Back in 2009 Evan Lorenz had a problem. Right around the market bottom, he was too good at spotting undervalued stocks to buy, so he had to leave the hedge fund where he was previously in charge of running the short book—there simply weren’t any good stocks to short around at that time.
After he moved to New York and started work for Grant’s Interest Rate Observer, his talent at finding overvalued companies brought him right back to China, which is now his main focus in his work for Grant’s.
Epoch Times spoke to Mr. Lorenz about the origin of China’s debt problem, possible solutions, low growth, a difficult adjustment process, as well as a coming devaluation of the renminbi.
Epoch Times: What’s the biggest problem facing China right now?
Evan Lorenz: It does seem like China’s overinvestment bubble is starting to pop with bad repercussions for China and the rest of the world at the moment. In the context of numbers: China is approximately a $10 trillion economy. Its banking system is approximately $29 trillion plus in size. Its bank assets are roughly three times GDP.
Anne Stevenson-Yang of JCapital Research looked at the number of loans and bonds that have to be rolled over or evergreened because the borrowers themselves can’t service them. She concluded about 24 percent of all bank assets may, in fact, be impaired.
They are evergreening problem loans instead of actually writing them off. So they look money-good on the balance sheet, but the problem is just kicked forward in time.
That would imply that bad debt to GDP is approximately 68 percent. The last time that China had an overinvestment bubble was at the end of 1999.
At the end of 1999, China’s bad debt to GDP was estimated to be 33 percent. It’s estimated because there were no real good numbers at the time. As much as people doubt China’s official statistics today, at least we have those statistics at hand and we can actually look at them.
So the problem is at least twice as large in terms of China’s output today as it was in 1999. In ‘99 China had a lot going for it. It was about to enter the World Trade Organization (WTO); it was opening up its economy more to foreign investment. It was allowing U.S. and other foreign banks to come in and recapitalize and improve the management of its own domestic banks.
Today China doesn’t have a WTO it can join, it’s economy has already been opened to foreign investment, and its banking system is much larger than the rest of the globe.
China’s banking assets as a percentage of world GDP are about 40 percent. There is no precedent for a banking system in one country being that large in terms of output. The United States in 1985 peaked at about 33 percent of GDP.
Japan when the Yen was surging in the early 90’s peaked at about 27 percent of GDP. 40 percent is just a number we’ve never seen in history.
If you look at Japan in 1991, its banking system was, for all intents and purposes, insolvent. They just didn’t write off loans and for the next 20 years the economy had no real growth.
China was able to outgrow its bad debt in the late 90’s and early 2000’s but between 1999 and 2005 China’s real GDP at a compounded 9.5 percent per year.
It had a lot of things that it could do then that it just can’t today. If we assume that it needs to grow at twice the rate to deal with a problem twice as large in terms of GDP, China would need to generate real GDP growth of around 20 percent in the next 6 to 7 or so years. I don’t think there’s any credible person right now that thinks China can grow that fast.
Epoch Times: So no growth for China in the future?
Mr. Lorenz: Much lower growth. It’s unclear whether it’s going to be 0, 1, 2, or even -1 percent but I do expect lower growth.
China is going to have to deal with this gigantic debt overhang as it’s both a very poor and increasingly old country.
Its working age population peaked last year, according to the World Bank. So its workforce is going to be contracting at the same time as they have this debt overhang that they have to work through. It has a lot of problems. It was poor before it got rich, it’s going to get old before its fully developed.
You have a lot of unserviceable liabilities tied to a lot of assets that can’t actually service them, so yes growth does slow.
Historic Debt Binge
Epoch Times: Please tell us more about the China’s historic debt binge.
Mr. Lorenz: Well, China has been generating about 30 percent in new debt as a percentage of GDP each year since about 2009. Again that’s one of those unprecedented things we’ve never seen in history before. Today we have a large stock of financial obligations that cannot be serviced by the real economy.
When debt grows at a much faster pace than nominal GDP for a number of years, that is unsustainable and it eventually ends. It seems like China has reached the end of its debt-servicing capability relative to its stock of obligations. The problem now is how China proceeds going forward.
It has in the past, when its run into these hurdles, tried to go through one last, great surge of lending and we saw that around the transition of CCP chairman Xi Jinping in the last Congress of 2012.
To try to grow out of this current slowdown and problem it would have to go through a much larger debt binge. That would just add more unproductive debt tied to more unproductive products which would leave the ultimate reckoning much worse. It’s actually better for China if they deal with the problems today rather than try to kick the can down the road.
Epoch Times: Why is much of this debt unproductive?
Mr. Lorenz: Well go back to the 1999 example. Back then a large portion of China’s population was essentially rural or near-rural. Applying almost any capital to people who had almost no capital applied to their labor is a huge increase in productivity so even though you had a lot of mal-investment, the gigantic surge in productivity was enough to make up for that and the economy and grow over that.
Go to China today … Where are the next big projects that could add to productivity in China?
Deal With It
Epoch Times: How does China deal with the debt problem?
Mr. Lorenz: China could do one of two things. It could force write-downs in its banks and force the banks to raise capital. But again, if the banking system is approximately $30 trillion in size and the bad assets are approximately 24 percent or so, that’s $7 trillion to $8 trillion of bad assets in China’s economy, which is about $10.3 trillion in size. It simply doesn’t have the capital to recapitalize those banks.
