A woman counts Chinese yuan bills. (Benjamin Chasteen/Epoch Times)A woman counts Chinese yuan bills. (Benjamin Chasteen/Epoch Times)

He was right about subprime, right about gold, and early in his call for a Japanese crisis. Is Texan investor Kyle Bass too early in his call for a China banking crisis and currency devaluation within the next two years?

“It’s a foregone conclusion but we don’t know about the timing, it feels like it’s happening as we speak,” he told Grant Williams of RealVisionTV in an interview. Bass had first stated his pessimistic view of China in late 2015 when the currency was under pressure and the country was bleeding capital to the tune of $100 billion per month.

Since February of this year and so-called Shanghai Accord or the G20 finance ministers, outflows have abated, although the currency has declined to a multi-year low of 6.66 per U.S. dollar.

There are so many perfect parallels to the U.S. mortgage credit system or the European banking system and the Chinese banking system.

— Kyle Bass, Hayman Capital
The exchange rate of the Chinese yuan versus the U.S. dollar over a year (Bloomberg)

The exchange rate of the Chinese yuan versus the U.S. dollar over a year (Bloomberg)

So why does Bass think the situation in China is intensifying? Everybody knows China has too much debt, especially corporate debt. As a result, the country’s total debt to GDP ratio is higher than 250 percent according to a range of different estimates. This is not much higher than Japan’s government debt ratio of 245 percent of GDP, so why focus on China now?

“The Chinese corporate bond market is freezing up. Since April 11th the Chinese corporate bond markets had 150 cancellations out of 210 announced deals,” says Bass. And indeed, the Chinese corporate bond market, which has helped keep unsustainable corporate debt afloat and also backs trillions in repackaged loans called Wealth Management Products (WMP) is in trouble in 2016.

Source: McKinsey

Source: McKinsey

According to Bloomberg, Chinese companies raised 1.85 trillion yuan ($280 billion) of onshore bonds between April and July this year, 30 percent less compared to the three preceding months.

Bankruptcies are also on the rise. Although corporate defaults are still in the low double digits, Chinese courts handled 1028 bankruptcy cases in the first quarter of 2016, up 52.5 percent compared to a year earlier.

“There are so many perfect parallels to the U.S. mortgage credit system or the European banking system and the Chinese banking system. There are things that go on in those systems that show you there are problems,” says Bass, emphasizing the acuteness of these problems. “We see it starting now.”

While there are clear parallels to what happened in the United States in 2008 and Europe in 2010, Bass says that China’s problems are a magnitude larger. “They have asset liability mismatches in wealth management products that are more than 10 percent of their system. Our mismatches were 2.5 percent of the system and you know what they did,” he says. 

According to Bass, the bad loans will first hit the banking system and then lead to a sharp devaluation of the Chinese yuan. 

“How they deal with this, it’s not armageddon. They are going to recap the banks, the are going to expand the People’s Bank of China’s (PBOC)  balance sheet, they are going to slash the reserve requirement, they are going to drop their deposit rate to zero, they are going tot do everything the United States did in our crisis,” he said.


All of these policy measures would lead to a depreciating currency all other things being equal. But China’s currency is already under pressure as mostly Chinese citizens are taking their money out of the country because they don’t trust the banking system any longer. Bass estimates that bad loans could lead to losses of up to $3 trillion or 30 percent of GDP. Chinese citizens’ savings are backing these loans and they don’t want to wait around to find out whether Bass’s number is correct or not.  “In China, the credit excesses are already built in,” says Bass. 

They are going to do what’s best for China. And what’s best for China is to materially devalue their currency.

— Kyle Bass, Hayman Capital

Goldman Sachs estimated that net capital outflows from China in the first quarter of 2016 were around $123 billion according to a report, 70 percent of which came from Chinese citizens funneling money out of the country. They do this in spite of harsher capital controls in 2016 and use either illicit methods like smuggling or legal ones like buying up Vancouver and New York real estate.

According to Bass, there is no way out for the regime, which is trying to manage the devaluation as much as it can. “The Chinese government wants a devaluation, they just want it on their terms.”

Reuters had previously reported that the Chinese central bank would not mind seeing the currency slip to 6.80 against the dollar, a target it will likely overshoot if things don’t change materially.  

Bass also shines light on why the regime would not be opposed to devaluing the currency, albeit measuredly. He says one of president Xi Jinping’s closest aides, vice premier Wang Yang, thinks the Japanese made a mistake by not devaluing in the mid-1980s, right when they were blowing up their own credit bubble. 

“Wang has said that he thinks Japan’s critical error was agreeing to the Plaza Accord. Japan decided to be submissive to the United States once again, to sacrifice their economic growth for that of the United States,” as the dollar devalued and the Japanese yen strengthened, the United States finally emerged out of a decade of stagflation. what happened to Japan at the beginning of the 1990s was less flattering. According to Bass, however, this time will be different: “They are going to do what’s best for China. And what’s best for China is to materially devalue their currency.”

