Kyle Bass Interviews Mark Cuban: "AI Will Help The FANG Stocks Crush Bitcoin"

Entrepreneur and TV personality Mark Cuban is one of the most visible businessmen in America (present occupant of the Oval Office aside) - though whether his reputation is warranted or not is open to debate. LIke Trump, he is a master of self-promotion - he authored a popular business book - the aptly titled “How To Win At The Sport Of Business” (Cuban owns the Dallas Mavericks) - and is one of the hosts on a popular network reality TV show, “Shark Tank.”

And in an interview Kyle Bass for RealVision Television, Cuban shares his opinions on artificial intelligence and ICOs, which our readers know are two of the most-overhyped tech trends of the year.

But first, Cuban and Bass warm up with some small talk about parenting, where Cuban readily shares his strategy for raising kids to not become, in his words, “entitled jerks.”

MC: It"s like, you want something? You have to earn it. It may be doing math. Like, with my 8-year-old, it"s math for money. You have to answer math questions to earn $1 or $5.

 

With my middle daughter, it"s reading a non-school book. So, I"ll give her a history book or a biography. And she"ll make $20. If it"s over 300 pages, she can make more.

 

And then my oldest daughter is a challenge. My 14-year-old, that"s a whole different beast. All those things worked up until this year.

 

So, we"re working through trying to figure out what kind of jobs she can do. So, the point being that, I want them to recognize like I did growing up, that you have to earn what you"re going to get and that it"s just not going to be waiting for you. And so, whether that amount is $5 million like I have now or $10 million when they get to 30, then who knows? We can adjust. But it"s I think now is really where it matters and the habits that I get them into now are important.

While Shark Tank doesn’t pay as well as some of his other ventures, Cuban says doing the show is a labor of love. He says he enjoys hearing stories from parents about how watching shark tank inspired their kids to become more entrepreneurial.

In one notable aside, Cuban confirmed what many dedicated “Shark Tank” fans have probably suspected for years: The producers intentionally pick some of the more outlandish pitches (remember Cougar Energy? The energy drink shot marketed toward tired, single, middle-aged woman?) to inject a little excitement into the show.

Though sometimes the silliest pitches can yield surprisingly strong returns, Cuban said.

MC: Yeah. Because it"s TV, right? So, I invested in a guy - so when I first did the show - I came on as a guest 7 years ago. And there was a guy that did a little dance - I want to draw a cat for you, right? And I gave him $25,000 for a third of his company, and all we did was draw stick figures of cats. And he charged $10 a pop. And people were buying them. And so, literally, I got probably a 50% return of my $25,000 investment.

 

And also, on top of that, I got hired to do 10 cats at $1,000 apiece by somebody because the silliness of it is what sold. But I made the investment, not because I wanted to draw cats, right, but because he was really good at SEO. And so sometimes you see somebody who doesn"t really know how to manifest their skill set. So, you start with them here, and we did some things there, and then we took his creativity and pushed him into other areas. And now he"s on to bigger and better things, which is great by me.

Bass then moved on to asking Cuban a few questions about how he manages his $3.3 billion.

Cuban said he doesn’t think about investing strictly in terms of monetary return. When he chooses companies to invest in, he thinks in terms of the company’s overall impact.

Moving on, Bass asked how Cuban how he thinks about passing on his wealth to his children.

Cuban says he’s considering a similar approach to Warren Buffett whereby he leaves either $5 million or $10 million to each of his children in his will, with conditions so they don’t receive the money until they’re thirty. Cuban often speaks about how his teenage work experience selling garbage bags and delivering newspapers helped prepare him for life as an entrepreneur.

Cuban: So, when I wrote my will initially, it was $5, and not till they were 30, right? So that I wanted them to go through life. And I know my wife, if she outlives me - probably will - she"ll fill in the blanks like she does today, right? Like, my kids want money today, it"s like, how are you going to earn it? I"m not that dad that says here"s a present, right, here"s a bank account, here"s a debit card, just use it, or whatever-- no. Here"s your Amazon account. Not at all.

Their conversation soon turned to global central bank policy, and how aggressive money printing by the largest CBs has helped distort the global cash-to-GDP ratio, which now stands at around 170%, compared to historical levels of just 40%...

KB: Yeah. So, when we think about-- global cash balances today are the largest they"ve ever been. So when I think about what happened is - the first QE that happened in the US, and Europe, and Bank of Japan, Bank of England had to fill a hole, right? There was there was a hole.

 

Given the global financial crisis - global financial institutions were insolvent. They had to print that money. They had to inject it-

 

MC: No question.

 

KB: - in the banks. And that"s something that you and I would have done if we were running these institutions. Whether or not we agree with expanding fed balance sheets, we"d have to do it. So, the second part was the part that felt good, the part where we started to see some growth, and started to see cash getting distributed. And the interesting thing is it was fed policy was unintentionally distributed to the wealthy because the wealthy are the only people that could use leverage and assets, and they don"t spend it right away.

 

MC: And because of this drop in the stock market, people who could afford to lease got out of the market. And because so many people lost their homes, whatever savings you had, you used to try to save your house and to try to reimagine your life, if you will, and recreate your -

 

KB: Exactly right.

 

MC: And so, you"ve got a greater disparity in standards of living, and that"s where we are today.

However, this excess liquidity created by the central banks will eventually evaporate as advances in artificial intelligence and automation trigger a deflationary spiral as they push more humans out of the labor market.

Cuban believes that - for better or worse - automation will change the world, and that companies should be proactive about engaging in it.

Ultimately, this trend will benefit tech stocks like Amazon and Apple. The biggest tech companies, Cuban said, are going to continue to swell in size, influence and profitability.

KB: - so innovational that we"ve had good deflation. But I think now, when you look at the price of just about anything in life, it"s going up. My view -

 

MC: See, I would disagree. Right. I think artificial intelligence is going to change everything, everything, 180 degrees. I"ve been in the tech business. I started selling PCs in 1982, right? I started selling local area networks - we were the first companies - my first start-up in 1983. I sold that, and then I started trading just tech. I started a hedge fund - started just trading tech stocks - sold that within 90 days. And then we started streaming, then first hide - all these things have happened that have changed how we do business, changed how we lived our lives, changed everything, right, the internet. But what we"re going to see with artificial intelligence dwarfs all of that.

 

KB: And you think it will be deflationary?

 

MC: Yes. Because there"s going to be -

 

KB: Because it displaces jobs?

 

MC: A lot of jobs.

 

KB: OK. That"s not good.

 

MC: Well, you can make arguments, right - it"s not a question of how it plays out over 100 years. It"s a question of how plays out over 10 years, 20 years, right? Who knows what exactly - But I can tell, at the beginning, which jobs are going to be displaced. I can tell you the real estate is going to be displaced. I"ve talked to major companies that, they"re asking me, Mark, we"re going to have all this extra real estate in all these towns. What are we going to do with it? Do you have any ideas? And I"m talking to them about -

 

KB: Because they"re going to be centralizing their operations?

 

MC: Just fewer people.

 

KB: Fewer people.

 

MC: Yeah. Just fewer people. So, the concept of you calling in to make an appointment to have somebody pick up your car to get your oil changed, right-- someone will still drive to get your car, but there"s going to be no people in transacting any of it.

 

KB: That"s terrible.

 

MC: It is what it is.

Cuban says he agrees with Vladimir Putin’s assessment that whichever country wins the AI innovation race could wind up controlling the world.

KB: Or best professors, for that matter. They"re pulling them out of school.

 

MC: Exactly right. And so, Vladimir Putin says the winner in AI controls the world. China puts together a future plan saying whoever dominates in AI-- and they"re subsidizing Tencent, Alibaba, et cetera, right?

