’s Daily literally laughed at George Soros when the aging billionaire said he was short Asian currencies in Davos. “Declaring war on China’s currency? Ha ha,” PD wrote. Chinese media also called Soros a “crocodile,” a “predator,” and said his yuan gambit “cannot possibly succeed.”
That’s what Bass means when he says the Chinese seem to be quite ornery for a country that claims to be unabashedly confident about the prospects for their economy. Bass, like Soros, is betting on a steep devaluation of the yuan. In fact, he thinks a one-way bet on RMB weakness is “the greatest investment opportunity right now.” The thesis is simple. Here’s some of our commentary from last week followed by key excerpts from the CNBC interview which should serve as a nice recap of why Bass thinks the yuan is set to fall by 30-40%:China’s banking system, Bass told CNBC, is a $34 trillion ticking time bomb, and when it explodes, Beijing will need to plug the holes. $3.3 trillion in FX reserves will be woefully inadequate, he contends.
“Very few people have looked at what the cause of the problem is,” Bass begins. “They’ve let their banking system grow 1000% in 10 years. It’s now $34.5 trillion.”
Bass then goes on to note that special mention loans (which we’ve discussed on any number of occasions) are around 3% of total assets. “If they lose 3%, that’s a trillion dollars,” Bass exclaims. Ultimately, Bass’s argument is that when China is forced to rescue the banking system by expanding the PBoC’s balance sheet, the yuan will for all intents and purposes collapse. This is of course exacerbated by persistent capital flight.
Below, find some other soundbites from the interview. Notably, towards the end, Bass says that if China is right and speculation around a much larger devaluation is indeed unfounded, then it’s curious why China seems to care so much about what “one fund manager in Texas thinks.”
From Kyle Bass:
“The IMF says they need $2.7 trillion in FX reserves to operate the economy. They’ll hit that number in the next five months. Those who think they can burn it to zero and they have a few years ahead of them, they really only have a few months ahead of them.”
“When they lose money in their banks they’re going to have to recap their banks. They’ll have to expand the PBoC balance sheet by trillions and trillions of dollars.”
“No one’s focused on the banking system. Focus will swing to it this year.”
“A Chinese devaluation of 10% is a pipe dream. It will be 30-40% by the end.”
“If some fund manager in Texas is saying that your currency is dramatically overvalued, you shouldn’t care on a $10 trillion economy with $34 trillion in your banks. I have, call it a billion – it’s so small it should be irrelevant and yet somehow it’s really relevant.”
“If 4% of the population takes out their $50,000 quota, the FX reserves are gone. We lose ourselves in the numbers. $3.3 trillion is a big number, but the reserves to bank assets number is one of the worst in the world.”
Put simply: China has an enormous debt problem and the rapidly decelerating economy means that the country’s banks will only be able to paper over the soaring NPLs for so long. If Beijing wants to eliminate the acute overcapacity problem that’s contributed mightily to the global deflationary supply glut, it will mean allowing the market to purge misallocated capital. And that means bankruptcies and a wave of defaults. “The unwavering faith that the Chinese will somehow be able to successfully avoid anything more severe than a moderate economic slowdown by continuing to rely on the perpetual expansion of credit reminds us of the belief in 2006 that US home prices would never decline,” Bass begins.
“Banking system losses – which could exceed 400% of the US banking losses incurred during the subprime crisis – are starting to accelerate,” Bass adds. “Our research suggests that China does not have the financial arsenal to continue on without restructuring many of its banks and undergoing a large devaluation of its currency.”
What Happens Next? – Fasten Your Seatbelts
The troubles in China are much larger than market participants believe. Everyone (including Chinese citizens) knows something is wrong, but few, if any, can put their finger on exactly what it is. The narrative to date has been focused on the symptoms of the problem (i.e. capital outflows and low commodity prices) as opposed to the problem itself. We believe the epicenter of the problem is the Chinese banking system and its coming losses. Once analysts, politicians, and investors alike realize the sheer size of the impending losses and how they compare to the current levels of reserves, all focus will swing to the banking system.
As it is obvious that China’s economy is slowing and loan losses are mounting, the primary question is what are China’s policy options to fix the current situation? We believe that a spike in unemployment, accelerated banking losses / a credit contraction, an old-fashioned bank run, or more likely the fear of one or all of these events, will force Chinese authorities to act decisively. The policy options that China has then are limited to:
1. Cut interest rates to zero and let the banks “extend and pretend” bad loans – lower interest rates will force more capital abroad putting downward pressure on reserves and the currency.
4. Fiscal stimulus to revive the economy – this will help some chosen sectors of the real economy, but at the expense of higher domestic interest rates (if not done in conjunction with Chinese QE). The 2009 fiscal stimulus was primarily executed through the banking sector so a similar program would require a properly capitalized banking sector. Also, any increase in Chinese investment would reduce China’s trade surplus and ultimately pressure the currency.
Full article: “Fasten Your Seatbelts”: Kyle Bass Previews The Collapse Of China’s $34 Trillion Banking Sector (Zero Hedge)