Kyle Bass Warns: Xi Has "Built The Chinese Economy On A Foundation Of Sand"

Earlier this week, Chinese leader Xi Jinping became the third ruler in the communist country’s history to have his named enshrined in its constitution – and the first to receive this honor while still alive. But as China celebrates its most popular, and most powerful, leader since at least Deng Xiaoping, Kyle Bass, hedge fund manager and noted China bear, told Bloomberg the Communist Party will one day regret standing idly by as Xi consolidated his power.

“Today Xi is celebrated in media reports, but when future historians look back, he will be blamed for recklessly building the Chinese economy on a foundation of sand,” Bass, founder of Hayman Capital Management, said in an email Wednesday.

“Xi desperately seeks credibility, but true developed economies do not impose severe capital controls or move short-term rates hundreds of basis points overnight in attempts to manipulate their own currency.”

Xi, who launched the twice-a-decade National Party Congress last week with a three-hour speech where he laid out his vision for “communism with Chinese characteristics in a new era,” the philosophy that was enshrined in the country’s constitution by a unanimous vote. In a move that seemingly confirms suspicions that Xi plans to break with precedent and seek a third term after his second ends in 22, Xi appointed five new members to the Politburo,

China’s most powerful body, all of whom are too old to be viewed as credible heirs. Typically, Chinese leaders have pointed to a successor or possible successors by the time they begin their second term, ensuring that there’s a clear path of leadership transition.

Of course, Bass and others have been highly critical of the Communist Party’s heavy handed tactics. For example, the PBOC and the Chinese ‘National Team’, which exert powerful influence over the company’s financial market, have successfully tamped down equity market trading volume and volatility in the runup to the Congress, while guiding the yuan higher against the dollar.

However, China’s closed financial system and manipulated markets aren’t the only target of Bass’s criticism. He also pointed to China’s ever-growing pile of debt. Borrowing has swelled to 260 percent of gross domestic product at the end of 2016, Bloomberg Intelligence data show. Earlier this year, the country’s soaring debt burden inspired Moody’s Investors Service and S&P Global Ratings to downgrade the country’s sovereign credit rating.

In an interview earlier this month, Bass, who has called for a 30% drop in the Chinese yuan, said he expects the government to relax its grasp on the exchange rate after the National Party Congress. He said he believed once Xi consolidates power, he’ll allow natural economic forces to reassert themselves in the country’s banking system.

Since the yuan joined the IMF’s Special Drawing Rights basket a year ago, China has made little progress in making its currency more convertible and accessible. To wit, the yuan remains a secondary currency for settling global payments.

“China remains an emerging backwater when it comes to global currency settlements,” he said Wednesday.

As Bloomberg pointed out, Bass, who made a fortune betting against U.S. subprime mortgages, said in early 2016 that losses in Chinese banks could be four times bigger than those suffered by American lenders during the global financial crisis. He has said that crucial figures, like the share of non-performing loans, have been understated.

“Recklessly growing a banking system in pursuit of global economic growth and respect will cause severe financial instability in the years to come,” he said on Wednesday.

 

“The dangerous $40 trillion credit experiment with Chinese characteristics will run its course.”

As reported earlier this month, Bass has stuck to his pessimistic views on China (though he has moderated his view a bit, pushing back his expected timeline for signs of instability in the country’s debt market to emerge) while other noted bears reversed their positions as the next big yuan devaluation failed to materialize.

While China bears have underestimated the nation’s unique ability to control its market, the sheer pace and volume of credit creation can’t possibly be sustained forever, Bass said.
 

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: 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:

"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..."

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."