 

KB: They know it"s a race.

 

MC: It is a race. We cut our Office of Technology and Science to one person who was an assistant to Peter Thiel. That"s where we stand. So, we talk about infrastructure jobs, robots are built in Germany, and they"re getting bought by Chinese companies. In some respects, I think some Japanese companies bought as well. We don"t build robots here very well, right? I just invested in my first robotics company, Hirebotics that puts robots into companies. They"re in Kansas City, I think it is, now.

 

But they lease and rent and sell robots into all these different types of circumstances to replace people, right? But I had to learn. I"m not saying it"s a good thing or a bad thing. It"s going to happen with or without me. But I wanted to learn what was going on. Those building up a robotics industry here, investing in our AI industry here, that"s the new infrastructure. Because if we don"t do it, and China or Russia win those wars, we"re SOL. We"re out of luck, right?

 

And so, when we talk about the price of assets going up - if you"re talking about intellectual assets, if you"re hiring, like we were just saying, the price is skyrocketing. Montreal has become the center of the universe for computer vision. It"s not US-based schools that are dominating any longer in those areas. We"ve got lots more kids - MIT, all different schools, right? And kids are starting to realize there"s a place for them to go. And I"m out there telling people, the first trillionaire is going to come from somebody who comes up with something - 

Asked for his opinion on digital currencies, Cuban likened the inherently deflationary bitcoin to a work of art that appreciates as it ages.

But in Cuban"s view, the biggest tech stocks will eventually outperform bitcoin as they master the ability to innovate while also achieving massive scale.

KB: It"s just a digital asset that"s a collectible? Yeah.

 

MC: Right? And in this particular case, it"s a brilliant collectible that"s probably more like art than baseball cards, stamps, or coins, right, because there"s a finite amount that are going to be made, right? There"s 21.9 million bitcoins that are going to be made. And if enough people hold and don"t sell, and enough people borrow to buy, just like we saw in the stock market. Because look, as much as a share of stock is ownership in a company, that"s the all-time lie, right? You have no authority, no ownership.

 

KB: Unless you control it.

 

MC: Yeah. Unless you"re the controlling shareholder, or you are willing to spend a lot to make a lot of noise.

 

MC: It depends on what my expertise would be, right? I mean, I always tell people to  focus on what you know. And if you don"t know, just put it in an SPX cheap fund, right? And maybe, now, I might say, OK, put 5% in Bitcoin or Ethereum, just red or black, right? Because it"s like artwork, but it has -

 

KB: A finite amount of artwork.

 

MC: There"s a finite amount of artwork, right, or baseball cards. But yeah, I would just tell people an SPX fund. Because I think the job of America is still business. And I think, whatever benefits will come from AI or whatever, is going to--

 

KB: Filter into -

 

MC: Yeah. And I think the FANG stock"s are going to crush them. My biggest public holding is Amazon.

...Before the conversation turned to ICOs. Cuban insists ICOs are “an opportunity” though he says he avoids the “speculative” side of the market....which is confusing because the market is a massively speculative bubble where products are rare and “pitches” are legion.

KB: And then, when you move into ICOs, how do you think about ICOs? You mentioned
to me, it"s a seat license.

 

MC: Yeah. That"s exactly right. ICO tokens really are an opportunity - there"s two there"s two different ways to look at ICOs, right - one, as a quote unquote, "investment vehicle," which I don"t, right? Again, that"s just a scarcity play. It"s like it"s like an IPO in some respects. It"s just, if the float is small, and you can convince enough people on the road show to buy, it"s going up, right?

In summary, Cuban is categorically bullish about AI and ICOs, which is unsurprising. After all, he’s a tech guy who made his fortune selling broadcast.com to Yahoo in what turned out to be an ill-fated acquisition for the once-mighty internet giant. Still, if one has billions of dollars to invest in projects based on their purported “impact”, so-called “opportunities” in the ICO market are never in short supply.

Kyle Bass: "Today"s Market Resembles The 1987 Debacle On Steroids"

The US stock market celebrated the 30th anniversary of Black Monday with the 2017 version of a rocky trading day: Stocks sold off early, with S&P 500 futures recording their steepest post-midnight drop of the year. But the dip was reflexively and aggressively bought, and stocks even poked back into the green seconds before the close as algos mistook a repetitive Politico headline about Jay Powell’s chances of becoming the next Fed chair for news - leaving us with yet another record close.

Of course, the historical juxtaposition of the 1987 crash with today’s unnaturally placid markets practically forced even the most bullish of traders to question how much longer the present market paradigm - where markets listlessly drift through a seemingly interminable series of record highs while trading volume and volatility remain suppressed - can possibly last.

With that question in mind, Real Vision released a video early today containing interviews with some of the biggest names in the hedge fund universe. Though the interview was shot a few weeks ago, remarks from Hayman Capital’s Kyle Bass resonated with market"s mood.

Bass discussed what he sees as the many short- and long-term risks to the US equity market, including the rise of algorithmic trading and passive investment, which have enabled investors to take risks without understanding what they’re doing, leaving the market vulnerable to an “air pocket."

And with  so many traders short vol, Bass said investors will know the correction has begun when a 4% or 5% drop in equities snowballs into a 10% to 15% decline at the drop of a hat.

“The shift from active to passive means that risk is in the hands of people who don’t know how to take risk. Therefore we’re likely to have a 1987 air pocket. This is like portfolio insurance on steroids, the way algorithmic trading is now running the market place.

 

Investors are moving from active to passive, meaning they’re taking the wheel themselves all at a time when CTAs are running their own algo strategies where they’re one and a half times long and half short and they all believe they can come out at the same time."

 

“If you see the equity market crack 4 or 5 points, buckle up, because I think we’re going to see a pretty interesting air-pocket, and I don’t think investors are ready for that,” Bass said.

When it comes to identifying potential catalysts, Bass said the US’s deteriorating relationships with both China and North Korea present significant long-term risks...

“Our trade relationship with China is worsening our relationship with north korea whatever it is continually worsens. We’ve got three people at the head of these countries that are trying ot maike their countries great again, I think that’s a real risk geopolitically."

...While the unwind of G-4 central bank stimulus could hammer equities and bonds in the short term.

"But when you think about it financially, which is actually easier to calculate, the financial reason is the G-4 central banks going from a period of accommodation to a period of tightening, and that’s net of bond issuance."

In summary, investors better snap up those out-of-the-money S&P 500 puts before it’s too late, because central banks - try as they might - can’t forestall the return of volatility forever.

Kyle Bass Sounds Off On "Worthless" Puerto Rican Debt, The Crypto "Gold Rush", And Guns

With the dollar’s recent post-Fed bout of appreciation providing some much-needed relief for Haymarket Capital’s P&L, its founder Kyle Bass sat for an interview on Friday with Bloomberg’s Erik Schatzker. During the 20 minute discussion, Bass expounded on the importance of holding gold, his cautiously optimistic view on digital currencies, the misguided notion that holders of Puerto Rican debt will someday be made whole – oh, and Bass’s next big call: Long Greece - particularly the stocks and debt of Greek banks.

A few weeks ago, Bloomberg view published a Bass-penned editorial in which the hedge fund founder and CIO called on the IMF to stop bullying Greece -  publicizing the fact that he is now effectively long Greece. Greek government bonds have performed reasonably well so far this year: They’re up about 16%.

And if Bass is right, they could have another 20% to 30% over the next 18 months if the IMF abandons its insistence on austerity and acknowledges that debt relief will need to be part of the long-term alleviation of debt. Bass added that, in the near future, voters will elect a more business-friendly government that will help reestablish the country’s creditworthiness, much like the government of Mauricio Macri did for Argentina. 

