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Is China the Next Sub-Prime Event?

Freaking Heck's picture




 

By: Brad Thomas at http://capitalistexploits.at/

As mentioned in my writing on the Singapore dollar, the most dangerous thing in finance is the "thing" that never moves. This stability creates an illusion of control around which many positions are built, the greater the perceived stability the greater the positions, and the more other assumptions and forecasts are made.

The stability (or lack of volatility) in the Renminbi has been the one of the foundations that has made so many other variables more forecastable. No one can imagine the Renminbi being a highly volatile currency, let alone coming remotely close to repeating what happened during the Asian Tiger crisis of 1997! If this foundation of stability suddenly disappears then there will be a great increase in uncertainty and volatility in many markets across the globe.

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.

I think a reasonable bearish position on the Renminbi will be a great way to hedge out the uncertainty of outcomes with respect to how the Chinese economic miracle "unwinds".

For a long time I have been highly skeptical on the Chinese "economic miracle". Every contrarian bone in my body has been telling me that there is something not quite right with China's meteoric rise from an economy that was seemingly insignificant some 15 years ago to the economic powerhouse that we are led to believe it is today.

The Chinese economy has risen to prominence too quickly too soon. What has been the driver of this rise? Why did commodity prices explode skywards in 2002 having gone nowhere for the previous 30 years? I find it hard to believe that commodities became scarcer all of a sudden!

CRB Commodity Index

The CRB Commodity Index (the CCI)

Well, no one has been able to give me a straight down the line answer - at least one that an ordinary average trader like myself could understand. That is until I came across the following discussion with Mark Hart. Hart came to prominence together with Kyle Bass after shorting the "sub-prime thing" in 2007.

Hart's discussion on China starts at about the 55 minute mark. Note what Hart says about how he is applying his view on China (via options on the Renminbi). The interview was conducted in September but note that he has been "bearish" on China at least since 2011!

For more on the issues facing China you might like to read the writings of Gordon Chang and Michael Pettis. I think both present very objective views on China. I am not going to pretend to offer anything more than what these gentlemen offer with respect to the view on China.

Hart talks about buying "puts" on the Renminbi. What makes the trade so attractive is the extreme low level of volatility. Below is an index of implied volatility for 12 months to expiry at the money (ATM) calls on the USD/CNY.

Renminbi volatility

So we can buy calls on the USD/Renminbi for about 2.5% volatility. For comparison purposes - implied volatility on the AUD/USD is about 10%!

Hart talks about buying the CNY 7 strike call on the USD/Renminbi. To give you an idea of the leverage offered on a 12-month option at the CNY 7 strike – about $1,100 will get you a notional position of $1,000,000! To achieve a payoff of 10x all the USD/CNY would have to close at is 7.07, and at 7.15 a 20x payoff is achieved!

One can now appreciate what Mark Hart is on about - the gearing offered by options on the Renminbi is huge because volatility is grossly underpriced.

Is it so crazy to think that the Renminbi can get to a "tick or two" above 7 within 12 months?

CNY Chart

Well, let's not forget what happened to currencies in the past. Note what happened to the Mexican Peso during the "Tequila" crisis:

Mexican Peso Chart

...the Thai baht during the Asian Tiger crisis:

Thai Baht Chart

...or to the Russian Ruble during the LTCM crisis:

Russian Ruble Chart

Currencies can move and they move significantly when they have been sailing in calm waters for extended periods of time - just like the Chinese Renminbi now. Position for the unexpected. It is why Hart and Bass made so much money during the Subprime crisis.

- Brad

 

"Never think that lack of variability is stability. Don't confuse lack of volatility with stability, ever." - Nassim Nicholas Taleb

 

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Wed, 10/22/2014 - 09:41 | 5362967 andrewp111
andrewp111's picture

We don't really understand China. Nothing that came out of there would surprise me.

Wed, 10/22/2014 - 06:42 | 5362568 Never One Roach
Never One Roach's picture

Greed always ultimately undermines any institution, nation or culture. China's "Day in the Sun" is about to come.

Wed, 10/22/2014 - 06:06 | 5362546 limacon
limacon's picture

Run .

Then there is nothing that does not move .

https://www.academia.edu/8899526/How_to_run_faster_and_why_

Wed, 10/22/2014 - 05:43 | 5362534 AdvancingTime
AdvancingTime's picture

Is this China envy or something else?  Many Americans cringe when they think about the billions of dollars of consumer goods we import from China every month, but what makes it even more bizarre is that China is an American make product. Decades ago America started down a perilous path to build China into a world power.

Decades ago a pathological fear of  Russia and the Kremlin’s atheism caused America to seek a counter balance in the region. Central to the American effort was offering the prospect of economic incentives to China, we combined this with a hardline military response to communist aggression. Ironically, it was the China’s communist longevity the Washington wise men should have feared more. The article below delves into how and why America made China into the economic giant it is today.

http://brucewilds.blogspot.com/2012/09/china-made-by-america.html

Wed, 10/22/2014 - 05:32 | 5362524 AdvancingTime
AdvancingTime's picture

The debate continues as to how stable china really is. Much of the recent growth in China after 2008 came from a massive 6.6 trillion dollar stimulus program that expanded credit and poured massive amounts of money into the system. This money encouraged expansion and construction with little regard as to real demand or need.

