China, A Dutch Boy and a Dike

We’ve been talking about China for a long time.

Our thinking has been heavily influenced by the excellent work of Michael Pettis, Victor Shih, Charlene Chu and Red Capitalism, which was first published in 2011.

It was around that time, that we spent several weeks on the ground in China, meeting with local government officials, bank executives and real estate developers to better understand the extent of the growing excesses in the system.

Not much has changed since then although a lack of necessary reform, combined with the threat of tighter domestic monetary policy, has put China back on the front page despite ongoing government intervention.

Importantly, increased capital flight has put the economy at increased risk. The naïve China onlooker has always pointed to its “mountain” of FX reserves as “evidence” the government could paper over any problems. But recent events illustrate our long-held contention that paper can burn very quickly. The Asian Tigers burned roughly 20% of their reserves in the late 90’s yet the average Tiger still devalued its currency by over 50% at the time.

China had over $3.5 trillion in reserves at the end of last quarter. Since then, the government has burned over $500 billion propping up the stock market, its currency and its banks. The yuan is effectively 20% higher than its neighboring Tigers whose currencies have steadily devalued relative to the dollar over the past year.

Given the excesses in the system, a bigger fall is not out of the question, although it does remain out of consensus thinking. It’s time to rethink China if you have not already done so. Here’s a collection of excerpts from our work on the subject over the past five years, which should bring you up to speed:

A Cautionary FableApril 2, 2010

It is important for investors (and politicians) to understand that the concerns surrounding the rise of China today are not new. In fact, they are quite similar to past threats faced by our great nation – the Soviet Union in the 60s, Japanese Superiority of the 80s, and the Asian Tigers in the 90s. The lessons learned, from an investment perspective, are no different than the countless experiences of bubbles past – if something can’t go on forever, it won’t. If it seems too good to be true, it probably is.

More often than not, investors are rightly focused on the odds that circumstances turn negative. But every so often, it is much more important to consider the consequences of these low probability events. With so many believers in today’s Chinese growth miracle and China’s path to world dominance so obviously clear, risks to the downside are not immaterial.

Investors Hazard Bold Bet on Yuan: June 22, 2011

While China controls the amount of yuan going in and out of the country, the bears argue those restrictions are being loosened and aren’t as ironclad as some may think. And in a crisis, they said, foreign companies and investors will find a way to pull money out of the country. “With the entire world and their grandmothers looking for a yuan revaluation and continued inflation, I’m willing to a put a few chips on the table to wager that something in China may break along the way,” hurting the yuan, said Christopher Pavese, Broyhill’s chief investment officer.

Predictable Surprises: June 30, 2011

China’s debt-fueled speculative bubble is likely to be yet another victim in a long list of predictable surprises. As we discussed in a Cautionary Fable last year, forecasting the timing of such trend changes is always a challenging (and frustrating) exercise. But just because the timing is questionable doesn’t mean the risks should be ignored.

Consider that China’s local government debt load has increased by 36 times in nominal terms and five times relative to GDP since 1997. In just the last three years, total liabilities of local governments have mushroomed from 17% to 27% of GDP based upon the State Council’s Audit Report. With more than 80% of those borrowings going to infrastructure, it’s difficult to imagine that the return on investment for each additional project has not declined. Aggravating this debt load, about one quarter of it is promised with land sale revenue, making today’s real estate bubble even more detrimental to the command economy. Defaults are already happening, even with economic growth rates hovering near 10%.

According to Reuters, China’s regulators plan to shift 2-3 TRILLION yuan off local government balance sheets – a massive bailout that is multiples of TARP relative to China’s GDP. With monetary conditions in China now tighter than the 2007-2008 peak and a global economy much more fragile today, we wonder how fast this number will increase once slowing credit actually stalls economic growth.

Consider that in 1999, after borrowing and binging through the 80s and 90s, the NPL ratio of the Big 4 Banks was a massive 39% or roughly 20% of China’s GDP from 1988 to 1993. For China, this was a huge sum of money, equivalent to 25% of foreign reserves at the time. Contrast that with the banks current “reported” NPLs near 1% and consider that Fitch reports bad loans could rise to 15% to 30% of assets.

Have You Ever Seen A Gradual Rise in NPLs: July 12, 2011

It should have been clear for many years that China’s investment-driven growth model was leading to unsustainable increases in debt . . . But dangerously high levels of municipal debt are only a manifestation of the underlying problem, not the problem itself. Even if the financial authorities intervene, unless they change the economy’s underlying dependence on accelerating investment, it won’t matter. They will simply force the debt problem elsewhere.

In all previous cases of countries following similar growth models, the dangerous combination of repressed pricing signals, distorted investment incentives, and excessive reliance on accelerating investment to generate growth has always eventually pushed growth past the point where it is sustainable, leading always to capital misallocation and waste. At this point – which China may have reached a decade ago – debt begins to rise unsustainably.

China’s problem now is that the authorities can continue to get rapid growth only at the expense of ever-riskier increases in debt. Eventually either they will choose sharply to curtail investment, or excessive debt will force them to do so. Either way we should expect many years of growth well below even the most pessimistic current forecasts. But not yet. High, investment-driven growth is likely to continue for at least another two years.