I think you also have an interesting political situation in Greece where I think there"s going to be a handoff from the current Syriza government to kind of a more slightly-center-right but very economically independent new leadership in the next, call it, 18 months.

And so, I think you asked why now? And I think you"re starting to see green shoots. You"re starting to see the banks do the right things finally in Greece and you are about to have new leadership.

So, I think that you"re going to see - and if you remember Argentina as Kirschner was going to hand-off – hand the reins over to someone that was much more let"s say focused on business and economics than being a kleptocrat, I think you"re going to see something again slightly similar in Greece where you have leadership today that might not be the right leadership and the government-in-waiting, I believe, and I think you know Mr. (Mitsutakous) - I think you"re going to see something great happen to Greece in the and next, kind of, two years.

Asked if he still considers himself a China bear after the yuan’s surprising run of strength against the dollar, Bass answered in the affirmative. But the language he uses to talk about China has softened notably, with the investor now expecting a correction instead of an all-out collapse.

Chinese President Xi Jinping has been laser-focused on consolidating power during this year’s quinquennial Communist Party National Congress, set for Oct. 18. Once it passes, Bass believes that the PBOC’s grip on the yuan exchange rate will loosen and market forces will reassert themselves. Meanwhile, the country will also relax its focus on appeasing President Trump.

What I"m telling you is my guess is their laser-like focus on exchange rates and dealing with the Trump Administration is going to be relaxed a bit once Xi consolidates his power.

You know, their electoral cycle is a little different than ours if you want to call it that. Their NPCs happen every five years. Xi - this is the end of his first term. He"s going to solidify a second term. He"s going to reconstitute the Standing Committee of the Politburo and we think that he has consolidated power.

He"s quickly becoming the most powerful Chinese ruler since Mao and the question is will he have a third term. And so, once this consolidation of power is over and the NPC is finished I think you"re going to see more natural economic forces acting on their banking system.

He acknowledged that the appreciation of the yuan "has been terrible this year" for his hedge fund, which has predicted that the yuan would fall more than 30%. But he’s standing by the position for now with the expectation that over the next nine months “you’ll see the rubber hit the road.”

It"s been terrible this year. And again, you think about the time continuums of these big global macro events.

Unfortunately, it doesn"t fit into a nice envelope that works every month, every quarter, every year. And so, you have to stick with it as long as you can and in this environment, I think in the next call it nine months from October you"ll see the rubber hit the road.

Bass scoffed at the notion of investing in Puerto Rican debt, saying that investors would be lucky to walk away with between 10 and 20 cents on the dollar. The idea that the island, with a workforce of just 1.4 million people, will ever be able to pay back $70 billion in debt is ridiculous, he said.

These are two different questions - one is, should we help with hurricane? Absolutely. We should do everything possible.

Puerto Rico is just a simple math 101 question.

But on the debt question I just think you have to be a little crazy to think that $100 billion worth of debt or even $70 billion of on-balance sheet debt is worth anything with 1.4 million workers in an economy like Puerto Rico"s.

…

When you look at sovereigns and you look at history of sovereign defaults, recoveries and wipeouts are $0.10-$0.20 on the dollar - that"s what I think people are going to end up with.

Asked for his view on bitcoin, Bass said he’s accepted that he was wrong to dismiss it early on, saying he failed to grasp the technology. He acknowledges now that digital currencies are a “real asset class”. While he hasn’t yet figured out how to value digital assets, bitcoin’s deflationary features would presumably make it a strong performer as inflation rebounds over the coming years, Bass said. Bass said he doesn’t own digital currencies.  

Early on I summarily dismissed bitcoin and I shouldn"t have. And didn"t understand - truthfully, I don"t understand the depth of the algorithms, the technology and the fundamental foundation of bitcoin I didn"t understand. I spent a lot of time trying to understand it in the last call it six months and I believe that the digital-asset class of cryptocurrency is a real asset-class but in terms of kind of how the world views digital currencies we talked - when you look at global cash positions today given global Q/E, they"re now north of 110 percent of global GDP. So, we"re talking about almost $100 trillion of cash in the world.

That has never happened before in world history and so when I think about inflation - you"re starting to see wages move. You"re starting to see the price of all goods and services move. The thing that"s been really deflationary in the globe has been technology. It"s been a very positive deflationary force and I think that"s played out.

The technological deflation has played out so, now I think you"re going to start to see inflation and wages move. And this gets into crypto-currency.

The collective value of crypto currency is a little over $100 billion today. Global M2, global cash is like $80 trillion, $100 trillion; so, what"s $100 billion? The question is, what"s it worth? And as a store of value, a media of exchange and other currency I don"t think there"s any true institutional investor has any money in bitcoin – I know some have a little bit. They have nominal amounts invested but I think it will be an asset class that will work over time. I"m not sure how to value it yet - I really have no idea.

To be sure, Bass expressed skepticism about the red-hot market for ICOs, referring to it as a “digital gold rush” that will end with “a lot of people losing a lot of money.”

I think there"s a digital gold rush that"s gone on.

I think a whole bunch of people are going to lose a lot of money. These ICOs - you"re going to see a bunch of them go completely broke - a bunch of them are frauds. And that"s going to be problematic for all the people that just rushed in and so I feel like it"s a bit of a mania at the moment but

With the end of the interview approaching, the conversation veered toward gun control. Bass said that he and his son own dozens of guns and are close to many members of the armed service. However, he still believes that the state and federal government should maintain comprehensive gun registries, even though such precautions probably wouldn’t have stopped Las Vegas shooter Stephen Paddock from carrying out his horrifyingly deadly crime.

My son and I have this - we have this place here that we enjoy and when I think about this debate - should guns be registered? Absolutely. Should people be able to sell a gun from one to another without recording the buyer and the seller? Should every gun have a serial number and be registered with the federal government and local authorities?

I think this is a no-brainer. That"s just a pragmatist. The NRA fights that tooth-and-nail.

After all, people need to register their cars with the state, Bass said. Why not guns, too?

So, to sum up: Buy Greek bonds, buy Greek debt; hold gold, hold bitcoin; sell Puerto Rican debt, sell ICOs, sell yuan warning that "within nine months, the rubber will hit the road" on China"s currency collapse, and register all your guns...
 

Kyle Bass: China's $40 Trillion Banking System Has "Largest Imbalances I've Ever Seen"

Kyle Bass’s Hayman Capital has been having a rough year thanks to its widely publicized bet against China’s currency, which has more than reversed its 2016 decline – its largest annual drop since 1994 - as the People’s Bank of China has cracked down on potentially destabilizing capital outflows.

However, Bass – unlike a handful of other former China bears who’ve been forced to scale back, or even reverse, their positions – has said that he is standing by his belief that China’s corporate sector is massively overleveraged, and overdue for a collapse that could destabilize the global economy. Chinese banks, according to Bass, have more than $40 trillion in assets held against $2 trillion in equity.

The dollar’s bull run against the yuan last year helped spark capital outflows as wealthy Chinese worried about the depreciation of their currency. In response, the PBOC tightened restrictions on foreign-exchange transactions for individuals, local companies – quashing a roaring international M&A boom – and even foreign companies, which in some cases have struggled to pull their money out of the world’s second-largest economy.

“So what"s going on right now? Let"s get the elephant out of the room. Let"s talk about China.

Kyle Bass: OK, how much time do we have?

RP: As long as you need. Where are we? What the hell"s going on?

