Muddy Waters Research founder Carson Block believes that China’s overleveraged economy will eventually face a “day of reckoning.” He just can’t say when.
During an interview with Bloomberg’s Erik Schatzker, Block, who made his name betting against shady Chinese companies trading in the US, explains how the Chinese government’s massive stimulus has led to a potentially destabilizing explosion of corporate-debt growth in the world’s second-largest economy – and why the Communist Party won’t be able to contain the fallout once its twin bubbles -asset and credit - finally burst.
“I’ve felt for many years that it’s a giant asset and credit bubble. Under the old orthodoxy, that couldn’t be sustained for long, but if you look around the world, the ECB and the Fed are helping to sustain frothy asset values. Japan hasn’t made sense for a while.”
“Ultimately there will be a day of reckoning, I know that. I just can’t say if it’ll be two months, two years or 20 years.”
But even though traders who bet against the Chinese yuan last year made a tidy profit, Block believes betting against the Hang Seng Index isn't the best option for shorting China because the impact of PBOC intervention is too unpredictable on a macro scale. Betting against the Chinese stock market in aggregate could end up being a “widow maker” play like shorting Japanese government bonds was for several years.
Instead, investors should bet against individual firms or sectors – a less-risky option, in Block’s view.
“If you start with the macro thesis and say there are a lot of credit problems in China then start looking at industries that might be canaries in the coal mine or companies that might be canaries in the coal mine, then you might get it right.”
However, speculators should be mindful of a trait common among Chinese companies: There are many that somehow manage to keep going even though the financials suggest that they’re doomed. Understanding which companies have the guanxi – a Chinese term meaning business and political connections – to enable them to continue operating, and which companies don’t, is the most challenging aspect of betting against Chinese firms, Block asserts.
But what about the bull case for China? The argument that the Chinese government will be able to pull off a “soft landing” while successfully transitioning from a manufacturing powered to a services-powered economy is predicated on the view that Xi Jinping and the Communist Party exercise absolute control over the economy, and have near-unlimited resources to help them thwart an economic collapse.
Block says this assumption, common among westerners, is an example of “cognitive dissonance” often applied to the PBOC. Even though many westerners believe it to be true, China’s central bank isn’t some all-powerful monolith, Block contends.
“These guys are no more capable than our policy makers in the US have been. The US government has the most power in the world to avert a major economic catastrophe.”
“If [the Fed and Congress] weren’t able to prevent it, it’s because the laws of economics, the physics of economics eventually catch up.”
“I’m willing to bet that these guys can’t escape the laws of economics in perpetuity.”
The PBOC’s April decision to deleverage unleashed turmoil in the country’s financial markets, causing Chinese stock and bond markets to erase hundreds of billions of dollars in value.
Beijing announced Friday morning that it has moved the goal posts once again and introduced a new “counter-cyclical factor” to its mechanism for managing the yuan’s exchange rate with the dollar - an effort to curb volatility. The move sent the yuan to three-month highs, but traders are still unclear about how this new mechanism works and what exactly was changed.
The Chinese yield curve experienced a “double inversion” this week when three year yields eclipsed five year yields and seven year yields eclipsed 10-year yields. At the same time, rising base funding costs and interbank credit risk concerns have pushed banks' cost of borrowing beyond the rate they charge customers for loans for the first time in history. The one-year Shanghai Interbank Offered Rate has exceeded the Loan Prime Rate, the first time this has happened since the latter was introduced in 2013.X
Meanwhile, China's total debt-to-GDP has reached all-time highs.
Moody’s Investors Service sent offshore yuan tumbling earlier this week after it downgraded China’s credit rating to A1 from Aa3, saying that the outlook for the country’s financial strength will worsen, with debt rising and economic growth slowing. This leaves the world's hoped-for reflation engine rated below Estonia, Qatar, and South Korea and on par with Slovakia and Japan.