I want to stress this point. Right now everyone is worried about municipal debt levels and wondering if Beijing’s plans to resolve the problem will work or not to clean up the municipalities. But this is the wrong focus. The problem is not whether or not the municipalities will be able to repay. Repayment simply means shifting the debt servicing to another entity, and we should be worrying not about the debt-servicing ability of specific borrowers but rather about the whole system.

The problem, as I see it, is that the system has reached the point at which unsustainable increases in debt are necessary to sustain growth.

More Investors Shorting Chinese Yuan: August 1, 2011

Another yuan watcher is Broyhill Family Office, a North Carolina-based wealth management company. It’s also shorting the Chinese currency. Christopher Pavese, Broyhill’s chief investment officer, said that while no one knows how far the yuan may depreciate, he thinks the possibility is much greater than general market perceptions. Pavese says China’s debt-driven speculative bubble could lead to the devaluation of the yuan becoming a “foreseeable unforeseen.” “Predicting points in times like this can be challenging and frustrating,” he wrote. “But doubts about timing don’t mean the risks can be ignored.”

Pavese’s take on the yuan turned south after China’s National Audit Commission in June said local-government debt as a proportion of GDP had increased to 27% from 17% three years ago, and that more than 60% of the funds were invested in infrastructure. Pavese thinks local-government defaults may rise quickly as monetary conditions tighten in a shaky global economy, and a credit slowdown restrains the economy.

Arms of the State: September 7, 2011

If the economy continues to misallocate capital, high earning loans will increasingly be replaced by low yielding paper from the MOF. The banks will no longer have the ability to lend. If they can’t lend, growth slows. If growth slows, unemployment increases. If unemployment increases, the people are not happy and we have a larger problem in China.

No matter how optimistic you are about Chinese growth over the next five to ten years, you have to believe that investment growth rates will decline sharply, maybe extremely sharply. It is hard to put together a plausible scenario in which China rebalances and investment rates don’t come sharply down. Even the most optimistic outlook for China requires that investment growth rates drop by at least a quarter. Slightly more realistic scenarios require that investment growth rates drop by more than half. And of course, if my prediction is correct – that Chinese growth will slow to 3% – a rebalancing China will see investment growth drop by at least two thirds and probably a lot more.

Betting Against ChinaSeptember 19, 2011

A number of hedge funds have placed wagers against the Chinese currency. The moves run against conventional wisdom. China has been among the fastest-growing nations, and most economists expect the expansion to continue. And China has kept its currency within a tight band. The contrarians counter that the Chinese economy is facing huge debts and is a bubble waiting to burst.

These investors are buying “put” contracts from a bank, which give them the right, but not the obligation, to sell yuan and buy an equal amount of U.S. dollars at a set price. Earlier this year, the cost of a one-year contract allowing the investor to sell $10 million of yuan at 20% below current levels over one year cost just $15,000. If the yuan tumbled 30% the contract would produce a profit of about 5,500%.

Most banks won’t enter into these agreements with individual investors unless they’re a major client with extensive experience trading currencies, partly because the trade is considered highly risky. Christopher Pavese, chief investment officer at Broyhill Asset Management, suggests PowerShares DB US Dollar Index Bullish Fund, an ETF that in theory could do well if the yuan falls. Shorting WisdomTree Dreyfus Chinese Yuan, an ETF that wagers on the yuan, is another option.

The Ghost Malls of ChinaApril 17, 2012

China appears to have too much room for living. Based on international comparisons, the Economist Intelligence Unit reports, a country at China’s level of GDP per head should have 20 square meters of living area per person. In fact, the figure for China is over 30 square meters, which would mean that China is 53% over-housed. Even so, building continues apace: According to The Wall Street Journal, Official data show 2.98 billion square meters of residential property under construction at the end of February.

And the overcapacity isn’t limited to real estate. Chinese industry has been churning out massive amounts of steel, cement, and aluminum — so much that there are doubts about the economy’s ability to absorb the output. “With home prices now following transaction activity sharply lower,” concludes Christopher Pavese, CFA, chief investment officer at Broyhill Asset Management, “the biggest risk for the Chinese economy, as well as the rest of the world, is a sharp slowdown in new construction.” Pavese, recently went on a research trip to China, and shared some images from the Chinese real estate bubble — if, in fact, a bubble it is — with DailyFinance.

Keep Digging: June 7, 2012

It is too early to judge the legacy of China’s 2009 stimulus. There are, however, indications that capital has been stupendously misallocated. The 2009 stimulus has spawned numerous other questionable investments, fueled official corruption across the country, and has left behind a mountain of dubious debts. The world’s longest bridge recently opened in Shandong province. The largest indoor ski venue is under construction at Tianjin. The second- and third-tallest skyscrapers are rising in Shanghai and Wuhan. Domestic shipbuilders have lately built iron-ore carriers so large that they are unable to dock in Chinese ports. The country appears to be suffering from a case of investment gigantism.