KB: We"re in the such late stages of a game that is the largest global imbalance I"ve ever seen in my life. When you look at on balance sheet and off balance sheets, you look at on balance sheet in the banks, you look in the shadow banks. The number of total credit in the system, China is right at $40 trillion. Think about the number I just said. $40 trillion. And that"s using an exchange rate of call it 6.7 to the dollar, right? So it"s grown 1,000% in a decade. And we"re on a $40 trillion credit system on $2 trillion of equity on maybe $1 trillion of liquid reserves.

RP: Where do you get the equity and liquid reserves from?

KB: Well, it"s the amount of equity in the banks of China. It"s right at about $2 trillion. So that"s kind of a stated number. The reserves is my own calculation, right? The Chinese magically have leveled their reserves out around $3 trillion, which happens to be the minimum level of IMF reserve adequacy as defined by the IMF rule.

RP: So what have they been doing now? So, they were under pressure, and then everything kind of eased off, I guess, as the dollar started weakening a bit.

KB: Yeah. Actually, they"ve done three things. Well, so four things have caused this, quote, easing off that you refer to. Three have been driven by SAFE and the PBOC, one that"s been driven by our illustrious Trump. So the first three are, number one, they essentially halted all cross-border M&A. So if you look at the parabola of M&A coming out of China from 2012 to 2016, it reached dizzying heights in 2016. In 2017, it"s like 15% of the 2016 number and no new deals being announced. Now, they"ll always be some outbound M&A that"s driven by really policy at the Communist Party level, right?

They"ll always buy copper mines in Uganda. They"ll always invest in ports in Greece. They"ll always do things that are from a strategic perspective and a policy perspective. The things that the Communist Party needs to procure resources for its people over the long-term. But when you look at the rampant M&A of money leaving China, they just put a halt to it in November of 2016.

And the second thing they did was they made it impossible for multinational corporations to get their profits and or working capital out of China. And that"s something that has been a problem for a lot of the multinationals that do business in China.”

When asked how he intends to trade China’s inevitable unraveling, Bass said he believes the “ultimate” arbiter of China’s “entire macro situation” is its currency. He intends to remain short, with a target date between November 2017 and June 2018.

“RP: Somebody"s going to be holding that baby in the end, and China"s got the biggest basket in the short dollar issue.

KB: Yeah, but just think, just since January, the dollar index has gone roughly 103 to 92 and change. It"s come in 10% in less than a year. That is an enormous move. And it"s actually pretty beneficial to the US from a trade perspective, right?

RP: Yeah.

KB: Trump figured out very quickly that making America great again doesn"t mean a big, strong dollar. But I think the fourth thing that"s really affected the exchange relationship has been Trump"s inability to get anything done on the Affordable Care Act repeal and replace. Therefore, nothing"s being done on comprehensive tax reform. All we"re hearing now is there"s going to be a tax cut. Well, that"s not going to balance anything. And so his kind of inability to get anything done has also forced the dollar much lower.

RP: So, give us some timings how this plays out. What kind of ways are you looking at? Are you just looking at a currency trade here? Is that the most efficient way of doing this?

KB: That"s it. The ultimate arbiter of the entire macro situation I just described to you is the currency. So that"s where we stay.

RP: And what about a time horizon? I know it"s difficult. I don"t want to pin you down.

KB: Well, no, it actually requires you to pin me down because our investors pin us down.

RP: OK, so when the f***"s this going to happen?

KB: So my best guess is between November and call it June. November 2017, June 2018.”

Foreign multinationals have continued to do business in China despite an array of obstacles, including the Chinese economy’s implicit bias toward state-controlled companies. But now that the Chinese have erected all these barriers preventing multinationals from repatriating profits, Bass expects companies will eventually give up on the “carrot” that is the unrivaled growth potential of the world’s second-largest economy.

“RP: It sounds like they"ve got a temporary fix in place. So what changes the dynamic of that then forces those reserves lower? Because if we"re looking for this whole situation to kind of, you know, the apple carts get upset, how does that happen?

KB: Yeah. What"s interesting to me is, so -  the answer is I"m not sure. I know that in an effort to maintain economic and political stability for the 19th Party Congress, which happens this November 2017, Xi, and Wang, and the ruling elite of China wanted to maintain the stability, needed to maintain it at all costs. And so they"ve tied a knot at the end of their proverbial rope and they"ve been hanging on. But imagine if you"re Qualcomm, Ford, GM, Visa and you can"t get money out of China, you have a US auditor. And so you go through the end of the year, and they"re going to have to rethink how those profits are classified and maybe even how the working capital is classified.
And so it"s my view that they can"t do this forever. And to the extent that a multinational doing business in China is really having severe restrictions on their capital, they"ll just move to Cambodia, or Vietnam, or they"ll move somewhere in the region and start doing business elsewhere.

China wields this economic sword so beautifully. The carrot is so large. The delusion of riches is so great that companies and even investors are willing to suspend disbelief to chase that carrot, and the Chinese know it. And they do a masterful job.”

After highlighting the fact that the real risks to the Chinese economy involve financial stability, President Xi Jinping has begun a crackdown on shady WMP issuance and risky lending in the banks. But as Bass says, “it doesn’t matter who you parachute in to pilot the Titanic after it hit the iceberg.”

“So I think they"re kind of focused on getting through the NPC, and we"ll see what happens.

RP: When is that?

KB: So the way the Chinese electoral system works, it"s every five years. And so that"s this November. So they have kind of a presidential cycle every five years.

RP: And so, I"ve heard this before, is that seems to be a significant date that they just want things to go smoothly, and then they can take some harder measures to try and rectify the economy afterwards.

KB: That"s correct.

RP: And do you get any sense of that within China itself when you talk to people?

KB: You know, they"ve spent a lot of time on trying to get banks to do debt for equity swaps. Xi himself has said the real risk in the economy is financial stability. And really, he"s trying to crack down on excessive WMP issuance and risky lending in the banks. But it"s like, it doesn"t matter who you parachute in to pilot the Titanic after it hit the iceberg. It almost doesn"t matter.

My point is they have some brilliant people at the PBOC. They have some brilliant people in the Communist Party. But we had a lot of brilliant people in the United States that have been running capital markets for over 100 years, and you know how bad we screwed it up. And we only had $17 trillion on balance sheet in the banks, maybe another $5 trillion off balance sheet in an economy $17.5 trillion, and we detonated our banking system. They"ve got four times what we had."

In summary, China’s crackdown on outflows and bad debt were meant to ensure stability ahead of the Communist Party’s quinquennial leadership elections in November. Afterward, Bass expects a certain degree of complacency to develop regarding the economy. The country’s banking system has become too sprawling to control.

The collapse will arrive, Bass assures his listeners. Profiting from it is a matter of getting the timing right – something that’s incredibly difficult for short sellers.

Listen to the rest of the interview below:

Bitcoin's Biggest Bull Isn't 'Long Crypto', He's 'Short Government'

Six years ago, Kyle Bass provided a crucial context for the debt-laden world of ever-increasing sovereign debt:

"Buying gold is just buying a put against the idiocy of the political cycle. It"s That Simple"

And now, as interest in Bitcoin surges, Arthur Hayes, a former CitiGroup trader who runs BitMEX - a Hong Kong-based crypto exchange - asks an interesting question - In the coming war between digital currencies, which side will your money be on?

As CoinDesk reports, Hayes thinks blockchain is lighting a fuse that will ignite open combat between "true cryptocurrencies" (like bitcoin) and a new "digital fiat" controlled by central banks.

These two parallel currency systems are the inevitable outcome of his core investing thesis:

"A digital society needs digital cash."

In other words, bitcoin has brought the world cryptocurrency and institutions of all kinds will use the technology to their advantage.

