China’s Biggest Credit Bubble in the World

  • History has proven that credit bubbles always burst
  • China by far is the biggest credit bubble in the world today
  • BIS has identified an important warning signal to identify credit bubbles that are poised to trigger a banking crisis across different countries: unsustainable credit growth relative to GDP in the household and corporate sector
  • Post 2008 GFC, world’s central bankers have kept interest rates low and delivered just the right amount of quantitative easing in aggregate to levitate global debt, equity, and real estate valuations to the highest they have ever been relative to income
  • Central banks have pumped up the valuation of equities – S&P 500 has a cyclically adjusted P/E of almost 30x vs. a median of 16x, exceeded only in 1929 and 2000 tech bubble
  • China’s capital outflow spillover from its credit bubble has driven up real estate valuations around the world
  • Unique aspect of the global credit bubble is that China has emerged at its epicenter – since 2008, China has created the world’s largest M2 money supply, the world’s largest and most grossly mismarked banking assets, largest global trade with rest of world, second-largest GDP, and largest credit-to-GDP imbalances
  • Not only is China in a credit bubble that is poised to burst but it is linked to many other countries through trade and capital flows that also have large credit imbalances making the China bubble even more significant
  • Long stretches of prosperity tend to be delivered with increasingly speculative leverage and unproductive investment activity – China’s impressive growth has come overwhelmingly and almost exclusively from unsustainable credit expansion combined with extensive, largely unprofitable domestic infrastructure expansion
  • Has been a centrally planned misallocation to capital into white elephant, unproductive fixed-asset infrastructure projects that on balance will likely not ever generate sufficient ROI to justify their cost
  • Strong probability that China is headed for an infrastructure-led national financial and economic crisis that will likely also be a crisis for the international economy
  • In a Ponzi-financed economy, lenders lend more and borrowers borrow more based on the greater fool theory, the idea that asset prices will keep rising. It all works in upward spiraling, self-reinforcing fashion until it simply cannot go on any longer and then asset prices suddenly drop, to the surprise of the vast majority, and then there is self-reinforcing unwinding of the bubble, a financial crisis
  • PBOC report allegedly showed that off-balance sheet banking assets in China have risen to somewhere between USD 30 and 40 trillion recently – including both on-balance sheet and shadow bank assets, “Chinese banks have built up exposure to assets equal to 650% of GDP”
  • Reason that shadow bank asset growth is a concern is that these assets have long been regarded by credible analysts, bankers, and regulators as China’s least liquid and poorest quality loans
    • In many cases, these are non-performing loans once held on bank balance sheets that have been rolled over, taken off balance sheet, and newly funded through wealth management products and other shadow banking vehicles for the banks’ off-balance-sheet activities
  • Problem is that the idea of funding China’s rapidly growing long-term, illiquid, and heavily non-performing assets with rapidly growing short-term, liquid liabilities, all facilitated by the banks and tech companies, and all kept off balance sheet, is a formula for a systemic banking crisis
  • Chinese leaders have likely been implicitly sanctioning the acceleration of credit growth this year in their shadow banking markets to keep growth going at all costs even while publicly admonishing it ahead of the 19th NPC in November
  • Believe it is prudent to be positioned ahead of the NPC and ahead of everyone else who tries to scramble for the exits after it is too late
    • There can be some short-term pain in being early, but it was the early players who stuck it out and had the foresight and strength of their conviction who reaped the big rewards for their investors
  • Chinese equities have much further down to go down based on excessive valuations – banking crisis has not even happened yet in terms of losses being recognized through earnings charges and book value write-downs
    • Bad debt has been building up behind the scenes for two decades since the last banking recapitalization
  • Financial sector weight in the major Chinese and Hong Kong indices: 36% of Shanghai Composite; 43% of CSI 300; 44% of Hang Seng Index
    • Financials makes up 25% of China MSCI Index because 28% of that one is crowded out by 2 tech stocks, Tencent and Alibaba, each priced at a frothy 11x EV/Sales
  • By shorting overvalued Chinese equities through US ETFs and ADRs, one also gets the bonus of the yuan currency short imbedded in the trade; one also gets exposure to China’s coming shadow banking meltdown
  • When outflow pressure shifts from the elites to the masses of domestic bank and shadow-bank depositors, there is a high risk of bank runs and social unrest
  • When this threat becomes all too real and begins to transpire, that is when Chinese authorities will be left with no other viable option than to resort to massive quantitative easing to bail-out and recapitalize their banks and re-stimulate their economy
    • That is when the insolvency program in the Chinese banking system will have to be addressed and if China has true ambitions to transition from an emerging market to a developed economy, it will have to come clean on its NPLs
    • QE is therefore the only implicit guarantee that Chinese depositors should be relying on, but QE does not prevent a crisis – it will likely only coincide with the crisis
  • Say China’s non-performing loans are only half as bad as they were when it recapitalized its banks in the early 2000s – China ultimately confessed that 40% of its banking assets were non-performing loans that had built up in the wake of the 1997 Asian Financial Crisis
    • Let’s say it’s only 20% today; let’s assume the most conservative estimates for shadow bank assets of USD 9 trillion; along with USD 35 trillion of on-balance sheet assets, conservative estimate equates to USD 8.8 trillion of loans in the Chinese banking system today that will effectively never be repaid and will need to be written off
    • Such an amount is equal to 84% of China’s GDP, more than enough to wipe out all the equity in its Chinese banking system twice over
    • If the banks were to write that debt down and recapitalize the banks with money printing, it would equate to 37% of its M2 money supply, all else equal a 37% currency devaluation
    • This is our BEST case scenario – it will likely be worse
  • 1997 Asian Currency Crisis provides several mild-case scenarios for what we should expect from the coming Chinese yuan devaluation – in the second half of 1997, four Asian Tigers came off extensive credit bubbles that had been building over a prolonged period including Thailand, South Korea, Malaysia, and Indonesia
    • Their currencies all declined between 47% and 85% within six months
  • Another mid-case comparable would be post-Soviet Russia where in Russian financial crisis of August of 1998, ruble crashed 70% in one month
  • For the worst case scenario, comparable is China’s former communist neighbor, the Soviet Union
    • Soviet ruble was essentially a 100% wipeout, a zero though hyperinflation after the Soviet Union breakup the early 1990s
  • One key signal that the China’s credit bubble is about to burst is housing prices in China’s Tier 1 and Tier 2 cities. Home prices in Tier 1 and Tier 2 cities reflect one of the biggest asset bubbles in China to go along with its massive credit expansion
    • Real estate prices have been soaring for many years led by Tier 1 cities such as Beijing and Shanghai
    • Rent yields in Beijing recently hit a new low of about 1.25% an insanely high price-to-rent multiple of 80x
    • As part of China’s massive infrastructure buildout, there is an oversupply in housing
  • Another new catalyst that is heating up right now is the possibility of President Trump imposing trade sanctions on China for “unfair trade practices” to punish them for not taking a tougher stance on North Korea also perhaps to fulfill a campaign promise
  • We enumerate the catalysts for the imminent bursting of the Chinese currency and credit bubble discussed herein and in our other work:
    • Fed credit tightening puts pressure on Chinese currency
    • China and HK is now flashing a banking crisis warning signal in BIS “credit-to-GDP gap” model
    • China’s connections to other countries also flashing warning signals of credit bubbles about to burst
    • Pressure from Chinese capital outflows
    • Threat of bank runs from Chinese masses
    • Housing prices on precipice of drop in China Tier 1 and Tier 2 cities from record price-to-rent levels and supply/demand imbalance
    • Ongoing poor and deteriorating fundamentals of China’s non-financial listed companies linked to unsustainable infrastructure investment binge
    • Dwindling, encumbered, and likely overstated foreign reserves
    • Imminent threat of US trade sanctions on China
    • Looming cresting of China’s workforce population
    • China credit bust already started to unfold in 2015, an early warning signal, but just a taste of what is to come, because the credit imbalances have only become more extreme
    • Widespread Wall Street complacency ahead of China NPC political elections in November
  • As China bust and other banking crises play out in the next global economic downturn, precious metals will likely to be a key beneficiary
  • Considering gold specifically, we know that its supply is strictly limited and supply growth is substantially lower than the recent rapid growth in world monetary base
  • As fiat currencies around the world are debased, gold stands as an excellent store of value and a hedge against inevitable inflation
  • Gold has been recognized as money that is a store of value in all countries around the world for thousands of years
  • Cyclical correction in gold prices which began in 2011 has resulted in gold becoming historically cheap relative to the fiat monetary base of the world’s major economies
  • Central banks have already shifted from being net sellers to net buyers of gold since the GFC, yet gold remains undervalued relative to fiat money

gold target

Crescat Capital 2Q17 Letter, August 5, 2017

Image Source: Crescat Capital LLC

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