Is the great China crash upon us?

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.

Register your interest today (if you have not already):

David Llewellyn-Smith
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Comments

  1. Baruch Spinoza

    China has at its disposal an economy which is never considered – the communist economy. We are all looking at the capitalist economy, its indicators, cycles, rates, reserves, debts / liabilities etc – but we forget the deep communist economy which existed for decades and still exists today.

    It is an entirely hidden, entirely command, entirely deployable – think of it like modern money theorists think of sovereign currency and debt, something that can “just” be deployed.

    Yet it does not show up as debt, it does not show up as demand – it just shows up as a massive seething increase in GDP spurring on the economy.

    It comes in many forms all of which are simply “not registered” and hence the alternative indexes (electricity, water, energy use, resource demand, commodity stockpiles etc).

    When you have a standing army of a million, with 5 million in active reserves, and support ranging in the tens of millions to a hundred million in an entirely secret state run institution it beggars belief what they are achieving.

    It is an entirely secret organisation which is consuming as much as a third of the United States is.

    People just can not wrap their heads around the enormity of the ROC State and Military capacity – it is completely unprecedented in all of human history. And its off books.

    .

    • fitzroyMEMBER

      +1 The “loans” and “capital” are not the same as here. They are both used as mercantilist weapons.

    • I assume you are our resident China troll that has morphed once again (?) – yet another historical figure from the west…

      Not sure about the gist of your comments but sure just as our volunteering economy is not reflected in our national accounts (I think that is right (?)) there would be lots of activity and value tied up with the CPC that does not show up in their accounts. But yeah, China is such a mammoth entity that even if large sectors of its economy hit the wall other sectors and regions will likely power on regardless.

      Just a point of pedantry: The “ROC” generally refers to the Republic of China ie Taiwan whereas mainland China’s currently is the Peoples Republic of China (“PRC”) – but surely you know that (???).

      • Baruch Spinoza

        China, officially the People’s Republic of China

        I don’t care what Taiwan thinks – its part of China.

    • Yes but no. Funding long term assets at the short end of the curve and relying on the ability to constantly role the funding is a recipe for disaster regardless of who is in charge, communists or not. This is what is going with these wealth products. Sure liquidity can be introduced domestically but via the bank’s inability to trust other bank’s solvency will at some point hit the exit points in the economy (capital flight). This will ensure a depreciating currency and then all hell will break loose in international trade. So good luck to the commies trying to manage around that.

    • This is just the old argument that China doesn’t follow financial/economic models because its run by Commies and they can do stuff differently there. All fine and good in a relatively closed economy, I guess. Bad debts or unproductive activities could just be written off with the govt picking up the tab.

      But I don’t see how that works with the economy China now IS, which is fairly heavily linked to the rest of the global economy in a multitude of ways. Something somewhere is going to break and the Commies won’t be able to control all of the aftermath. Then we will see this whole thing collapse as the confidence in their ability to support it evaporates. It’s a built-in failure.

      When it really comes down to it there are not enough resources in the world to support a wealthy Chinese middle class. That could only change if the developed world got back to growth and was able to use that to pay China for lots more stuff. But that’s done now.

      • +1 for first paragraph.

        Resource in the world is not going to be impossible to solve. everything is constrained by energy, and we are only starting to tap into renewables and we haven’t even scratched the surface of nuclear yet.

      • Kevin, when I said resources I really meant money. For Chinse middle class to reach anything near Western levels requires one heck of a lot of economic growth, which the world cannot provide any time soon. I did not mean natural resources.

    • Very true.

      There’s a big communist party congress later this year. Very little upsetting will happen before then.

    • GramusMEMBER

      ROC..??? No, that is Taiwan.
      And you are right in part. But only in part.
      The place is FAR FAR more chaotic than you make it out to be.
      The unwind will be more chaotic than expected.

  2. At least Axoim capital admits they were totally wrong on the timing. Something a lot of people *ahem* seem to have trouble doing. Got to agree with HnH this time though if there is a slowdown what’s to stop the Chinese govt opening the credit taps again like they have done before? The Chinese fear social unrest more than anything and hey actually have real savings and production so it’s not all credit driven. As the real Ax cap says on Billions being early is the same as being wrong

    • What those open money spigots have done over the last 9 years is create dangerously big gap in the rich poor divide. The aspirants are getting a bit of ‘western style debt wealth’ to keep them happy, but its not a sustainable strategy ! There are limits to what can be done as it is just another form of a pea in shell game…

  3. I see your point Baruch, but isn’t it the case that that ‘off books’ activity/economy essentially domestic in nature. How is that hidden activity going to interact with the global monetary system?

    And how does it prevent massive dislocation amongst the newly emerged urban middle class of ROC. Does it not seem possible that if the ‘hidden economy’ is brought into play to offset the deterioration in the consumer/’capitalist’ style part of the economy, what you’re really seeing is the groundwork for huge social conflict that would be extremely difficult to constrain and, whatever the leadership accomplished, would still cause very significant disruptions to global trade/commerce – and of course from that, the possible ‘external event’ that helps our stack of cards to collapse???

