Is the Great China Crash Upon Us?

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By David Llewellyn-Smith, founding publisher and former editor-in-chief of The Diplomat magazine, now the Asia Pacific’s leading geo-politics website. Originally published at MacroBusiness

From Axiom Capital.

While we, as well as the few bearish peers we have, have warned of a pending “credit event” in China for some time now – admittedly incorrectly (China has proved much more resilient than expected) – the more recent red flags are among the most profound we’ve seen in years – in short, we agree with fresh observations made by some of the world’s most famous iron ore bears. Thus, while it is nearly impossible to pinpoint exactly when the credit bubble will definitively pop in China, a number of recent events, in our view, suggest the threat level is currently at red/severe.

WHERE IS CHINA AT TODAY VS. WHERE THE US WAS AT AHEAD OF THE SUBPRIME CRISIS? At the peak of the US subprime bubble (before the failure of Bear Stearns in Mar. ‘08, and subsequently Lehman Brothers in Sep. ’08, troubles in the US credit system emerged as early as Feb. ’07), the asset/liability mismatch was 2% when compared to the total banking system. However, in China, currently, there is a massive duration mismatch in wealth management products (“WMPs”). And, at $4tn in total WMPs outstanding, the asset/liability mismatch in China is now above 10% – China’s entire banking system is ~$34tn, which is a scary scenario. In our view, this is a very important dynamic to track given it foretells where a country is at in the credit cycle.

WHAT ARE THE SIGNS WE ARE SEEING? In short, we see a number of signs that point to what could be the beginning of the “popping” of the credit bubble in China. More specifically: (1) interbank rates in China are spiking, meaning banks, increasingly, don’t trust each other – this is how any banking crisis begins (Exhibit 1), (2) China’s Minsheng Bank recently issued a ghost/fraudulent WMP (they raised $436mn in funds for a CDO-like asset that had no assets backing it [yes, you heard that right] – link), (2) Anbang, the Chinese conglomerate who has used WMP issuance as a means to buy a number of assets globally (including the Waldorf Astoria here in the US),  is now having issues gaining approval for incremental asset purchases (link), suggesting global investors may be getting weary of the way in which Anbang has “beefed up” its balance sheet, (3) China’s top insurance regulator, Xiang Junbo, chairman of the China Insurance Regulatory Commission, is currently under investigation for “severe” disciplinary violations (link), implying some/many of the “shadow” forms of transacting in China could become a bit harder to maneuver (which would manifest itself in higher rates, which his exactly what we are seeing today), and (4) as would be expected from all of this, as was revealed overnight in China, bank WMP issuance crashed 15% m/m in April to 10,038 from 11,823 in March, a strong indicator that faith in these products is indeed waning.

Exhibit 1: Interbank Rates in China

Source: Bloomberg.

DOES CHINESE PRESIDENT XI JINPING HAVE ALL OF THIS UNDER CONTROL? In a word, increasingly, it seems the answer is no. What’s the evidence? Well, in March, interbank rates spiked WAY past the upper corridor of 3.45% to ~11% (Exhibit 2), a strong indicator that the PBoC is losing its ability to “maintain order”. And, admittedly, while there are levers the PBoC can pull, FX reserves are at scary low levels (discussed below), suggesting the PBoC is quickly running out of bullets. Furthermore, corporate bond issuance in China was negative in C1Q, which means M2 is going to be VERY hard to grow (when MO is negative); at risk of stating the obvious, without M2 growth in China, economic growth (i.e., GDP) will undoubtedly slow – this is not the current Consensus among market prognosticators who think things are quite rosy right now in China; yet, while global stock markets are soaring, the ChiNext Composite index is down -7.5% YTD vs. the Nasdaq Composite Index being up +12.8% YTD. In our view, given China’s importance to the global commodity backdrop, we see this as a key leading indicator (the folks on the ground in China are betting with their wallets, while global investors continue to place their hopes on: [a.] a reflationary tailwind that we do not believe is ever coming [China is now destocking], and [b.] hope that President Trump will deliver everything he’s promised [which, in this political environment, we see is virtually impossible]).

Exhibit 2: Overnight Reverse Repo Rate

Source: Bloomberg.

