IS OUR BEARISH THESIS ON THE CHINESE FINANCIAL SYSTEM PRICED IN YET?

Takeaway: On an immediate-term basis, yes. On an intermediate-to-long-term basis, no. A crisis appears unlikely, but structural headwinds will remain.

SUMMARY BULLETS:

 

  • At any rate, the fact that the PBoC chose to disseminate this “quit whining” message to the broader public nearly one full week after it was first published is a reiteration of their conservative bent and an explicit affirmation of our call that the PBoC won’t be there to save the day this time.
  • This stance was no less backed up by the powers that be atop the Chinese communist party. Per Xinhua, the official state-run news agency: “It is not that there is no money, but the money has been put in the wrong place.”
  • All told, in the face of slowing deposit growth, the confluence of rising NPLs and/or the perpetual debt rollovers of SOE borrowers on top of balance sheets clogged with long-term assets that are held to maturity is something that will remain a sustainable headwind to the abundance of liquidity across the Chinese financial system.
  • From a deposit growth perspective, it’s not like Chinese households are going to save more, at the margins – especially in the context of the Communist Party’s economic rebalancing agenda. Structural headwinds to export growth (potential CNY overvaluation, sluggish growth in the EU and SAFE’s regulatory crackdown on “fexports”) will limit inflows of new capital into the Chinese economy as well.
  • As such, we expect credit growth to slow sharply from recent levels and remain sustainably slower for the foreseeable future. That will weigh on observed rates of economic growth and future growth expectations, which should reflexively perpetuate greater [unreported] NPL exposures.
  • Layer on NIM-compressing interest rate liberalization – which the PBoC recently affirmed they are forging ahead with – and you have one heck of a three-pronged bearish thesis for Chinese financials stocks, as outlined most recently in our 6/12 presentation.

 

The question from here, however, is: “Is all the bad news priced in?” While that’s always the hardest question for an in-the-money short-seller to answer, we’ll at least take a shot at answering it for the sake of maintaining our reputation for being both actionable and accountable with our research calls:

 

  • It is our opinion that the bad news is likely priced in on an immediate-term basis – i.e. don’t pile into the short today expecting another -5% down-day tomorrow/this week.
  • On a intermediate-to-long-term basis, however, there’s little-to-no chance that the end of Chinese financial repression and the commensurate unwinding of the country’s fixed assets investment bubble is priced in – especially if the Shanghai Composite takes out its DEC ’12 lows in the coming days and/or weeks.
  • Can the CHIX ETF go back to $8 (i.e. down another -25% from the current price)? Can CAT go back to $22.17? Can FCX go back to $8.40? Can copper go back to $1.25/lb.? Can the AUD/USD go back to $0.60? When we see consensus start to ask those kinds of questions, that’s when we’ll consider our bearish thesis on the Chinese financial system priced in. 
  • While it’s neither prudent nor analytically precise to make crisis calls like Barron’s did this weekend, we do think headwinds will remain across the Chinese financial system for the foreseeable future – at least until the PBoC meaningfully alters their stance (which is an obviously improbable scenario at the current juncture).

 

*** For the rigorous analyses backing our conclusions, please source the hyperlinked work listed at the conclusion of this note.***

 

SHORT-TERM HEADWINDS: NO EASING; NO LIQUIDITY

Down -529bps today, China’s benchmark Shanghai Composite Index took it on the chin largely due to the consensus realization of one of the core tenets to our bearish TREND & TAIL thesis on Chinese financials and property developers: the PBoC won’t be there to save the day this time.

 

One week ago, the PBoC sent out a note to commercial banks telling them that they will “continue to implement the prudent monetary policy while fine-tuning it at a proper time”. The statement continued: “Banks should allocate positions beforehand and keep abundant reserves. Prudence is needed in arranging asset portfolios and controlling liquidity risks arising from the credit binge.”

