Prominent Texas hedge fund manager, J. Kyle Bass, became a global celebrity on February 11, 2016 when his investment letter to fund holders predicted that the RMB was going to crash soon under the souring bad loans of the country's banking system. Bass’ prediction was based on the possibility of a loan loss of RMB 22.75 trillion (USD 3.5 trillion) that will force China’s banking system to shed 10% of its assets. The implied loan loss ratio is 28-30% under Bass’ scenario.
Officially, the amount of bad loans stands at RMB 1.27 trillion at the end of 2015. Though many analysts feel that the figure understates the true amount of non-performing loans, few analysts believe Bass’ figure. China International Capital Corporation (CICC) has calculated the highest estimate of non-performing loans in the banking system under the worst hard landing scenario to be RMB 10 trillion (USD 1.5 trillion). CICC estimates that the total credit exposure faced by Chinese banks, including loans and investments in corporate bonds, receivables investments, and credit exposure from wealth-management products, may reach RMB 122 trillion at the end of 2015. The banking system currently has a loan loss reserve of over RMB 2 trillion and annual profit before provision of taxes of over RMB 2 trillion. CICC feels that the Chinese banking system has the capacity to absorb as much as 8 trillion of credit losses without eroding equity and being forced to look for state help.
CICC was set up by Morgan Stanley in 1995 with China Construction Bank Corp. as part of efforts to develop the country’s capital markets. CICC is known to be one of the most professional Chinese investment banks, with the industry's best research capability. Though Morgan Stanley divested its 34.3 percent stake in 2010 for about $1 billion, CICC remains an industry pillar.
Bass’ focus on the accumulation of bad debt in China as its economy slows is at the center of a debate about the trajectory of RMB. Whether the currency stay on course as the country's economic managers have vowed, or whether it will drop significantly as Bass predicts, is the question waiting for an answer. Of course, whether China continues as the locomotive of global growth, or whether it sinks into decades of stagnation like Japan after its credit bubble bursts, is another extension of the debate.
We will look at the issue from two perspectives: first the IMF formula for adequate reserves, and the second, the theoretical economic dynamics of currency crises.
IMF Formula for Adequate Reserves
Before we use the IMF formula to calculate the amount of adequate reserves, we should stress that it is not clear what constitutes a “critical level” of reserves. There are many market debates on what the critical Chinese reserve level has to be before a crisis sets in. Nearly all of the predictions are arbitrarily drawn limits. We use the IMF formula here because it is the one used by Bass in his letter to investors. In the IMF formula, the country must look at foreign exchange requirements in the larger context of financing foreign trade, providing a standby fund to meet short term debt repayment obligations, setting aside a certain amount of funds to meet potential capital flight, with the figure proxy by the country's M2, plus a liquid fund to run the country's day to day operations and other liabilities. Note that the calculations made are in USD.
Bass computation for China: 10% * $2.2 Trillion + 30% * $680 Billion + 10% * (RMB 139.3 Trillion / 6.6) + 15% * $1.0 Trillion = $2.7 Trillion of required minimum reserves
The end January figure of RMB 3.23 trillion was getting close to the Bass minimum required level, especially if China keeps bleeding USD 100 billion per month as witnessed in December 2015 and January 2016. The computation above anchors Bass’ claim of the impending collapse of RMB.
However, there are two facts that Bass had either ignored or is not aware of:
First, he used the IMF formula that refers to countries with full capital account free movement. In country with partial account opening, the operating percentage to apply to M2 drops to 5%. In this scenario, China's minimum FX reserve is USD 1.6 trillion. In the case of full capital controls, the operating percentage to apply to M2 is zero. This number is intuitively clear: when a country employs capital controls, no domestic liquidity is allowed to get out of the official reserves. In such a scenario, China just needs half a trillion USD in reserves to run its economy.
Second are the enormous overseas assets held by the two sovereign wealth funds, China Investment Corporation (CIC) and the State Administration of Foreign Exchange (SAFE) Investment company. They hold USD 747 billion and USD 474 billion in assets respectively in their latest financial statements. Their combined USD 1.22 trillion is not included in the official reserves of China and they are available to the Chinese government anytime.
Our numerical analysis points to a much stronger international foreign exchange position than what Bass has presented. China is still far from the tipping point that Bass has projected. Of course, no country in the world can keep on losing USD 100 billion of reserves monthly for an extended period of time without the risk of confidence crisis overtaking all events. However, the Armageddon scenario is the realm of the novelist rather than the analyst.