CHINA’S FOREIGN EXCHANGE (“FX”) RESERVES ARE DANGEROUSLY CLOSE TO LOW LEVELS THAT WILL LIKELY CAUSE AN INFLECTION LOWER IN THE CURRENCY. Based on a fine-tuning of its formula to calculate “reserve-adequacy” over the years, the International Monetary Funds’ (“IMF”) approach can be best summed up as follows: Minimum FX Reserves = 10% of Exports + 30% of Short-term FX Debt + 10% of M2 + 15% of Other Liabilities. Thus, for China, the equation is as follows: 10% * $2.2tn + 30% * $680bn + 10% * (RMB 139.3tn ÷ 6.6) + 15% * $1.0tn = $2.7tn of required minimum reserves. Furthermore, when considering China’s FX reserve balance was roughly $4tn just 2 years ago, we find it concerning that experts now peg China’s unofficial FX reserve balance somewhere in the $1.6-$1.7tn range. Why does this differ from China’s $3.0tn in reported FX reserves as of Feb. 2017? Well, according to our contacts, when adjusting for China’s investment in its own sovereign wealth fund (i.e., the CIC) of roughly $600bn, as well as bank injections from: (a) China Development Bank (“CDB”) of roughly $975bn, (b) The Export-Import Bank of China (“EXIM”) of roughly $30bn, (c) the Agricultural Development Bank of China (“ADBC”) of roughly $10bn, as well as capital commitments from, (d) the BRICs Bank of roughly $50bn, (e) the Asian Infrastructure Investment Bank (“AIIB”) of $50bn, (f) open short RMB forwards by agent banks of $300bn, (g) the China Africa Fund of roughly $50bn, and (h) Oil-Currency Swaps with Russia of roughly $50bn, the actual FX reserve balance in China is closer to $1.69tn (Exhibit 3).

Stated differently, based on the IMFs formula, sharply contrasting the Consensus view that China has years of reserves to burn through, China is already below the critical level of minimum reserve adequacy. However, using expert estimates that $1.0tn-$1.5tn in reserves is the “critical level”, and also considering that China is burning $25bn-$75bn in reserves each month, the point at which the country will no longer be able to support the renminbi via FX reserves appears to be a 2017 event. At that point, there would be considerable devaluation in China’s currency, sending a deflationary shock through the world’s commodity markets; in short, we feel this would be bad for the steel/iron ore stocks we cover, yet is being completely un-discounted in stocks today (no one ever expects this event to occur).

The early 2007 analogy is a good one. This is coming at some point in the next few years. I remain on guard but skeptical at this point given China does have other levers it can pull to keep the credit running and is indeed pulling them in fiscal policy. As well, the problem can always be made worse before it’s made better. Authorities are, after all, bringing this on.

It’s a fascinating question. Could China endure a “sudden stop” in credit if counter-party risk exploded, much like happened to Wall St in 2008? The usual analysis reckons that China’s publicly owned banks can always be ordered to lend more but what if they lose faith in each other? It’s probably true that Chinese authorities could still force feed credit into the economy but, equally, it’s difficult to see how an interbank crash in confidence would not slow the injection, at minimum via choked off-balance sheet vehicles like WMPs.

There is no doubt, at least, about what happens when it does arrive:

  • the final washout of commodity prices;
  • Australian house price crash;
  • multiple sovereign downgrades, and
  • an Aussie dollar at 40 cents or below.

It’s the great reset event for Australia’s bloated living standards. That is why we say to you get your money offshore today. We can help you do that when the MB Fund launches in the next month with 70% international allocation.

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  1. PlutoniumKun

    There is a strong political imperative on Xi to keep things stable at the moment. China still has many policy instruments to hand, but there is plenty of evidence that more and more credit is needed in the economy to produce the same amount of growth as just a few years ago. As the always interesting and insightful Michael Pettis points out:

    But, as I have been arguing for years, China was not on the verge of a financial collapse and was never likely to collapse as long as regulators were credible and able to restructure liabilities in the banking system with relative ease. Financial crises are caused not by insolvency or economic downturns, but rather by highly inverted asset-liability mismatches severe enough to cause a breakdown when evaporating liquidity prevents the rolling over of liabilities. On paper, the Chinese financial system seems plagued by such mismatches, but liabilities in a closed banking system with all-powerful regulators are much more stable than they seem because the regulators have many ways to restructure liabilities through the banking system.

