Top US hedge fund manager says China heading for financial chaos

Kyle Bass, the American hedge fund manager who correctly called the 2008 subprime mortgage crisis, believes China is heading for financial chaos because of rapid credit expansion in the country's banking system.

In the most bearish prognosis yet by a significant commentator on the world’s second biggest economy, Bass forecast that China’s banking system will suffer a loss four times greater than that suffered by US banks during the great recession.

The crisis will also have repercussions on the euro, because in the last few years the European Central Bank had actively targeted weaker exchange rates to stimulate Europe's export sector.

“We have been vigorously studying China over the last year, with the view that the rapid credit expansion in the Chinese banking system will result in significant credit losses that will require the recapitalisation of Chinese banks and materially pressure the Chinese currency,” Bass wrote in a note for investors.

“This outcome will have many near-term and long-term effects on countries and markets around the world. In other words, what happens in China will not stay in China,” said Bass, who is co-founder and managing partner of the Dallas-based Hayman Capital Management.

China’s economic growth fell to 6.9 per cent for 2015, the slowest rate in 25 years, and the government says that this is a consequence of the economy changing and part of what it sees as the “new normal” of moderate expansion.

Bass however believes that the situation is far more serious. He said that credit in China has reached its near-term limit, and the Chinese banking system will experience a loss cycle that will have profound implications for the rest of the world.

Bass believes that China has used off-balance-sheet lending to grow its assets to more than three times the size of GDP - the banking system has grown into a “gargantuan $34 trillion (€30 trillion) behemoth”, which is 340 per cent of GDP.

“What we are witnessing is the resetting of the largest macro imbalance the world has ever seen,” he said.

In his assessment, because of non-performing loans, China’s financial institutions are set lose 10 per cent of their assets, which would force the government to print around €9 trillion to keep banks liquid and the yuan currency could lose over 30 per cent of its value against the dollar.

“The weakening renminbi is just a symptom of the larger banking problems,” he wrote.

Many economies, including Ireland and other Eurozone economies, Japan, Russia and several Southeast Asian countries, have gained significant price advantages at China's expense.

“If China is to achieve the required clawback of its real effective exchange rate, the renminbi will need to devalue against a trade-weighted basket of currencies and not just the dollar,” he said.

In conclusion Bass wrote: “The next 18 months will be fraught with false-starts, risk rallies, and second-guessing. Until China experiences a significant devaluation, it will not be able to cope with the build-up of credit that has helped fuel its rise, but may, in the short-term, be its undoing.”