After the devaluation and the recapitalization of the banking system, however, it’s time to buy again: “If you have any money left, it will be the best time in the world to invest. It will be the greatest time ever to invest in Asia.”

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Shorting the Chinese currency is the most popular trade among hedge funds in 2016. As one trader in New York puts it: “Everybody is betting on a devaluation of the yuan.”
Mark Hart of Corriente Capital, for example, thinks the Chinese currency will go down 50 percent against the dollar in 2016.
Despite some relatively substantial swings, the currency is more or less unchanged for the year, though, as China has used $100 billion of its currency reserves (it had as many as $4 trillion at its height in August 2014) to defend the yuan as even more capital flowed out of the country.
So investors like Mark Hart and Hayman Capital’s Kyle Bass think this reserve drain caused by capital outflows cannot continue forever and, at some point, China will just have to let its currency go. But is this really true?
Banking Crisis
At the heart of the argument in the short yuan community is China’s bad debt problem, which nobody really disputes.
“China’s banking system is approximately $30 trillion in size and the bad assets are approximately 24 percent or so. That’s $7 trillion–$8 trillion of bad assets,” says Evan Lorenz of Grant’s Interest Rate Observer, citing research from J Capital Research.
Its stock of liquid assets with which it can defend its currency are probably a lot smaller than that $3.2 trillion. — Evan Lorenz, Grant’s Interest Rate Observer

So international investors are selling not just the bad assets and moving the money abroad to safety. The same is true for Chinese citizens, according to research by Goldman Sachs and the Institute of International Finance, at least as much as they can without being hindered by capital controls.
Chinese corporates are also paying back foreign debt or are investing in overseas assets, again putting pressure on the currency.
“You saw China can do a $44 billion bid for Swiss seeds and chemicals group Syngenta AG, you saw China’s Zoomlion bid $3.3 billion for Texan crane maker Terex Corp., and you have Chinese companies bidding around $3 trillion for General Electric’s home appliances business,” says Lorenz.
Defending the Currency
The only entity standing between this wall of cash leaving China ($637 billion in 2015 according to the IIF) and a much lower Chinese yuan is the People’s Bank of China with its already much depleted stash of foreign exchange reserves of $3.2 trillion as of Jan. 31, 2016.
This seems like a lot, but the hedge fund managers are speculating that China can’t use all of the $3.2 trillion to defend the currency because some of it is needed to finance imports and other international obligations. Kyle Bass, for example, estimates that $2.7 trillion is tied up.
Chart of China’s total foreign exchange reserves (Bloomberg)
Lorenz also says a lot of the money is held in illiquid investments, like loans to Venezuela, and cannot be used to defend the currency like U.S. Treasurys, which China can sell at any time. As of December 2015, China had $1.25 trillion in Treasury holdings, according to the U.S. Treasury.
“Its stock of liquid assets with which it can defend its currency are probably a lot smaller than that $3.2 trillion. I’ve heard estimates of anywhere from $800 billion to $1.2 trillion of its reserves might actually be illiquid,” says Lorenz. The exact composition of China’s currency reserves is a state secret.
Enough Money
Peking University professor Michael Pettis, however, thinks China’s stash is large enough, at least for the moment.
“The appropriate amount of reserves China needs to guarantee necessary imports and the payment of obligations on the capital account is probably [$1.4 trillion],” he wrote in a note to clients of GlobalSourcePartners.
Pettis argues that the People’s Bank of China (PBOC) can actually draw on foreign currency within the banking system to defend the currency or use it for trade because the biggest banks in China are state-owned.
It’s all about staying in power.— Willem Middelkoop

He also notes that China has some reserves stashed away in a very unlikely place: commodities. China stockpiled a lot of base metals and energy commodities as soon as their prices started to decline a few years ago. State-run companies thought it was a buying opportunity. Because Chinese growth has slowed and many of the commodities haven’t been used, they could now be liquidated relatively easily for dollars.
“So China may actually have the equivalent of more foreign exchange reserves than reported, perhaps around $3.5 trillion,” wrote Pettis.
He also thinks China needs less working capital to finance imports because their prices have declined and it does not need to worry as much about export shocks like other countries. It exports more manufacturing goods rather than commodities, unlike Brazil and Australia for example. The Brazilian Real is down 28 percent against the dollar over one year.
The Brazilian Real versus the U.S. dollar over one year. (Google Finance)
But even Pettis says China can’t afford to keep bleeding reserves at the current pace, or it will result in a loss of confidence, regardless of fundamentals.
“If China continues to lose between $40 billion and $100 billion a month in reserves for many more months, the depletion in reserves itself becomes self-fulfilling as credibility is undermined,” he wrote.
No Devaluation
One compelling argument to solve China’s reserve drain is just to devalue 20 to 50 percent, be done with it, and keep the reserves. But this is unlikely to happen, says Lorenz.
“Chinese corporates have taken out large U.S. dollar and other denominated debt in the last couple years in a bet that the renminbi was going to appreciate. So you would first of all bankrupt the companies that had borrowed internationally,” he says, as they could not repay dollar-debt with earnings in renminbi which have dropped sharply in value.
He also notes that such a large move in an election year would only add fuel to the flames of the likes of Republican presidential candidate Donald Trump, who accuses China of being a currency manipulator.
Last but not least, it could also undermine China’s bid to become part of the International Monetary Fund’s (IMF) reserve currency in the Special Drawing Rights (SDR)