    To understand China’s growth, it has to be recognised that there is absolutely nothing new about whats happened in China, despite the hyperbole we regularly read. As Pettis again points out, the Chinese essentially use the same economic policy as 19th Century America. The core question is whether China follows the US, UK and South Korea in following through successfully, whether it goes the route of Japan and long term stagnation, or follows countries like Brazil and Argentina, who stagger backwards as often as they stride forward. The Chinese are acute students of economic history, so they are well aware of the dangers. They may, however, not be able to control things if it goes out of control. Pettis, btw, has said that while he thinks there is a real danger of a financial crisis, he thinks it is more likely that China will soon fall into a low growth pattern, similar (if not quite as bad) as post 1990 Japan.

    That said, there is I think a unique danger in China. It is that so many of the Chinese rich have stashed enough money abroad that they may find it better to flee than to work their way through a difficult period. There is a real possibility I think that even if the regulators do everything right, a panic reaction to some bad news could lead to a huge financial run. There is also a multiplicity of informal lending schemes in every Chinese town and city (many of which, I suspect, are ponzi schemes), which could potentially run badly out of control.

    1. Jim Haygood

      China is experiencing the same awkward issue as the US and Europe: despite valiant central bank efforts to boost the money supply (Chinese M2 is rising at 10.6% p.a.), inflation just won’t take off. It’s running at 0.9% p.a. That’s painful, in a commodity-oriented economy.

      With even smart guys like Kyle Bass massively short China and screeching, “Look! It’s blowing up! Run for your lives!” every time iron ore prices take a header, one has to presume that Ms Market is not going to accommodate their dreams of Midas-like wealth, at least not yet.

      Presumably the Chinese authorities still have a few more tricks up their sleeve before the deal goes down.

      1. NotSoSure

        Kyle Bass is massively overrated just like pretty much every guy who made their name during the subprime crisis. His Japanese trade haven’t gone anywhere either. Another example is John Paulson.

    2. jsn

      Excellent comment.

      From the perspective of a system entirely obsessed with itself, NeoLib Capitalism, it is difficult to imagine the tools and opportunities of a system with profoundly different values. The authors of this paper are hampered by such an obsession it seems to me.

      No doubt the Chinese leadership is as keen to hold on to power as ours is, but they see different means due to different values and power structures.

    3. Oregoncharles

      19th Century America had financial depressions on a regular and frequent basis. Does China?

      1. PlutoniumKun

        China has had at least two significant financial crises since the economy opened up, although they weren’t strictly speaking financial depressions as the banking/finance system is very different. As Pettis suggests, it may be that one reason the US did so well in the 19th Century is that its banking crises actually allowed it to flush debt out of its system, in contrast to (for example) the more staid Japanese system which allowed debts to build up and dealt with it by pretending they didn’t exist. His article is actually an excellent overview of the variations on successful growth models, and as he says since nobody really knows why some economies escape the middle income trap and others don’t, its really guess work as to whether the Chinese are doing it right.

      2. Spunky McGregor

        Posting as a lay-person, the answer I think you are looking for is no, they have not had depressions or recessions like the United States and Europe, or even Japan. However, again as a lay-person, this is no reason for me to think that the system is necessarily better-managed. The free markets, for all of their downsides regarding income inequality and slow gentrification, tend to be much more efficient than state-run economies like China. I do not take Chinese stability over the last thirty years as an indication that they haven’t had a recessionary event, or even several of them. I take it as an indication that they have had them, but have injected capital and rolled over these liabilities as they essentially handed money out to wealth-eating SOE’s to maintain growth rates. The point of this article and other like it, I believe, is that eventually, everything must succumb to gravity. China is no different. I am too young to remember the seventies when people thought Japan would rule the world, but I predict that this growth miracle will have a very similar ending.

        Again, just my two cents on the matter.

        1. Arizona Slim

          I remember the seventies very well. And, yes, there was a great deal of fear re: Japan ruling the world. How wrong that prediction turned out to be.

          And, while we’re talking about the seventies, permit me to reminisce about my years as a college student. I had a prof who was a world-renowned authority on the Chinese economy. The biggest challenge in his field? Reconciling official State Statistical Bureau numbers what was *really* happening in China.

          1. PlutoniumKun

            It hasn’t changed really, interpreting Chinese economics statistics is still more art than science. Even Beijing probably doesn’t know for sure as there are significant incentives for the regions to distort figures being reported upwards.