Now China finds itself in a credit trap. For years the people of China have had the habit of saving much of what they earn but the low interest rates paid at banks has not rewarded savers. With few investment options much of this money has drifted towards housing and driven housing prices sky high. The economic efficiency of credit is beginning to collapse in China and the unwinding of China’s giant credit spree could be very painful. More in the article below.

http://brucewilds.blogspot.com/2014/03/china-and-great-credit-trap.html

Wed, 10/22/2014 - 06:40 | 5362567 Never One Roach
Never One Roach's picture

Good article.

Wed, 10/22/2014 - 04:28 | 5362482 luckylongshot
luckylongshot's picture

Why do we get an endless stream of incompetent journalists on ZH  predicting gloom and doom in China? They all base their conclusions on the assumption that China has a bankster controlled central bank. While if this were the case China would be in trouble this is not the case as China owns its central bank. This means the Chinese can write off loans and make loans interest free and this means there is no chance of a meltdown occurring in China. Europe in the middle ages had a public banking system like China does and went for 500 years without a depression or hyperiflation. A better topic would be why the west does not adopt public banking.

Wed, 10/22/2014 - 10:21 | 5363136 LawsofPhysics
LawsofPhysics's picture

Correct, the chinese culture invented paper money for christ's sake.  This culture is a single party individual-crushing culture that is all about advancing china, period.

Everyone else in the world is fighting amongst themselves, china is fine with the current arrangement.

 

"A better topic would be why the west does not adopt public banking."  --  please, are you completely ignorant?  That would involve shifting ownership from a relative few to the public, we cannot have that.  Only losses can be socialized...

Wed, 10/22/2014 - 10:27 | 5363204 Johnbrown
Johnbrown's picture

Right. Because it's the "public" that controls public property.

You are the ignorant one.

Wed, 10/22/2014 - 05:31 | 5362523 AdvancingTime
AdvancingTime's picture

Many people forget years ago when China needed banking "expertise" it turned to, and partnered with the American banks. These banks became what we know as our "Too bid to fail." On top of that add the icing to the cake of political corruption and we have the Great Financial State of China.

Wed, 10/22/2014 - 04:28 | 5362481 vyeung
vyeung's picture

Its won't be the next sub-prime becoz you don't have NINJA loans in China, down payments are LARGE, thus alot of equity in the market.

Will other more sectors retrace, sure, will the real state market decline, YEAP, but its not SUB-PRIME.

Wed, 10/22/2014 - 05:26 | 5362518 AdvancingTime
AdvancingTime's picture

It will be a disaster because shadow banking has run a muck! The economy is a house of cards of a different color.

Wed, 10/22/2014 - 04:05 | 5362470 Rodders75
Rodders75's picture

xyz

Wed, 10/22/2014 - 04:03 | 5362469 Rodders75
Rodders75's picture

Yes. The Argentine Peso before 2001 didn't move for 10 years. 

Wed, 10/22/2014 - 03:18 | 5362435 limacon
limacon's picture

Does nothing make sense ?

See 

https://www.academia.edu/8897094/Passwords_to_Babel

No , No !

Passwords-R I !

Wed, 10/22/2014 - 03:16 | 5362434 limacon
limacon's picture

Does nothing make sense ?

See 

https://www.academia.edu/8897094/Passwords_to_Babel

Wed, 10/22/2014 - 00:34 | 5362280 Bumbu Sauce
Bumbu Sauce's picture

What say you 50 cent bloggers?

Tue, 10/21/2014 - 23:43 | 5362163 reader2010
reader2010's picture

Most western investors don't really understand the final phase of China's modernity that started in 1978. They tend to look at it from their US-centric dualistic point of view, and always try to tie it to the most recent past of the US financial market. Fatal mistake.

Tue, 10/21/2014 - 23:27 | 5362121 daedon
daedon's picture

Chinese are not Americans, they think quite differently.  There is construction everywhere in China,  the money printing is backed by something, as opposed to the west, where corruption and incompetence rule the day.

Wed, 10/22/2014 - 05:18 | 5362514 Which is worse ...
Which is worse - bankers or terrorists's picture

No, he's right there's not much corruption in China. /s

Wed, 10/22/2014 - 11:32 | 5363572 t0mmyBerg
t0mmyBerg's picture

Yes as well as central coordination of lots of the economy so massive waste of resources which would not occur with market based price signals.  Of course we are not immune from such abuses.

But at least in China they are not above putting corrupt officials to death for corruption.  That is something we should do here.  It is like in a sci-fi book I recently read where a group called the Timent Electorum took it upon themselves to assassinate officials who failed to properly represent the interests of those they represented.  Would that we had a Timent Elecotrum for in the US.

Wed, 10/22/2014 - 00:50 | 5362301 GoldenDonuts
GoldenDonuts's picture

Empty decaying condiminiums don't offer too much security.

Wed, 10/22/2014 - 05:38 | 5362529 AdvancingTime
AdvancingTime's picture

Many people don't know that it is not uncommon for the buyer to have to finish the interior of these units after they buy them. I ask how many of these towers in these "ghost cities" remain unfinished on the inside?

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