Theoretical Economic Dynamics of Currency Crisis
In economics, there are three main generations of models explaining how and why currency crises occur. These models evolved with earlier currency crises and they are very important in understanding and preventing future recurrences.
First-generation models put unsustainable current account deficits as the cause that ultimately leads to crisis. The canonical first-generation model has a country running a persistent current account deficit with the central bank using reserves to cover the balance of payments deficit. This imbalance eventually exhausts a country's foreign reserves with the ultimate crisis occurring when local currency holders rush out to avoid devaluation. This model applies to typical emerging market currency crises.
China's present situation clearly does not fit this model. The country runs a persistent current account surplus and had been building up its foreign exchange reserves for years.
An updated version of the first-generation model is the "soft trilemma" scenario. This version applies to countries pursuing an accommodative domestic monetary policy while trying to maintain a de facto currency peg at the same time. When the central bank runs out of reserves to support the peg, it must devalue. Many analysts who expect a further RMB devaluation hold the view that China will keep on easing monetary policy aggressively to support the economy and thus will have to give up supporting its currency at some point in time. They believed the country will open the capital account after its inclusion in the Special Drawing Right (SDR) basket of the IMF.
The devaluation assumption presumes the country has an open capital account and that the country will sacrifice its exchange rate stability in the "Impossible trilemma". The trilemma requires a country to give up one of these: independent monetary policy, open capital markets, or a stable exchange rate. But China has rejected picking a corner and has instead gone with a “soft trilemma” solution by giving a little ground on all three. They have some but not complete monetary independence, a managed rather than floating currency, and some capital controls.
Economists point out that such a soft approach is not workable in the long run. Markets will keep on questioning just how long the commitment to the managed exchange rate policy can work and the second-generation model is designed to answer this question.
In the second generation model, crises are self-fulfilling: if market participants believe a country must ultimately abandon a peg, the very actions of investors shorting the domestic currency may bring about a crisis. Second-generation models were developed to help explain why Britain but not France was forced out of the ERM, and why some Asian economies devalued in 1997-98 while others did not.
These second-generation models put the emphasis not on fundamentals, but credibility. People's Bank of China (PBoC) Governor Zhou apparently succeeded in this regard after his post-Chinese New Year press conference. The market has been stable for a few weeks now after a volatile six months.
Third-generation models of currency crises shift attention from macroeconomic fundamentals toward financial sector risks. In this model, serious currency mismatches in banking or private sector balance sheets create such a systemic imbalance that an accidental triggering event can easily throw the whole country into a currency crisis aka bank run type of capital flight. These risks are often exacerbated by long-term projects financed with short-term borrowing. Implicit government guarantees to backstop financial firms can also create self-fulfilling crises in this model as these guarantees often lead to careless balance sheet expansion with serious time and currency mismatch in the balance sheet.
In the case of China, an important risk comes from the sizable build-up of private sector debt post 2008. As a share of GDP, private non-financial sector debt was less than 120% in 2008, and it was close to 200% of GDP last year. In fact, China has seen some of the fastest growth in private sector debt in recent years and it has the highest ratio to GDP of any large emerging market (EM) country. On the other hand, China has a stable public debt profile relative to other EM countries and the country possesses fiscal space to socialize bad loans. In fact, much of the private debt consists of state owned enterprise (SOE), corporate, and local government financing vehicle (LGFV) debt. The government start taking over LGFV debt in 2015 and is set to completely take over LGFV debt by the time these loans mature. China's external debt is small, only around 2% to 5%. In general, China's debt profile has deteriorated but is not dangerous.
The unanswered questions are: how large are existing non-performing loans, when and if the government will allow the banks to recognize bad debt, and in a slowing economy will the authorities resort to easy monetary conditions aggressively to cushion a debt unwind? The latter two measures could create a channel back to a speculative attacks. The Chinese government is well aware of the challenges posed by the banking sector and the likelihood of a capital account opening seems remote now. The bad debt situation will improve with the growing economy through the denominator effect. Talk of short term currency crisis is premature in the immediate future, much less in a few months time.
Bass made his name in 2007 when his Hayman Capital earned 212% by shorting subprime mortgages. However, the fund's return averaged only 1.56% annualized in the ensuing 8 years. His fund management performance is mixed. At the moment, Bass’ analysis of a crashing RMB seems off the mark.