Here"s what Hayes sees shaking out as a result: Governments will respond to the proliferation of cryptocurrency by withdrawing banknotes from circulation, and governments will issue digital fiat that functions similarly to cryptocurrency.

But don"t be fooled, according to Hayes, the similarities here are all on the surface.

Government-controlled digital fiat will be the antithesis of absolutely everything true cryptocurrency stands for. Central bank"s issuance of digital money will lead to a brave new world where governments are able to monitor and control every single transaction in an economy.

And countering that overreach is the reason Hayes believes bitcoin and other cryptocurrencies have a value proposition not just today, but for years to come.

When Hayes talks about digital money, he sees the scope of battle on a truly global scale, not just within the U.S., but all across Europe, in China and in India.

What all these country"s governments have in common, according to Hayes, is the desire to use digital fiat as a tool of economic control.

He sees digital fiat as an instrument that will allow governments and global central banks to monitor every financial transaction, tax every sale and even lock out people from the payment system if they don"t have the right government-issued licenses.

Shifting digital fiat into cryptocurrency, he reasons, will be the only way to preserve privacy. Plus, cryptocurrency will allow individuals and businesses to trade in jurisdictions where parties don"t trust electronic fiat – or each other, for that matter – because they know cryptocurrencies cannot be tampered with.

Hayes said:

"If you want to have a financial presence – and not have somebody else know what you"re doing at all times – then you"ll use a form of cryptocurrency."

A form of cryptocurrency that"s true, like bitcoin, zcash, monero or dash, he says, is one that offers users both privacy and security.

But there may be limits to the value propositions of even true cryptocurrencies today. For example, Hayes sees small value transactions are out of line with a once resounding narrative in the space, that bitcoin is – and should be – a payment system for consumers. Hayes told CoinDesk:

"I don"t think bitcoin is going to replace consumer facing activities, like buying a cup of coffee or buying a magazine at a 7-Eleven."

Hayes called bitcoin"s user experience "terrible" for these purchases, because public blockchains are slower than private payment systems. So, for a trip to Starbucks, buying coffee with Apple Pay is a better experience than paying with bitcoin, he contends. It"s an interesting observation in that many of bitcoin"s strongest proponents tend to envision a world where the cryptocurrency is used for everything. Even still, Hayes is just as bullish on bitcoin, as he continues to reiterate what a fantastic mechanism it is for online international payments and anonymity.

And "those trade flows are massive," he said.

China Capitulation: Corriente Advisors' Mark Hart Ends 7-Year Bet On A "Massive Yuan Devaluation"

China bears like Kyle Bass claimed victory last year after bets that the Chinese yuan would weaken paid off handsomely – particularly if they were supercharged by leverage. Hopefully, for their sake, yuan decided to lock in those gains early this year. Because since January, China’s currency has whipsawed higher, reversing most of its 2016 depreciation as the US dollar has endured a period of broad weakness, and Chinese policy makers have turned their attention to managing the currency’s valuation against a basket of currencies.

But Mark Hart, who, like Bass is a Texas-based fund manager, and who built his bear case against China on the theory that the PBOC would opt for a series of one-off devaluations in the yuan, instead of allowing it to gradually depreciate, which would be tantamount to a policy error.

Here’s more from a post on Hart’s outlook that we published last year:

“Hart believes that the Chinese crawling devaluation is an error as it carries with its the latent threat of much more devaluation in the future, thus encouraging even more outflows, which in turn forces China to sell even more reserves, which destabilizes the economy even further, forcing even more devaluation and so on.

Instead, a one-off devaluation would allow policy makers to “draw a line in the sand” at a more appropriate level for the yuan, easing pressure on China’s foreign-exchange reserves and removing an incentive for capital outflows, according to Hart, who’s been betting against the currency since at least 2011. He adds that China should devalue before its $3.3 trillion hoard of reserves shrinks much further, he said, because the country can still convince markets it’s acting from a position of strength.”

According to Hart, while a devaluation this year would be “jarring” and may initially accelerate capital outflows, it would ultimately put China in a stronger position. He said the country could explain the move by saying it would put the yuan at a level more reflective of market forces and allow the currency to catch up with declines in international peers.

However, the 50% devaluation that Hart had been anticipating never materialized. So, after seven years, Bloomberg is reporting that Hart has (pun intended ) had a change of heart after spending $240 million on his losing bet against the currency, which nearly cost him his sanity.

Hart is now taking the other side of the trade, joining the ranks of Bridgewater Capital’s Ray Dalio and other yuan bulls:

“Mark Hart spent seven years and $240 million waiting on a crash in China’s currency.

He lost sleep. He lost clients. He damn near lost his sanity.

And now he’s lost his conviction: Hart, who called for a more than 50 percent yuan devaluation last year, has turned bullish on China and its currency.”

According to Bloomberg, Hart’s dedication to his short-yuan position left employees demoralized at his Fort Worth, Texas fund. Hart claims that his investing thesis was sound. His biggest mistake? Hart says he was “too early” in putting on the trade.

“His reversal hasn’t come easily. From his base in Fort Worth, Texas, the hedge fund manager spent countless nights on the line to Hong Kong, parsing market news and exchange rates. At times, the stress took a toll on Hart personally and left his employees demoralized.

‘I always thought we had a good risk-reward trade on, but we made a number of mistakes, including being way too early,’ Hart, who started the yuan bet after predicting both the U.S. subprime mortgage bust and the European debt crisis, said in a telephone interview. ‘And now the world has changed.’”

Hart now believes that G-20 leaders tacitly conspired to a “Plaza Accord”-type agreement to stanch the dollar’s appreciation while putting a floor under the yuan last February during a G-20 summit in Shanghai.

“In cool hindsight, the 45-year-old founder of Corriente Advisors sees last year’s Group of 20 summit in Shanghai as a key turning point. Like many investors, Hart suspects the meeting resulted in a tacit agreement among world leaders to prevent the yuan from tumbling. He calls it China’s “whatever it takes” moment - when policy makers resolved to prop up the currency at any cost.”

The agreement has tremendously benefited China, Hart says.

“‘China now has the breathing room it needs to either temporarily stave off a slowdown with fiscal and monetary stimulus, or reform, grow and upgrade itself into the world’s largest developed economy,’ Hart said.”

Regardless of whether Hart’s “conspiracy theory” is accurate, China has clearly succeeded in stabilizing the exchange rate. The yuan ended a three-year slide in late December and has rallied almost 7 percent in 2017. China’s central bank strengthens its daily reference rate for onshore yuan for a ninth day on Thursday, the longest run of increases since January 2011. The PBOC raised the yuan reference rate by 0.06% to 6.5269 per dollar, extending the strengthening streak since Aug. 28 to 2%. Meanwhile, the offshore yuan surged, sending the USDCNH below 6.50 for the first time since May 3, 2016.

Even at its weakest point, the yuan never weakened enough for the options that Hart originally purchased in 2009 to pay off. His dedicated China funds, which had fixed lifespans, bought options that were designed to deliver one of two outcomes. According to Bloomberg, a massive payoff in the event of a currency crash, or a near total wipeout if a major devaluation failed to occur.

"China Faces Its Comeuppance" - Kyle Bass Warns Of "Tectonic Shift" In US Relationship

Hayman Capital"s Kyle Bass ventured on to CNBC this morning to drop some painful truth bombs about Trump"s "drastically changed Chinese diplomacy" and China"s looming "come-uppance."

Bass began by highlighting what he calls a "tectonic shift" in US-China relations in the last few days, pointing to two crucial events...

