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.
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Courtesy of RealVision, here are some of his latest thoughts:
“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?
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.