- Investors tend to shy away from complex situations because they are difficult to understand. However, complex situations are exactly where the outsized profits lie for those who are willing to dig deeper.
- The Chinese financial system has two sides, a scary one and a strong one.
- There is one thing China has that no other market economy has.
I’ll start this discussion with the story of American Express (NYSE: AXP) and its 1963 salad oil scandal.
Anthony “Tino” De Angelis, a former commodities broker, figured that he could trick inspectors by putting just a few feet of salad oil in his containers and make it look like the containers were full as the oil floats on top of sea water. This allowed him to borrow huge amounts against the salad oil collateral. At one point, the oil market crashed and it was impossible to cash in on the collateral as there wasn’t any.
AXP took the biggest hit with a supposed loss of about $58 million, or roughly $600 million in today’s dollars. This scandal made AXP’s stock price drop from $65 in October 1963 to $37 in January 1964. Warren Buffett took advantage of the situation and invested $20 million in AXP, or approximately 40% of his portfolio. The aftermath cost AXP another $30 million and the rest is history.
What does this have to do with the Chinese financial system? My point with this story is that outsized long-term returns can be achieved if one is willing to look where others won’t, and understand the risk reward situation properly. Buffett saw that the scandal wouldn’t send AXP into bankruptcy and that apart from the scandal, the business was sound and healthy.
There’s a lot of commotion around the Chinese financial system, so the question we have to answer is whether it will survive and whether China will continue to develop as it has been for the past 30 years.
The Chinese Financial System
Let’s start by discussing what the China bears have to say.
The key figure here, Kyle Bass, correctly predicted—and made a lot of money on—the U.S. housing crisis in 2008. Bass says that there will be a collapse in China’s banking system as the Chinese economy is built on a foundation of sand because true developed economies don’t impose severe capital controls or move short-term rates hundreds of basis points overnight in an attempt to manipulate their own currency.
This manipulation and artificial control of the Chinese financial system leads Bass to believe that as soon as more natural forces are allowed to play within the banking system, the Chinese currency will have to drop at least 30%. Further, something that has to crack is the shadow banking system where wealth management products created to cater for investors looking for higher returns created a $4 trillion market promising investors returns of 10, 12, 15, and even 20 percent.
There are two important beliefs behind the shadow banking system. One is that the Chinese government will protect the assets, and the other is that the Chinese economy will continue to grow forever. Further, most of the shadow banking instruments are invested into real estate projects which means that the faith in the Chinese real estate market must not decline as it would create a chain of defaults.
High amounts of loose credit for developers and government-owned corporations is what Bass is talking about when he says the Chinese economy is built on a foundation of sand. But as investors, we have to ask ourselves whether the situation is really so bad that there is absolutely no future for the Chinese economy, or if China is still cheap even if the government loses its tight grip on the economy.
The International Monetary Fund recently concluded its assessment of the Chinese financial economy by saying that China’s big banks are well capitalized while the smaller banks may need to raise even more capital.
It’s important to note that Chinese financial assets are currently at 470% of GDP which is a huge number. A big problem is the artificial hand leading the environment. Many companies are simply forbidden to fail, especially those on the local levels and that are government-owned, in an effort to maintain social stability.
The expansionary monetary policy created to sustain growth has lowered interest rates and led investors to seek higher returns in more complex financials products. There is also the expectation that that the government stands behind debt issued by state-owned enterprises and local government financing vehicles which contributes to moral hazard and excessive risk-taking. The IMF concluded its report by saying that:
“International experience suggests that China’s credit growth is on a dangerous trajectory, with increasing risks of a disruptive adjustment or a marked growth slowdown.”
This might sound correct to the outside world, but China is a different economy than what we are used to. The Chinese economy is a political one, a market socialist system which has many banks and their portfolios are owned by the state or other state-owned enterprises. The Chinese state has the ability to intervene in and impact economic outcomes in a way that isn’t possible in the western capitalist world which is exactly what Kyle Bass has been mentioning as a liability, not an asset. The government focus pushes the banks to support the real economy.
The difference between what happened in the U.S. in 2008 and what is going on in China now is that China is proactive and not reactive. The government has set up a financial stability committee and created all sorts of regulations aimed at cooling down risk taking and adding stability to the financial system.
One example of the regulatory activities are the already notorious real estate market curbs, and also the recent regulation that limits fintech companies to a 36% interest rate. The regulatory changes made the stocks of fintech companies extremely volatile. A Chinese wealth manager, Jupai Holdings (NYSE: JP) went from a price of $8 in May, to a high of $28 in October only to fall to the high teens as the new regulation came out.
What’s interesting is that the regulatory environment was already known in May which means that investors investing in such companies aren’t really knowledgeable about the environment, which is similar to what the AXP situation was when the salad oil scandal hit it.
Now, will all of the above lead China to fail?
I’ve already mentioned that the government has much more maneuvering power than western counterparts and it can intervene to stabilize the financial system and keep it stable for the long term. Apart from that, China has one of the highest savings rates in the world.
As an interesting note, China owns about $1.3 trillion in U.S. Treasuries. This offers significant maneuvering space to protect the yuan.
It’s easy to pick on the new kid, but there are financial instabilities practically everywhere.
Ray Dalio is short Italian banks with more than $1 billion while Kyle Bass is long Greek banks and is short China. Who will win? I don’t know but we will keep digging into the global financial system to see where we can find protection and where the biggest risks are.
As for China, it’s definitely risky, especially the shadow banking system with $40 trillion in assets and about $2 trillion in equity, but there is so much more to China than that.