1. Things changed drastically when US launched unilateral sanctions on China over North Korea...

"Xi is a control freak and he absolutely doesn"t appreciate the United States acting unilaterally"

2. Things escalated when Trump sold $1.4bn in weapons to Taiwan, angering Beijing more as Bass notes:

"Taiwan was the one area which Beijing has asked Trump to stay away from during his meeting at Mar-a-Lago."

"Since the death of Otto Warmbier, any chance of meetings with North Korea are now off.. and our diplomatic relationship with China took a major step for the worse yesterday."

Bass notes that "China is trying to make marginal changes in its balance of trade with US - buying beef once again and importing a lot more crude oil from the US."

But then Bass shifts to the potentially even more precarious situation under the hood of China"s economy. As Reuters reports, China"s leaders want the restructuring of their massive non-performing loans problem to address financial risks while avoiding big employee lay-offs, and have instigated "cure by committee"...

"The solution for zombie firms isn"t just bankruptcy," a Shandong-based banking official told Reuters. "The impact of bankruptcy is just too big. Just think about the thousands of workers. Social stability is key."

Stability is always uppermost in the minds of Chinese leaders, and even more so this year, ahead of the five-yearly party congress this autumn, when a new generation of senior leaders will be selected.

"China is avoiding the crisis of calling in loans that can"t be repaid anyway," said Paul Gillis, professor of accounting at Peking University"s Guanghua School of Management. "This buys time to do things in an orderly way."

But Bass makes the crucial point that there are over 12,800 credit committees in China right now - overseeing CNY 14.5 trillion in debt for equity swaps - which is 8% of China"s total non financial debt, and is over 3x the official NPL figure of 1.6%-1.9% of GDP.

His final blow to any hopes that this solution will work...

"This exceeds all the equity in the entire Chinese banking system."

However, Bass"s final warning of the endgame of this credit bubble is far more ominous, because all of the new-found economic confidence and military condidence is "based upon a massive credit expansion and they"re going to have a comeuppance..."

Crisis Meet China - China Meet Crisis

By Chris at www.CapitalistExploits.at

Earlier this week, Kyle Bass spoke on Bloomberg about the reckless expansion of the credit system in the Middle Kingdom.

He warned about the ballooning asset-liability mismatch in the shady $4-trillion wealth management products (WMPs) market.

And went on to say "this is the beginning of the Chinese credit crisis" while admitting it could take some time for things to really start unraveling.

A fair call...

How many of us have figured the trend out, only to allocate too much capital to a trade and even lose on a trade which finally works... eventually? I know I have. I"m pretty sure Kyle"s position sized pretty well. After all, this is far from his first rodeo.

In the interview Kyle referenced an SCMP article from a few weeks ago that went largely unnoticed by most. It was on the Chinese government coming up with more and more creative ways to stem the capital outflow underway since mid-2014:

"China"s foreign exchange regulator, SAFE, has asked for cooperation from multinationals, including Sony, BMW, Daimler, Shell, Pfizer, IBM and Visa, to manage and control the flow of capital out the country."

This all feels a bit deja vu-ish.

Long-time readers will know we"ve been bearish on China and the renminbi for well over 2 years now. Back in October 2014 we said that:

"I don’t know exactly how a breakdown in the renminbi will play out. However, it is a sure bet that all those markets that prospered over the last 15 years or so on the back of a China will do badly. Where things become shady is the collateral damage to other markets that have had nothing to do with the Chinese economic miracle."

A few months later, we took a closer look at the cracks appearing in China"s interbank lending market, indeed feeling (correctly in hindsight - lucky us) that timing had arrived to short the currency cross via the options market:

"The interbank lending market is an integral part of any country’s banking system as it is where banks maintain their short-term liquidity requirements. Often a bank will have a mismatch between between short-term assets and obligations and as such they will have to enter the interbank lending market to maintain optimal liquidity. If a bank has excess short-term reserves they may want to lend these out to other banks who have a shortfall in short-term reserves. The opposite also occurs where a bank, with a short-term funding deficit, will enter the market to borrow funds to match short-term liabilities.

The behavior of the interbank lending market can provide one with a good appreciation for the liquidity of the banking system as a whole. If there is a lot of liquidity in the system (more short term assets than liabilities) the interbank rate will fall, if there is scarcity of short term assets relative to liabilities then rates will rise. So a rising interbank rate is generally associated with contracting liquidity conditions. Rapid rises in interbank lending rates are often associated with banking or credit crisis. This happened in the lead up to the GFC. What happened was that as banks began to fear the ability of other banks, who are their counter-parties, to make good on their obligations they demanded higher rates especially from banks already facing liquidity problems which only compounded their original the situation.

A rapid rise in a country’s interbank lending market is also a good predictor of the direction of a country’s currency, or at worst a confirming indicator. Let’s have a look at the interbank lending market of a few emerging nations over the last 12-18 months and then look at what is happening with the renminbi. I think it is instructive for what we have been positioning for in our funds."

In truth, it was an easy bet to make.

Volatility was around 2%! NOT buying put options would have been like having Scarlett Johansson invite you into her bed and then falling promptly asleep. You just couldn"t do that. And so you had to buy.

Taking a look at the Chinese interbank lending today:

Not yet getting critical but worth watching.

And pricing of the options:

So a 6.6% move to make 100%. Seems reasonable but nowhere near as good as it looked in late 2014 - unfortunately.

The problem - if there is one - is that 12 months is a long time to date an ugly girl, work for a nasty boss, or drive a Lada. But it isn"t a particularly long timeframe to hold an option for.

And yet that"s the best the option market gives us.

Sure, you can throw your towel into the ring in the futures markets but if, like me, you dislike leverage and margin calls (because you WILL get it wrong at some point), then you"re going to have to figure some better way to ride this pony.

The answer, I think, is this.

- Chris

"What you see when the liquidity dries up is people start going down... and this is the beginning of the Chinese credit crisis." — Kyle Bass

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On The Edge Of An "Uncontrollable Liquidity Event": The Definitive Guide To China's Financial System

While most traders over the past month have been obsessing over developments in Washington, the real action - most of it under the radar - has played out in China, where as discussed over the past few weeks, domestic liquidity has tightened notably, culminating with an unexpected bailout by the PBOC of various smaller banks who defaulted on their interbank loans as interest rates, particularly on Certificates of Deposit (CD) - which have become a preferred funding conduit for many Chinese banks - but not only, spiked. Ironically, these mini PBOC bailouts took place only after the PBOC itself decided to tighten conditions sufficiently to choke off much of the shadow debt funding China"s traditional banks.

As a result, the interbank CD rate rallied strongly, leaving a narrower or negative spread for some smaller banks, whose legacy carry trades (see below for details) suddenly became unprofitable. Also, as reported last Tuesday, several small banks failed to meet overnight repo obligations. This liquidity tightness has been mainly due to escalating financial deleveraging, as the PBOC has lifted market rates and rolled out stricter macroprudential policy rules.

But all those events in isolation seem as merely noise against what otherwise appears to be a relatively benign, even boring, backdrop: after all, neither China"s stock, nor bond markets, has seen even remote volatility in recent months, and certainly nothing compared to what was experienced one year ago, when the Chinese turmoil nearly led to a bear market across developed markets. Then again, maybe the markets are simply once again behind the curve due to all the inherent complexity of China"s unprecedented, financialized and extremely complex pre-Minsky moment ponzi scheme.

Last last week, Deutsche Bank analysts led by Hans Fan released what is the definitive research report summarizing all the latest troubling trends facing China, which judging by capital markets, nobody is paying any attention to. They should, because as Deutsche Bank puts it, if taken too far, they threaten an "uncontrollable liquidity event", i.e., the financial cataclysm that Kyle Bass and other perma-china-bears have been waiting for.