 

Essentially, the PBoC was firmly telling Chinese banking institutions to avoid channeling liquidity that could be better used for interbank lending and/or SME credit expansion, for example, into illiquid investment vehicles (such as WMP and Trust products), which is an activity that has been taking place with great frequency in recent quarters. In the context of the PBoC refusing to ease monetary policy in any meaningful way, credit misallocation has weighed heavily upon interbank liquidity ahead of (and likely through) dividend payout season:

 

  • China’s four major state banks owe roughly CNY250 billion in cash dividends for 2012, of which CNY146 billion will be distributed to A-share holders; and
  • Bank of China and China Construction Bank will pay out on 7/12, while ICBC and Agricultural Bank of China will pay out on 7/19 and 7/22, respectively.

 

At any rate, the fact that the PBoC chose to disseminate this “quit whining” message to the broader public nearly one full week after it was first published is a reiteration of their conservative bent and an explicit affirmation of our call. This stance was no less backed up by the powers that be atop the Chinese communist party. Per Xinhua, the official state-run news agency: “It is not that there is no money, but the money has been put in the wrong place.”

 

LONG-TERM HEADWINDS: SECULAR LIQUIDITY CONSTRAINTS (RISING NPLs/DEBT ROLLOVERS + SLOWING DEPOSIT GROWTH) AND NIM-COMPRESSION

By “wrong place” we assume they are referring to the country’s fixed assets investment bubble – where the long term credit instruments underpinning it having been increasingly funded by shorter-term liabilities in the form of WMP and Trust products. All told, in the face of slowing deposit growth, the confluence of rising NPLs and/or the perpetual debt rollovers of SOE borrowers on top of balance sheets clogged with long-term assets that are held to maturity is something that will remain a sustainable headwind to the abundance of liquidity across the Chinese financial system.

 

From a deposit growth perspective, it’s not like Chinese households are going to save more, at the margins – especially in the context of the Communist Party’s economic rebalancing agenda. Structural headwinds to export growth (potential CNY overvaluation, sluggish growth in the EU and SAFE’s regulatory crackdown on “fexports”) will limit inflows of new capital into the Chinese economy as well.

 

As such, we expect credit growth to slow sharply from recent levels and remain sustainably slower for the foreseeable future. That will weigh on observed rates of economic growth and future growth expectations, which should reflexively perpetuate greater [unreported] NPL exposures. Layer on NIM-compressing interest rate liberalization – which the PBoC recently affirmed they are forging ahead with – and you have one heck of a three-pronged bearish thesis for Chinese financials stocks, as outlined most recently in our 6/12 presentation.

 

IS ALL THE BAD NEWS PRICED IN?

The question from here, however, is: “Is all the bad news priced in?” While that’s always the hardest question for an in-the-money short-seller to answer, we’ll at least take a shot at answering it for the sake of maintaining our reputation for being both actionable and accountable with our research calls:

 

  • It is our opinion that the bad news is likely priced in on an immediate-term basis – i.e. don’t pile into the short today expecting another -5% down-day tomorrow/this week.
  • On a intermediate-to-long-term basis, however, there’s little-to-no chance that the end of Chinese financial repression and the commensurate unwinding of the country’s fixed assets investment bubble is priced in – especially if the Shanghai Composite takes out its DEC ’12 lows in the coming days and/or weeks.

 

Can the CHIX ETF go back to $8 (i.e. down another -25% from the current price)? Can CAT go back to $22.17? Can FCX go back to $8.40? Can copper go back to $1.25/lb.? Can the AUD/USD go back to $0.60? When we see consensus start to ask those kinds of questions, that’s when we’ll consider our bearish thesis on the Chinese financial system priced in.

 

IS OUR BEARISH THESIS ON THE CHINESE FINANCIAL SYSTEM PRICED IN YET? - 2

 

While it’s neither prudent nor analytically precise to make crisis calls like Barron’s did this weekend, we do think headwinds will remain across the Chinese financial system for the foreseeable future – at least until the PBoC meaningfully alters their stance (which is an obviously improbable scenario at the current juncture).