A Parody About China: August 8, 2012

Caixin recently reported on the Rise in Bad Loans spreading to places like Guangdong and Mongolia. Remember, these figures are still low by historic standards, particularly considering the 40% NPLs taken by Chinese banks during their most recent credit crisis. But this time around, given the magnitude of the boom displayed above, it wouldn’t take much to wipe out all bank capital in the system today. We figure that a rise equal to a quarter of the last peak would easily do it.

Anecdotally, loans aren’t the only thing going bad in China. Last month, a large section of a highway collapsed in Luchun County, Yunnan Province. The accident caused a van to plunge over 1 kilometer off of a cliff. The 133-kilometer road opened for use April 27, at a cost of about 4.2 billion yuan.

Chinese Math: April 21, 2013

China’s structural rebalancing has only just started. This fading “recovery” is simply a countertrend bounce within an extended decline in economic activity. A recent IMF Working Paper concluded, “There is little doubt that China’s extraordinary economic performance over the past three decades is in large part attributable to investment” and that, “Going forward, the challenge is to engineer a gradual reduction in investment to a path that would maximize social welfare.”

The problem with even a “gradual” reduction is that the magnitude of any reduction is still absolutely massive. For example, China would have to reduce the investment share of GDP by at least 10% and perhaps as much as 20% just to get into line with other emerging economies at equivalent stages of economic development. We reviewed the arithmetic behind such a massive rebalancing in a presentation titled, Easy Money, back in November 2011.

On Gold & China: April 24, 2013

In our last post on Chinese Math, we discussed the implications of China’s export and investment-led growth model. To put this growth in perspective, consider that imports of energy and metals increased by an average of 45% annually from 2010 to 2011 while their share of China’s GDP rose to an all-time high. Mainland China now accounts for 9% of global energy imports while its share of global metal imports is 26%.

We expect China’s slow down (hard landing) to be much more severe than the consensus and given its disproportionate share of the world’s commodity consumption, the impact will be most uncomfortable for the world’s metal exporters. We continue to believe that the Australian economy is the most vulnerable to crack’s in China’s façade given its concentration of trading partners (China now represents 28% of Australian exports up from 6% a decade ago) and its concentration of exports (as ores and metals make up 72% of goods shipped to the mainland). But Australia is not alone in its vulnerability. The CRABS are the commodity rich countries that are riding China’s spending spree. They are Canada, Russia, Australia, Brazil and South Africa. We think the CRABS will ultimately be a much bigger problem than the PIGS.

As we discussed in a recent letter to investors, “We have long believed that the recent crisis marked the beginning of the end for the China-driven commodity-demand theme. The implications of this inflection point will have significant consequences, but perhaps the most important consideration for now is recognition that the secular move in commodities has broken down for the first time in over a decade.

Chu Got It: June 27, 2013

After this week’s Barron’s Cover titled, China’s Looming Credit Crisis, it’s safe to say that the risks to the Chinese economy are well reported. However, after reading through various reports on the recent cash crunch, it’s more difficult to conclude that the risks are well understood. The importance of China to global growth means that increased stress in the Chinese economy translates into elevated risk levels for asset prices in the rest of the world. Conventional wisdom is coming around to this view, but we still question if the consensus truly understands the magnitude of what we have been watching develop for the past three years. This post is a recap of what we know, what we’ve discussed, and what other reliable sources have shared with us.

How Do You Say Minsky In Mandarin? July 1, 2013

China’s credit growth has outpaced nominal GDP growth in every quarter except one since 2009. Perhaps more concerning is the recent trend of more rapid credit growth driving even slower economic growth, with the economy now slowing to levels last seen in the wake of Lehman’s collapse. In other words, the excess borrowing that occurred to “avoid” the financial crisis has not been absorbed by the real economy, yet more debt is being piled on top of this today.

Another difference between the surge in credit today and the one which occurred in 2009, is the increasingly perilous structure of China’s debt, as noted in Ponzi Finance. Bank loans accounted for most of the initial credit surge, but the shadow banking system has supported spiraling debt since 2012. While loan growth barely accelerated beyond 15% last year and has actually dipped entering 2013, trust loans have more than doubled in the past twelve months. Per SG, “The ever-greater role non-bank financing has played in this credit cycle has clearly increased the vulnerability of China’s already burdened financial system. A fast rising debt load of an economy suggests either deteriorating growth efficiency or high and rising debt service cost, or in many cases both. There is clear evidence that China is suffering from both of these.”

Liquidity is the pillar of China’s financial system and the only thing hiding the extent of the economy’s bad debt. Since the Fed began its recent Taper Talk, that liquidity has dried up, leaving China vulnerable to a squeeze as hot money runs for the exits. We view the recent credit crunch as yet another indication of long term issues coming home to roost.

If you’ve made it this far, two things are clear:

One, it’s probably a safe assumption that you are very interested in the current state of Chinese affairs. And two, you are likely quite exhausted from all of our ramblings.

So, to kill two birds with one stone, you can check out this recently released excerpt from Vikram Mansharamani’s book Boombustology. The chapter, Is China Next, was first published in 2011, but the underlying logic still sheds some light upon current dynamics within the country.

As always, we welcome your feedback. Does China worry you?