Pessimism towards the outlook for China’s economy has reached unprecedented levels of late.
A slowing economy, rapid increase in indebtedness and series of embarrassing policy bungles towards liberalising its financial system has seen even the most optimistic of China bulls question their beliefs.
The uber-bears, such as famed US hedge fund manager Kyle Bass, smell an opportunity, predicting that financial Armageddon is about to hit China’s banking system.
In his view, the mortgage meltdown that hit the US in 2008, an event in which he made his name, could potentially pale in comparison when it comes to what will happen next in China.
While being bearish towards the Chinese economy is an understandable outcome, and one that is becoming increasingly embraced by the investment community, Tao Wang, economist at UBS, believes Bass will be proven wrong when it comes to the outlook for China’s economy, banking system, and the crux of his terrifying call, a devaluation in the remnimbi of around 40%.
Without naming Bass specifically, Wang rejects the idea that a wave of bad debts is about to sweep through China’s banking system, leaving the government no other option than to liquidate a large chunk of its FX reserves to recapitalise the nation’s state-owned banks.
Here are four reasons why Wang is not backing Bass’ call.
While we acknowledge the seriousness of challenges facing the Chinese economy and exchange rate regime currently, we do not think it as bad as some believe because:
1) The RMB appreciated from an under-valued position and we believe is only modestly over-valued, and China has no intention to risk destabilizing domestic and global markets by using a sharp depreciation to promote exports.
2) Banking sector losses should be derived from bad banking credit rather than total system assets, which would be much smaller than as currently expected by some. More importantly, banks have ample liquidity and do not have to recognize bad debt all at once, and do not require an immediate large capital injection.
3) China does not need to use FX reserves to recapitalize banks nor follow the US approach. Fiscal policy can and will continue to play a bigger role for supporting growth, and we believe the state will help recap the banks directly when necessary instead of beating around the bush.
4) China’s $3.2 trillion in FX reserves do not include CIC [China’s sovereign wealth fund] assets (much of it actually from capital gains) or bank recap funds. IMF’s composite metric suggests that China needs $2.7 trillion in FX reserves without capital controls to defend against shocks and attacks – but China has capital controls and can implement them more strictly.
While Wang expects both economic growth to slow and corporate balance sheets to weaken further, in line with Bass’ call, he suggests that “the risk of an immediate systematic financial crisis as very small due to high domestic saving and ample banking liquidity, extensive government ownership of banks and many debtors, and capital controls”.
“(This) will enable slow recognition of NPLs [non-performing loans] with banks continuing to lend to the economy while raising more capital to help speed up debt write-off’s over time,” says Wang.
“Notwithstanding serious depreciation pressures, we expect the RMB exchange rate to depreciate modestly with the help of persistent current account surplus, tighter capital controls and some loss of reserves.”
That fits with majority of economists views, a so-called “muddle through” approach that will neither see economic conditions deteriorate sharply not improve dramatically in the years ahead.
However, as markets have seen time and time again, just because the majority are calling for one outcome doesn’t mean that it will eventuate.