And, as usual, it all started with rising interest rates, which in turn is leading to increasing funding pressure, which if left unchecked, could lead to dire consequences for China"s underfunded banking system.

Here is a fantastic explanation of everything that has happened in China in recent weeks, and more importantly, what may happen next, courtesy of Deutsche Bank. We urge readers to familiarize themselves with the content as we will refer back to this article in future posts.

* * *

Only in early stage of financial deleveraging

China’s monetary policy has been shifting gradually towards a tightening stance since 2H16. Targeting the liabilities side of the banking sector, the PBOC hiked rates of monetary tools, such as MLF, SLF and OMO (Figure 1), and withdrew liquidity on a net basis after the Chinese New Year (Figure 2). At the same time, it targeted the asset side of the banking sector when it rolled out stricter MPA rules by including off-BS WMP credit in broader credit assessment and imposing stricter-than-expected penalties on banks that fail to comply.

As a result, the key indicators in the money market, including repo and CD rates, all suggest stretched domestic liquidity. For example, the 7-day repo rate, which is the most representative liquidity indicator, has exceeded the interest rate corridor ceiling of 3.45% several times this year (Figure 3). Moreover, the interbank CD rate spiked to 4.6% on 20 Mar 2017, up c.180bps from last year’s low (Figure 4).

We summarize in the below diagram recent financial deleveraging efforts by regulators.

Why push forward financial deleveraging?

We believe the PBOC aims mainly to contain the fast-growing leverage in China’s financial sector. In our view, the country’s financial leverage basically relates to speculators borrowing excessive wholesale funding to grow assets and chase yield, rather than relying on vanilla deposits. To measure this, we believe one of the good indicators of financial leverage is the credit-to-deposit ratio, calculated as total banking credit as a percentage of total deposits. The higher the ratio, the more fragile the financial sector, and the more likely the banking system will run into difficulties to finance unexpected funding requirements. Traditionally the loan-to-deposit ratio was widely used to measure system liquidity risk, but has become increasingly irrelevant in China, as banks are growing their bond investments and shadow banking books to extend credit.

As shown in Figure 6, the credit-to-deposit ratio in China’s banking system has risen sharply by 27ppts since 2011 to reach 116% as of February 2017. We see the rising credit-to-deposit ratio basically is a function of increasing reliance on wholesale funding to support strong credit growth. As of end 2016, borrowing from banks and NBFIs accounted for 17% of total liabilities, against 8% 10 years ago (Figure 7).

Which banks are more leveraged? Joint-stock banks and city/rural banks

As we have long argued, the risks are not evenly distributed in China’s banking system; there are notable differences in the balance sheet structures of different types of banks. As shown in Figure 8, medium-sized banks, which mainly include joint-stock banks, recorded the highest credit-to-deposit ratios and hence are most reliant on wholesale funding. At the same time, small banks, which mainly include city/rural commercial banks, also delivered notable increases in credit-to-deposit ratios, despite a lower absolute level. The credit-to-deposit ratio for small banks has increased by 30ppts since 2010, vs. 14ppts for the big-four banks in the same period.

On the liabilities side, medium-sized and small banks mainly rely on wholesale funding, i.e. borrowing from banks and NBFIs. As of 1H16, wholesale funding made up 31% and 23% for medium-sized and small banks, respectively, against only 13% for big-four banks, as shown in Figure 9.

A closer look into interbank CDs – funding pressure ahead

Wholesale funding for smaller banks has been obtained mainly by issuing CDs in the interbank market. Interbank CDs have supported 20% of smaller banks’ assets expansion over the past 12 months. Since the introduction of interbank CDs in 2014, CD issuance recorded strong growth and the balance jumped 89% yoy to Rmb7.3tr in Feb 2017 (Figure 10), or 3.4% of total banking liabilities.

Joint-stock and city/rural banks account for 99% of issuance (Figure 12). In the coming months these banks have ambitious CD pipelines. More than 400 banks announced plans to issue CDs worth Rmb14.6tr in 2017. This represents 60% yoy growth from the issuance plan in 2016. Investor-wise, WMPs, various asset management plans and commercial banks themselves are the major buyers, which combined make up 79% of the total balance (Figure 13).

However, we view banks that are more reliant on CDs as more vulnerable to rising rates and tighter regulations.

Reflecting tighter liquidity, the interbank CD rate has rallied strongly, with the 6-month CD pricing at 4.6% on average. Some CDs issued by smaller rural commercial banks have been priced close to 5% recently. This would have pushed up the funding cost and notably for smaller banks. If banks invest in low-risk assets such as mortgages, discounted bills and treasury bonds, this would lead to a negative spread. Alternatively, banks can lengthen asset duration, increase the risk appetite, add leverage or slow down asset growth. Among these alternatives, we believe a slowdown in asset growth is the most likely.

Caixin previously reported CDs are likely to be reclassified as interbank liabilities, capped at 33% of total liabilities. This potential regulation could add funding pressure for banks with a heavy reliance on interbank liabilities. With Rmb4tr interbank CDs to mature during Mar- Jun 2017 (Figure 16) and interbank liabilities exposure approaching the limit (Figure 17), joint-stock and city/rural banks are subject to notable funding pressure.

We show the listed banks’ issuances in the chart below. INDB, SPDB and PAB are among the most exposed to interbank CDs.

* * *

What are the implications?

Are we close to a “tipping point”?

For now, probably not, especially in a year of leadership transition. In our view, the risk of an uncontrollable liquidity event is low, as the PBOC will do whatever it takes to inject liquidity if needed. In the domestic liquidity market, the PBOC exerts strong influence in both the volume and pricing of liquidity. With 90%+ of financial institutions directly or indirectly controlled by the government, PBOC will likely continue to give liquidity support. In 2H15, the central bank established an interest rate corridor to contain interbank rates within a narrow range and pledged to inject unlimited liquidity to support banks with funding needs.

However, continuing liquidity injections do not come without a cost. A bigger asset bubble, persistent capital outflow pressure and a lower yield curve over the longer term are side effects that China will have to bear. At the same time, the execution risk of PBOC itself is rising.

Implications on system credit growth

We expect system credit growth to moderate from 16.4% yoy in 2016 (16.1% in Feb’17) to approximately 14-15% yoy in 2017 (Figure 23). As a result, the credit impulse is likely to trend lower from the current high level (Figure 24). The slower credit growth is mainly attributable to several factors: 1) a tighter liquidity stance to push up the funding cost of smaller banks and to force them to slow down asset growth; 2) further curbs on shadow banking; 3) a higher  bond yield to defer bond issuance; and 4) slower mortgage loan growth.

Appendix A – Liquidity flows in China’s interbank market

New deposits supported 55% of asset growth in China’s banking system in 2016. The remaining 45% of new assets were mainly funded by borrowing from PBOC (19%) and borrowing from each other (19%, including bond issuance). While borrowing from NBFIs remained flat for the entire system, it was the main funding source for medium-sized and small banks. We summarize the liquidity flows in China’s interbank market in Appendix A.

Liquidity injection from PBOC. Over the past 12 months, to offset the liquidity drain from falling FX reserves, the PBOC has injected a huge amount of liquidity worth Rmb5.8tr into the banking system, which is equivalent to 400bps of RRR cuts (Figure 29). Of this injection, 30% and 24% have been made to support joint-stock banks and policy banks, respectively (Figure 30). For details, please see our report, PBOC liquidity facilities: Doing whatever it takes, 23 January 2017.