The other option is to kick the can down the road and rollover loans that can’t repay their interest to borrowers and pretend that they’re money-good. Japan did it for 25 years.
What we saw in Japan was that the economy did slowly rebound toward consumption in the context of almost zero real growth. Now that overstates how bad things were in Japan because the population declined. Real GDP per capita did increase a little bit but I think if you talk to anybody in Japan, things aren’t as good today as they were in the high-flying 80’s.
Epoch Times: Do you foresee the same scenario for China?
Mr. Lorenz: I think it is one likely scenario. There doesn’t have to be a mark-to-market event in China’s financial system like there was in the United States.
Regulators are much more forgiving about keeping high marks and balance sheets to keep banks seemingly solvent. In the United States, there are a lot of mechanisms which force banks to take their licks when they get them. So we could see a scenario where China has little nominal growth for a number of years as it absorbs its bad debt. Given the size of its debt overhang, this could be a long period of low growth.
Furthermore, China is a lower income country and that doesn’t really deal with the fact that on the East coast of China you have places with relatively high GDP per capita but on the West, you have areas with very low GDP per capita. Also, it doesn’t deal with the fact that China’s working age population, according to the World Bank, peaked last year and is actually declining going forward.
As much as they did to rescind the One Child Policy, it would take 18 years for that to actually start bearing fruit and start producing more people of the working age. Demographics are a slow-moving shift.
Demographics and economics are working against them.
Is Inflation the Solution?
Epoch Times: What about creating massive inflation?
Mr. Lorenz: They could inflate away the debt, but that would imply a massive devaluation of the renminbi. I do believe a massive devaluation of the renminbi is coming but it’s not that simple.
A central bank can choose any two of the three following things. It can have a floating exchange rate, it can have an open capital account, or it can have control over domestic monetary policy.
Well China’s capital account isn’t fully open, but it’s very porous and a lot of money has been flowing across the border. It does have a quasi-peg to the U.S. dollar and that means that it can’t really ease as much domestically as it would want to, to cushion the economy right now.
You have seen the central bank try to ease the effect of money fleeing China by doing a lot of short-term operations to keep banks liquid. This is in the context of reserves declining pretty rapidly. In January, we saw foreign exchange reserves decline by a little under $100 billion. They’re now under $3.2 trillion which are the lowest levels since May of 2012 if I’m not mistaken.
A large number of reserves have been pledged to other Chinese entities including the China Investment Corporation [China’s sovereign wealth fund] or used both for domestic or foreign policy like lending to places like Venezuela.
It’s not like those funds can be utilized today if China wanted to defend its peg; you just can’t liquidate some of those assets. Its stock of liquid assets with which it can defend its currency are probably a lot smaller than that $3.2 trillion. I’ve heard estimates of anywhere from $800 billion to $1.2 trillion of its reserves might actually be illiquid.
Devaluation
Epoch Times: So why not just devalue and be done with it? Then they could keep the reserves.
Mr. Lorenz: There’s a few problems with it. China needs to devalue enough, and probably a little bit more to create interest from outside investors in Chinese assets. If it devalues by 3-4 percent and people expect 10 percent, then all that 3 percent will do is create more expectation for devaluations and increase outflows.
What they need to do is devalue enough so people think buying assets in China right now is actually cheap and a good investment. Maybe they need to overshoot a little bit.
A number of Chinese corporates have taken out large U.S. dollar and other foreign currency denominated debt in the last couple years in the bet that the renminbi would appreciate and this was very cheap debt to service in the future. So you would bankrupt all the companies that had borrowed internationally.
So for one, it would lead to bankruptcies domestically. Two, it would be a political catastrophe right now. We’re in the middle of a U.S. election right now. China has already become an election issue. I have to imagine that the Republican front-runner Donald Trump is going to make China headline news until the election in November should they devalue 10-15 percent. That may lead to trade sanctions or some problems for China down the line.
Also, while China was approved to be part of the special drawing rights (SDR) for the International Monetary Fund at the end of last year, I don’t think it actually becomes part of the SDR bucket until October of this year.
The IMF could withdraw that approval, which would be a major loss of face for China. China also has staked a lot of its credibility on maintaining its peg and it doesn’t seem like officials want to lose face after they lost so much credibility in terms of their management of the stock market last year.
So it seems like they’re fighting it, they try to prop up the offshore renminbi, they spend funds doing that, investors attack it, and its back-and-forth with money slowly seeping out and reserves decline.
The other thing I threw out there is that we kind of think of China as one, homogenous actor. There’s a lot of different vested interests in China. So while you’re seeing money flee China right now and you see the PBoC trying its best to prevent massive outflows, you’re also seeing some of the largest cross-border mergers and acquisitions emanating from China.
You saw China can do a $44 billion bid for Swiss seeds and chemicals group Syngenta AG; you saw China’s Zoomlion bid $3.3 billion for Texan crane maker Terex Corp.; and you have Chinese companies bidding around $3 billion for General Electric’s home appliances business for example.
Those are outflows and it actually makes China’s problem worse in terms of money leaving the country. Part of the problem is that these are state-owned entities. It’s the same people in the party, different parts of the party who are benefiting from these cross-border bids to get foreign assets at the same time as other parts of the party are trying to fight money flows abroad in order to prop up the state.
The Consumption Story
Epoch Times: Ok so much for the bad news. What about the China consumption and rebalancing story the media is pushing?
Mr. Lorenz: The service sector is doing better than the industrial, fixed investment side of the economy. