Impending Credit Bust and Currency Crisis in China

Crescat Capital 3Q17 Quarterly Letter, November 18, 2017

  • Given that China has been about 50% of global GDP growth since 2008, we strongly believe that its credit bubble bursting will lead to global financial market contagion
  • Saw this start to develop in 2015 but China mounted yet another enormous but unsustainable credit surge ahead of the National Party Congress. The China credit bubble has only gotten bigger
  • Now that the NPC is behind us, China must attempt to rein in credit growth while still growing its economy. It is almost an impossible task. Stresses are already appearing in Chinese credit markets
    • Sovereign yield curve in China has inverted twice already year, a warning sign of an impending recession
  • While Fed officials remain confident in their ability to engineer their first-ever soft landing for the economy late in a business cycle, China’s soon-to-be-retiring central bank governor, Zhou Xiaochaun, appears in stark contrast
    • He is not celebrating victory over the economic cycle at all. Last month at the NPC, he warned of the possibility of a “Minsky moment” just as we did in our last quarterly letter
  • A Minsky moment is a severe “debt deflation,” a stage of the long-term business/economic cycle that Irving Fisher would later define based on the 1930s Great Depression
  • Conventional wisdom on Wall Street is that China has absolute control over its economy and multiple levers that it can pull to prevent crisis and continue to grow it
  • China has had essentially only one lever and that has been more credit growth. The problem is that its central planners do not even have control over this lever as the PBOC made clear its recently released English version of the China 2017 Financial Stability Report
  • China now admits that the combination of on- and off-balance sheet assets among its banking institutions has exploded to 70 trillion USD equivalent as of the end of 2016
  • PBOC also revised its assessment of 2015 off-balance sheet bank debt upward by about 100%
  • Problem in China is that shadow lending has been growing literally out of control and outside the direction of central planners. We believe this is the largest credit explosion in any major country ever relative to GDP, indicating that China’s banking assets are vastly mismarked and overstated
  • China has an enormous hidden non-performing loan problem that essentially renders the entire Chinese banking system insolvent, more than wiping out all its equity capital and potentially leaving more than one billion Chinese depositors to bear substantial losses
  • China certainly was the growth engine of the world for the last few decades but that growth is about to come to an abrupt halt. At this stage, in our view the China credit bubble is as ripe as it gets to burst
  • China is simply in the biggest credit bubble ever and it translates to the biggest currency bubble ever given the sheer magnitude of yuan denominated credit when converted to dollars at the current exchange rate
  • Regarding China’s foreign reserves, in our analysis, we believe China’s reserves are fully encumbered given the many years of running a pegged currency against constant capital outflow pressure
  • We believe pressure from capital outflows has only increased recently as evidenced by China’s resorting to increased capital controls, but the latter has also been discouraging foreign capital inflows
  • China is trying to attract foreign capital into its credit markets but supply is much greater than demand. Years of Minsky-style Ponzi finance have finally caught up with them
  • Non-performing loans cannot be refinanced with ever more massive amounts of new credit every year. Marginal contribution to real GDP growth from new credit growth has diminished to the breaking point
  • These are all signs of an impending credit bust and debt deflationary pressures that can only inevitably be met with a massive QE and currency crisis

Image Source: PBOC, China 2017 Financial Stability Report, Crescat Capital