Borrowing from interbank market. Policy banks and big-four banks are net interbank lenders, while joint-stock and city/rural commercial banks are net borrowers. Joint-stock and city/rural banks not only borrow from policy/big banks, but also from each other. This could potentially lead to stronger contagion effects if some of them run into liquidity stress.

Lending/borrowing between banks and NBFIs. There has been a sharp rise in net claims to NBFIs from banks (Figure 33). We believe this is due to rising shadow banking transactions and also arbitrage activities with funds self-circulating within the financial sector. Clearly as shown in Figure 34, small banks are key lenders to NBFIs

Appendix B - What is driving the financial leverage?

From the accounting perspective, we believe the rising credit-to-deposit ratio is mainly due to bank credit circulating back into the banking system as non-deposit liabilities. In normal cases, when a bank makes a $100 corporate loan or purchases a $100 corporate bond, the bank books the credit to a corporate on the asset side while it also books a deposit on the liability side. We show a normal case in Figure 35. However, if a bank’s money circulates back into the banking system, just like in the two cases we illustrate in the diagram below, the $100 deposit is removed but interbank borrowing or borrowing from NBFIs would increase by $100. While there are likely to be many variants of bank credit circulation, we elaborate on two cases in detail.

Case #1: Bank credit circling via NBFIs

It is well known that NBFIs have been serving as SPVs to channel shadow banking credit from banks to corporates in past years. What is  insufficiently addressed though is that NBFIs also have been acting as channels for bank credit circling. Let us show a simple example below:

• First, Bank A invests in an asset management plan packaged by an NBFI. This is booked as a receivable investment on Bank A’s balance sheet.


• Second, the NBFI invests further in a CD issued by Bank B. Bank B books the CD under interbank borrowing. The money circulates back into the banking system and no deposit is generated.


• In some cases, if the yield of the CD does not cover the cost of issuing the asset management plan, the NBFI will leverage up in the bond market by pledging the CD through repo transactions. The leverage could be built up by two transactions: 1) entrusted bond investment (“Daichi” in Chinese); or 2) entrusted investment (“Weiwai” in Chinese), which we discuss in detail in our 2017 outlook report.


• In this case we use the investment in a bank’s CD as an example. In reality it applies to investment in interbank CDs, interbank negotiated deposits and financial bonds issued by banks, which are all circulating money back into the banking system.

The bank credit circling through NBFIs is growing rapidly. This is evidenced by strong growth in banks’ receivable investments, which reached Rmb21tr as of end-2016 to account for 10% of commercial banking assets, as shown in Figure 36. This represents 80% CAGR in balance since 2013. The majority of these investments was made by medium-sized and small banks. Note that not all receivable investments are credit circling, but we believe it should make up a notable portion. We summarize the structure of banks’ receivable investments in Figure 38.

The NBFI here could be any trust company, broker, fund subsidiary or insurance company. We believe brokers and fund subsidiaries should be the key players, as their bond trading leverage in the interbank bond market is much higher than other participants (Figure 37).

Case #2: Bank credit circling via corporates

Corporate loans may circle back into the banking system as well. This is because many corporates use borrowed but idle cash to buy bank WMPs. Below is a simple example:

• Firstly, Bank A makes a loan to a corporate.


• Secondly, the corporate uses the loan proceeds to buy a wealth management product issued by Bank A.


• Thirdly, Bank A invests the WMP fund in a financial bond issued by Bank B. This corporate deposit would circle back to the banking system as a non-core liability.


• To make this process economic, in many cases it would require leverage. The corporate borrowing cost may be at 4%, but the financial bond issued by Bank B may only yield 3.5%. To compensate the yield shortage, Bank A has to entrust the WMP fund to a third party and to leverage up by pledging the bonds through repo transactions. This process is called entrusted investment (“Weiwai” in Chinese, or entrusting to an external party).

This type of transaction is not an individual case. As shown in Figure 39, corporates purchased Rmb7.7tr WMPs in 1H16. This accounted for 7% of total corporate debt in China, or 29% of total WMP AUM in the system. SOEs, large private corporate and listed companies enjoy ample bank lending resources with low interest cost. However, the lack of attractive investment projects in their own business prompts them to invest in the financial market (i.e. bank WMPs).

Kyle Bass Has Found A "Breathtaking" Opportunity With The "Greatest Risk-Reward Profile Ever Encountered"

Last February, when Kyle Bass announced the upcoming launch of a dedicated fund to short the Yuan, as part of a bigger macro short unveiled in his report on “The $34 Trillion Experiment: China’s Banking System and the World’s Largest Macro Imbalance”, many were skeptical if not outright mocked the Hayman Capital founder.

One year later, it is those who invested alongside Bass that are laughing, because as Bass writes in his latest letter to investors, "I am pleased to share that the Hayman Capital Master Fund, LP"s estimated net performance for the calendar year of 2016 was +24.83%", or double the S&P"s return including dividends. Putting this return in a longer context, those who have invested with Hayman since the fund"s inception in 2006, this represents an inception-to-date return of +436.75% and an annualized return of +16.70%.

Not bad.

So where is Bass now? As he unveiled in his letter, he is sticking with Asia, which he will cover with a brand new Asia-focused fund, his third, "designed to provide investors with nuanced access to perhaps one of the largest imbalances in financial markets history."

Bass explains the reason for his shift back to macro investing, which began 2016, as follows: "we reorganized our portfolio to invest in the macro themes that began to reveal themselves early in the year. Exploiting our reflationary view, we invested in global interest rate markets, currencies, and commodities across the world."

As the above returns confirm, Bass was clearly successful last year and is why he plans to continue doing more of the same in the current year:

As we enter 2017, we believe enormous macro imbalances are just beginning to unwind. As central bank monetary policies have become impotent, these imbalances will likely continue to unfold in what we believe to be a much more predictable manner. Over the past several years, economic gravity has been pulling one way and central banks have been using aggressive monetary policy to pull the other. Investing in macro, while this phenomenon has existed, has been difficult to say the least. From here- on, we expect to encounter significant changes in global fiscal policies along with a continuation of the upward movement of general price levels for consumers and producers alike. This type of environment plays into our strengths at Hayman. 

Bass believes that government policy changes "will likely act as accelerants to the underlying imbalances which have been accumulating for the past eight years (and in some cases, the last three decades), which is a polite way of saying a mean reversion to a state prior to the unprecedented central bank intervention over the past 7 years."

In terms of his outlook, Bass notes that "Unlike establishment prognosticators, we hold a nuanced view of the world that contemplates higher global inflation, tepid real economic growth, and severe imbalances in select Asian financial systems and currency markets."

In other words, it"s all about Asia, again.

And it is likely Asia which he envisions when as he further writes, "global markets are at the beginning of a tectonic shift from deflationary expectations to reflationary expectations."

Bass then gives his investors a rhetorical question: "What happens to economies at maximum leverage when interest rates begin to rise?" 

Just guessing here but, either bad things, or the central banks reengage to prevent even a modest, 10% selloff?

Whatever the right answer, Bass says that "reconciling the potent strengths of the world’s largest economies with their inherent weaknesses has revealed various investable anomalies. The enormity of the apparent disequilibrium is breathtaking, making today a tremendous time to invest. Over the past 18 months, we have focused on a particular set of asymmetries, which we are now seeking to exploit."

However, what we found most notable about Bass" relatively short letter is the following admissions:

One opportunity in particular has the greatest risk-reward profile we have ever encountered in our decade of being a fiduciary. As investors of ours, you are positioned to take advantage of one of the world’s greatest macro imbalances.

He did not disclose what the opportunity was, but left readers on the following optimistic note: "We expect the next few years to be the best years for macro investing since the late 1990s."