 

IS OUR BEARISH THESIS ON THE CHINESE FINANCIAL SYSTEM PRICED IN YET? - Barron s China Credit Crisis JUN  13

 

If you’re betting on systemically risky bank failures and a loud, disorderly bursting of China’s credit bubble, you will likely be sorely disappointed. As we have pointed out in our work, the Chinese sovereign has ample fiscal and foreign exchange firepower to meaningfully mollify that outcome. Moreover, the fact that much of our three-pronged bearish thesis is largely the result of policy directives suggests that the story can change at the drop of a favorable headline.

 

For now at least, investors should continue to expect a prolonged bleeding of Chinese financial sector fundamentals, as well as the long-term threat of destabilizing capital outflows from the Chinese economy. For the rigorous analyses backing our conclusions, please source the hyperlinked work below.

 

Darius Dale

Senior Analyst

 

  • THE CHINESE FINANCIAL SYSTEM IS FREAKISHLY STRESSED (6/19): There appears to be no end in sight for desert-like liquidity conditions across the Chinese financial system.
  • REPLAY PODCAST AND SLIDES: ARE YOU SHORT CHINA [AND OTHER EMERGING MARKETS] YET? (6/12): We think the outlook for Chinese credit growth is structurally impaired. Moreover, we anticipate that growth in non-performing loans will accelerate sustainably over the long term. Lastly, we believe that net interest margins across the Chinese banking industry face immense regulatory headwinds that may ultimately have dire consequences for China’s fixed assets investment bubble. At a bare minimum, investors should steer clear of these obvious value traps over the intermediate-to-long term. Moreover, we continue to believe assets linked to Chinese industrial demand will remain under pressure for the foreseeable future.
  • IS CHINA PREPARING FOR SYSTEMIC FINANCIAL RISK? (6/10): Recent policy developments call attention to the systemic risks facing China’s banking system. Additionally, MAY growth data came in soft.
  • IS A RATE HIKE(S) COMING DOWN THE PIKE IN CHINA? (6/4): No change to our dour view of China’s TREND-duration growth outlook or the pending bifurcation of FAI and consumption growth.
  • IS THE RECENT RALLY IN CHINESE EQUITIES SUSTAINABLE? (5/17): We do not think the recent strength in the Chinese equity market is sustainable, as China’s 2H13 growth outlook appears dicey at best.
  • WHY IS CHINA GOOSING ITS EXPORT FIGURES AND HOW MUCH LONGER WILL IT CONTINUE? (5/8): Chinese firms are goosing exports to drive incremental liquidity into the banking system – a phenomenon that appears set to slow from here.
  • TWO CHINAS? (5/1): Financial system headwinds continue to outweigh consumption tailwinds within the Chinese economy.
  • REPLAY: Will China Break? (4/30): The Party’s use of state owned banks to drive economic growth through fixed asset investment has left the financial system loaded with bad assets.  The bad assets mirror bad investments in the real economy.  They also can limit the ability of Chinese banks to make new loans.  Following the financial crisis, the Chinese government pushed too hard on the FAI growth lever, building infrastructure projects “for the next 10 years.” It has also left the banking sector choked with bad debts that may limit future lending.  Those factors should slow Chinese FAI growth and slower Chinese FAI growth should be negative for commodity prices and resource-related profits, all else equal.
  • CAN CHINA AVOID FINANCIAL CRISIS? (4/26): The risk of a Chinese financial crisis is heightened to the extent that financial sector reforms are not appropriately managed.
  • REPLAY: EMERGING MARKET CRISES (4/23): We currently see a pervasive level of risk across the emerging market space at the country level and have quantified which countries are most vulnerable. China is particularly vulnerable to experiencing a financial crisis.
  • IS CHINA CAREENING TOWARDS FINANCIAL CRISIS? (3/28): Systemic risks are present across China’s financial sector – as is the political will and fiscal firepower needed to avert a crisis.

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