    4. different clue

      If the Chinese rich try to flee in some visible manner, would the ChinaGov be able to use all its armed and police power to physically stop them from fleeing . . . by banning airplanes into and out of China, by freezing all train travel anywhere near a border, by closing all ports and banning all ships and boats from moving in or out, for long enough to round up and contain all the prone-to-flee wealthy?

    5. Yves Smith Post author

      I must confess to not having read Pettis’ comparison to the US in the 19th Century, he has severely discredited himself. The big driver of US growth then was population increase, period. The US went from 5 million people in 1800 to 76 million people in 1900. The US was giving away land during most of that century to have it exploited, ie, farmed.

      The US did build railroads….which virtually all went bankrupt. They were more important as vehicles for stock market speculation than as productive companies. Industrialization didn’t get going in a big way until the 1880s, which was also the time period during which the US had repeated depressions, leading to the William Jennings Bryant campaigning for a more flexible currency.

      1. PlutoniumKun

        Well, I simplify his article, he’s focusing more on the specific policies the US pursued. The US of course had great advantages in population and resources, but so did Argentina and Brazil. I suspect Pettis focused on the US to emphasise that there is really nothing particularly new about the Chinese growth model – in reality Japan and South Korea are closer examples.

        I think his broad point is that almost all countries which have achieved high growth have ignored Ricardian ideas of free trade and used protectionism and some form of financial repression to accelerate industrial development, but why some make it and others get stuck as middle income countries isn’t clear. He actually suggests that the railroads is a good example of what the US got right. They went bust, they were bought up cheap, and the new owners were able to reduce carriage costs significantly as the debt load had been wiped out.

    6. RBHoughton

      PBoC will allocate funding more tightly, focusing on the banks which have a genuine need. No worries.

    7. Penny

      Very odd to see the UK as an exemplar of economic growth. However, assuming the author means during the UK growth in the19th century, one would imagine the assiduous historians in China’s politbureau would at least consider the mess created by the post-War I UK government and the subsequent Brazil like back and forth growth evidenced throughout most of the industrial heartland of low growth/no productivity Britain.
      Doesn’t seem like much of an example to emulate.

  2. Susan the other

    I can’t relate to this article except by knowing the recent history of the dollar-unleashed. Wherein our leaders said it wasn’t our problem, it was the problem of everyone who had to use the dollar. So the yuan is not quite in that position as a global currency yet, but it is still a tool for the Chinese. They can’t just say, “Oh never mind – we are going to let the whole thing crash to the ground because the value of the yuan is sacred and unconnected to the lives of Chinese people”… Are you kidding? Of course they will supply the money for as long as it takes. We can forget money as we once knew it – putting nickels in our piggy banks. It’s over, Gott sei dank.

  3. Synoia

    This says it all:

    It’s the great reset event for Australia’s bloated living standards. That is why we say to you get your money offshore today. We can help you do that when the MB Fund launches in the next month with 70% international allocation.

    Fear of loss is a great motivator after the paragraphs of carefully worded (and somewhat obscure) “the sky is falling” words.

    Also China’s foreign currency reserves quoted do not include their Treasuries, which are readily converted into cash – because of the full faith and credit of the US Government, which can credit dollars at will in exchange for treasuries.

    The US may want China to grovel, but it does not want it to collapse – because supply chains.

    1. dontknowitall

      According to it seems Chinese FX reserves mentioned in the article also include US Treasuries held by China, I quote from their site:

      “In China, Foreign Exchange Reserves are the foreign assets held or controlled by the country central bank. The reserves are made of gold or a specific currency. They can also be special drawing rights and marketable securities denominated in foreign currencies like treasury bills, government bonds, corporate bonds and equities and foreign currency loans.”

      They also note FX reserves have not stopped increasing and have increased by $4bn to $3.009 trillion in the month of March at double the expected increase. It is easy for westerners to forget the amount of control the government of China has over everything and also the amount of power Chinese businesses have over people (persons and businesses) who owe them money. I think the Chinese government will do everything and anything to avoid a mess.

    2. Sandler

      Can’t forget the spruiking for a fund at the end. I guess enough realized the subscription was a waste of money. I stopped reading MB a couple years ago happily.

