On Friday we presented Kyle Bass' latest interview in which the Texas hedge fund manager explained the reasoning why he thought shorting the Yuan is the "greatest investment opportunity right now [11]." The crux behind the argument was well-known to Zero Hedge readers, namely China's peaking credit cycle driven by soaring bad, or non-performing, loans which have so far been swept away, but which courtesy of a $35 trillion financial system are nothing short of a "neutron bomb [12]", as we first dubbed the embedded risk, waiting to go off. Here is Bass:
What I think the narrative will swing to by the end of this year if not sooner, is the real issue in China is not simply that profits have peaked. The real issue is the size of their banking system. Do you remember the reason the European countries ended up falling like dominoes during the European crisis was their banking systems became many multiples of their GDP and therefore many, many multiples of their central government revenue. In China, in dollar terms their banking system is almost $35 trillion against a GDP of $10 and their banking system has grown 400% in 8 years with non-performing loans being nonexistent. So what we are going to see next is a credit cycle, and in a credit cycle you see some losses, but if China's banking system loses 10%, you are going to see them lose $3.5 trillion.
Today, months after we first covered the breadth of this most disturbing for Chinese bulls topic, the FT caught up with this critical [13], for China's financial system, issue and reports that "the downturn in China’s fortunes — particularly across its heartland heavy industry — is already hitting the banks. Annual non-performing loan rates have been doubling annually since 2012. China Merchants Bank, China Everbright and ICBC are seen as among the most troubled."
That's based on official data, which is grotesquely low and completely fabricated. The true NPLs data is well-hidden by everyone from the lowliest bank teller to the Politburo in Beijing, who all know that merely the recognition of the problem would be sufficient to spark if not a full-blown panic then certainly accelerate capital outflows form the nation to an unstoppable degree, especially if the latest estimate which we presented last November [14]from Fitch's Charlene Chu, of 21% in non-performing loans, is accurate.
Back to the FT which notes that "China bulls point to the still low level of NPLs — barely 1 per cent at the big lenders, and 1.8 per cent at mid-tier banks this year, according to analyst forecasts. As a gauge, NPLs in Greece have risen to between 30 and 40 per cent amid that country’s crisis" but then adds that "China experts at independent research house Autonomous suggest investors are underestimating a spiralling problem. Across the board, loan losses will rise by $845bn this year, Autonomous predicts. That, they think, will be enough to shrink profits by 6 per cent at big banks."
Actually if Fitch is right, the problem is in the trillions, but let's assume a more modest figure. Here is what the FT says next:
Some policymakers are privately worried about yet another underestimated issue — whether loan losses, when they materialise, will be recoverable. In western banking markets, so-called loss given default rates can typically range between 30 and 70 per cent. In China, where property accounts for the bulk of collateral used to back loans, LGDs may be far higher. Even if inflated property values do not collapse, collateral values may prove far too optimistic. In China’s nascent property ownership culture, the land on which developments are built is typically state-owned, limiting recovery values.
Considering that one of the biggest scandals in China in 2014 [15]was the realization (as many had warned previously) that millions of tons of commodities were rehypothecated countless times, and thus "pledged" as collateral to numerous counterparties, and that as a result these same counterparties were unable to make sense of who owns what at one of China's largest ports, Qingdao, it is probably quite safe to assume that LGDs in China are if not 100% (or more, which is impossible in theoretical terms but in practice is quite possibe, as another curious side effect of unlimited collateral rehypothecation), then as close to it as possible.
So putting all that together, and using a conservative estimate for NPLs, orders of magnitude below the 21% proposed by Fitch, what is the FT's estimate of China's "conservative case" neutron bomb going off in financial terms? Just about $7.7 trillion.
Investors in China’s banks may well recognise that the lenders cannot be compared with institutions that operate along western lines and will expect hazier disclosures and readier state interference. They are also likely to think that China will not allow its banks to fail. But if analysts, like those at Autonomous are to be believed, China’s banks could require up to $7.7tn of new capital and funding over the next three years. State bailouts could send the government debt to GDP ratio spiralling from 22 per cent to 122 per cent. That kind of shock would be a challenge for any country, even one of China’s vast might.
Again, this is the conservative NPL case. Now assume 21% NPLs.