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China is probably looking forward to the new year. A fresh start on Feb. 8, putting all the currency chaos behind.
This may well remain wishful thinking, as events are going from bad to worse—and Jan. 6 is no exception.
The Chinese yuan fell 0.6 percent—this is a lot for a big currency—to 6.55, the lowest level since March 2011. Traders dumped the yuan after China’s central bank fixed its value 0.22 percent lower, another official devaluation.
China first devalued the yuan in August of 2015 and then intervened with great force in the market to keep its value relatively stable, spending $255 billion of its foreign currency reserves by the end of November.
China’s foreign exchange reserves as of Nov. 30, 2015. (Bloomberg)
After the International Monetary Fund included China in its basket of reserve currencies in November as well, Beijing reduced the reserve burn and let the currency drift down gradually.
Beijing also gave the market a fair warning, as it said it would index the value of the yuan against a basket of currencies, not just the U.S. dollar.
The yuan’s value in U.S. dollars dropped in 2015, but it rose against the trade-weighted basket. This gives Beijing justification to further devalue against the dollar.
(Capital Economics)
“China is going to have to dramatically devalue its currency,” Kyle Bass, principal at Hayman Capital Management LLC., told Wall Street Week. He thinks the devaluation could be as much as 20 percent.

So investors took heed and are getting out of the yuan as fast as they can. After all, why stick around to lose money in a falling currency. The problem: This herd behavior leads to, you guess it, a falling yuan. 
And while Chinese regulators can stop them from wantonly selling the mainland currency (CNY) because of capital controls, nobody is stopping them from selling the freely traded offshore yuan (CNH), mostly traded in Hong Kong
READ about China’s two different currencies here
The CNH dropped 1.1 percent against the dollar, trading as low as 6.70, the lowest since September 2010. The spread between the mainland and the offshore currency also widened to a record 2.5 percent.
Capital Outflows
Behind the move in the currencies is the tectonic shift in capital flows. Up until 2014, China attracted capital, driving the exchange up. Now capital is moving out, driving the exchange rate down.
“You’ve gone from a period which you had this one-way bet—the currency was going to appreciate, capital inflows—to the reverse. Having a period in which your own residents want to diversify into something else,” says Harvard professor Carmen Reinhart.
She thinks China is facing “a significant internal debt crisis,” which is why domestic citizens and international investors are moving their money out.
READ Carmen Reinhart on China’s Debt Crisis
“You do have a shift in capital flows and in fact, that shift has also accelerated purchases of real estate in London, in Boston, in New York. You see that it’s not just Treasurys. We see that from China and we see that from Russia,” she says.
Bloomberg estimates as much as $367 billion of capital left China in last three months of 2015. Epoch Times previously estimated capital outflows of $850 billion in the first nine months of 2015, so the total could be more than $1.2 trillion, the same as Societe Generale’s worst case estimate. 
China’s big trade surplus is the reason it didn’t have to sell more foreign exchange reserves to keep the currency from collapsing. 
Why Devalue
There is nothing China can do against the capital flows per se, expect for completely reforming its economy.
It can intervene in the markets by selling its foreign currency reserves to stop the exchange rate from collapsing. For the onshore yuan, it can also enforce capital controls more strictly, which it has done, but that goes against the promised reforms. 
However, given only bad choices, managing a gradual devaluation in the offshore and onshore yuan is actually the best of the worst.
Past currency crises, like the British pound devaluation in 1992, the Asian financial crisis in 1997, and the recent Ruble crash, show the value of the currencies will always drop to its equilibrium level—no matter how much a country spends intervening in the market.

So if the currency has to drop, China can at least keep its large stash of foreign currency reserves, although cynics may then ask what good are they for after all. 
“The foreign exchange reserves are just that: they are foreign. They are not renminbi [RMB]; they are not money that can be brought to bear domestically,” says Fraser Howie, author of “Red Capitalism.”
A lower currency on the other hand will support the country’s export sector, which, thanks to rising land and labor costs, is not as competitive as it used to be. Kyle Bass thinks a devaluation will help China “come back to some level of competitiveness with the rest of the world.”
It needs to compete not to generate growth, as many think. Although the Beijing Academy of Sciences just estimated GDP will only grow 6.7 percent in 2016 (below the official target of 7 percent)—it is employment and public sentiment that matters most to the regime.
The export sector still contributes around 10 percent to total employment.
Gordon Chang, author of “The Coming Collapse of China” says: “Where you have people just sick and fed up, especially when the system is no longer delivering prosperity. When you have real serious economic problems, I think people are going to say, ‘I’ve had enough.’”
Until then, the yuan has a lot further to drop.

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