  4. A secular bear market could well persist for 10 years, so you need to keep some cash to sustain yourself till your risk assets come good and start paying cap gain / dividend.

  5. Michael Hudson has been pointing all this out for at least five years. It takes time for the imbalances to overwhelm the structure. We’re getting closer and closer to the tipping point and we wait…

    Perhaps China is using North Korea to distract the world?

    That FX threshold issue speaks volumes about the Chinese clamping down on the capital account and now shadow banking. Wouldn’t want to be owed money by a Chinese developer or buyer right now

  6. DominicMEMBER

    All those wasted words … all that unnecessary hand-wringing …. it’s very simple:

    China is not different, China is not special. China is doomed. In a major way.

    Only a matter of time, now.

    • GramusMEMBER

      China is different.
      Its political economy makes it different.
      Very different.

      That isn’t to say it isn’t subject to the fundamental laws of economics (or nature for that matter)
      but we need to be honest about what we are dealing with.

      • DominicMEMBER

        Gramus
        With the greatest respect, economic laws are equal wherever you are and whatever the context.

        China is fucked and will unleash an unholy amount of misery upon the world — but us in particular. I love the Chinese dearly but they have cocked this up spectacularly. They are the late ’80s Japanese crash x50.

        Let us not debate the point. The truth will be revealed soon enough.

  7. When are they going to war to stimulate and grow their economy just as the USA has done in the past 100 years? China has so much upside potential…

  8. Researchtime

    Wow – Cliffs are obviously trying to shut them up… desperate measures, over minute, which would be thrown out of court in an instant!

    ********

    Cliffs Natural Resources Inc. (“Cliffs”) is responding to articles published today by Barron’s Ben Levisohn and Axiom Capital Management’s Gordon Johnson with respect to an open market purchase of 200,000 Cliffs shares made yesterday by its Chairman, President and CEO, Lourenco Goncalves. These comments include statements that are inaccurate and materially misleading regarding Mr. Goncalves’ previous share purchases. In particular, Barron’s and Axiom inaccurately reported that Mr. Goncalves’ last open market share purchase occurred in March 2015. In fact, Mr. Goncalves has made multiple significant open market purchases of Cliffs shares since March 2015, totaling 300,000 shares, including two purchases in May 2015 and one purchase in May 2016. All of these purchases were reflected in Form 4’s filed with the United States Securities and Exchange Commission. Both Barron’s and Axiom would have been well aware of these later trades from publicly available information at the time their comments were made. Cliffs believes that such materially misleading misstatements are an intentional attempt to manipulate Cliffs’ share price to support the “bearish” position Mr. Johnson’s firm Axiom has historically taken with respect to Cliffs’ stock. As a result of these statements, Cliffs has already instructed its outside legal counsel to pursue appropriate legal action against all parties involved.

  9. Just how resilient are Australian households to an external shock ? …

    Housing affordability: 87% of Australians fear for future generations | Australia news | The Guardian

    https://www.theguardian.com/australia-news/2017/may/07/housing-affordability-87-of-australians-fear-for-future-generations

    About 87% of Australians believe future generations will not be able to afford to buy a home, a new poll shows. …

    … One in five Australians were struggling to keep up with mortgage or rental payments, the poll showed, and 23% would be in financial difficulty if interest rates went up by two percentage points.

    The lead researcher, Jill Sheppard, said the survey showed home ownership was still viewed as part of the Australian way of life. But Sheppard said those surveyed believed it was fast becoming unrealistic.

    “Young Australians are particularly pessimistic and have little faith that they will be able to buy a home and replicate the levels of home ownership of previous generations,” Sheppard said. … read more via hyperlink above …

    2017 13th Annual demographia International Housing Affordability Survey

    http://www.demographia.com/dhi.pdf

    Deluge of affordability data forces government’s hand | The New Daily

    http://thenewdaily.com.au/money/property/2017/02/02/housing-affordability/

    • New poll suggests one fifth of Australian home owners struggling with repayments | SBS News

      http://www.sbs.com.au/news/article/2017/05/07/new-poll-suggests-one-fifth-australian-home-owners-struggling-repayments

      Mortgage repayments have become a huge struggle for a significant chunk of Australians and most believe the dream of home ownership will be out of reach for future generations, a poll shows.

      As the federal government prepares to unveil housing affordability measures in Tuesday’s budget, an ANU survey shows that one fifth of people are struggling to meet mortgage or rent payments, with two per cent having fallen behind.

      Nearly a quarter said they would be in quite a bit or a lot of difficulty if interest rates jump by two percentage points, while nearly 90 per cent are concerned that future generations won’t be able to afford to buy a house.

      Significantly, almost half were willing to see their property values stop increasing even further to help improve affordability. … read more via hyperlink above …