  4. Oregoncharles

    “We can help you do that when the MB Fund launches in the next month with 70% international allocation.”

    Talking his book, perchance? Granted, it makes sense. Australia is in the unhappy position of dependence on a single customer.

    1. RUKidding

      Sadly there could be some rocky times ahead for the Lucky Country. Way too dependent on the Chinese.

  5. Colonel Smithers

    I know some people who are shorting HSBC, my former employer, and StanChart in anticipation of such an event.

  6. Knot Galt

    What will Xi do if and when it collapses? Can he pull an Obama and let the banking authorities off or will heads(literally) roll?

  7. cbu

    China has 6%+ growth rate and at least $20 trillion domestic deposits, as well as $3 trillion FX reserves. I doubt China’s economy will be the first one to crash, or crash at all.

    1. Spunky McGregor

      China has 6%+ growth rate…’

      They say they do, so why not, right? The problem is that this growth rate has been propped up by tremendous credit expansion, particularly over the last seven to ten years, since the GR. Now, every dollar of GDP expansion is costing more and more debt. This can’t go on forever, the only question is what happens when gravity catches up? IIRC, the Soviet Union experimented with a similar policy in the 50’s and 60’s as they attempted to catch the west in an economic race for GDP.

      With regards to FX reserves, the article speaks about what the minimum required FX reserves are for a currency, in this case the RMB. I know it states it in terms of the country, but the FX reserves to me are really a function of the value of the currency. This could be a misconception on my part, but there it is.

      Anyway, there really is no choice but to play until the deck is exhausted. I am interested to see how the next two to three years plays out. If China makes it through alright, then maybe all the folks talking about the invulnerable command economy will be proven right, and we can look back on these kinds of articles with a sort of vague amusement of how paranoid we were. I’m not in the former camp really, so then I will have to eat some crow.

  8. ginnie nyc

    This is a minor quibble, but Bear Stearns crashed in March 2007, not 2008.

    1. Bill

      In 2007 a couple of Bear Stearns hedge funds went bankrupt. In March 2008 the whole bank was sold for $2 a share (later changed to $10) to JP Morgan.

    2. Yves Smith Post author

      No Bear Stearns most decidedly collapsed in March 2008. The run started in early March and it was toast by Friday March 14.

      The Bear Stearms subprime funds imploded in July 2007.

  9. ewmayer

    Thankfully the South China Morning Post [cf. today’s Links] reassures us by explaining “Why China can deflate the world’s largest credit bubble in an orderly fashion”. /sarc

    That having been said, I think the article’s opening admission that “China has proved much more resilient than expected” – with ‘resilience’ here connoting ability and willingness to take measures to delay the day of reckoning while the debt bubble gets even larger
    – will continue to hold true beyond the predictions of most of the bears. As the old bromide goes, “the party ends only after the last bear throws in the towel.”

  10. Francesco

    This is total bullshit. China has many problems but it still has a large balance of payments surplus, extremely large domestic deposits and at least a meaningful part of their debt burden was to finance the larger infrastructure and industrial apparaturs in the world. In the meantime, UK has an absurdly high balance of payments deficit, the industrial apparatus is foreigners owned and is a huge energy importer (what will happen when oil be back to 80 or more ?) while the US has the same (or bigger) debt burden of China, a 3rd world level decrepit infrastructure and their big firms made large debts for buybacks at record level stock prices. I think analysts (do really exist anymore ?) in the west need a better assessment of the deep existential problems in their own countries. Then, yes, there is China too.

    1. skippy

      From the currant popular econnomic navel gassing’ yes it would seem China is building whilst America is hollowing out….

      Disheveled…. not that either one is really coherent in the process….

  11. Mickey Hickey

    China has the best educated Gov’t and Civil Service in the world. Universities in developed countries have large contingents of Chinese students in their STEM programs. I have a grandson in a primary school in Canada where entrance is by competitive examinations and auditions. Over 2500 applicants and 23 positions, one third of the students admitted are Chinese. The school was founded by the Irish and is still run by the Irish (Catholic) so there is no question of ethnic pull or money favourably biasing the selection.
    As to which country will thrive in the long run, I would put my money on China.

  12. Danny

    Nothing is likely to happen until after October when the 19th National Congress occurs. Xi will use everything in his arsenal – figuratively and literally – to not let the economy implode until after that point when he further consolidates power.

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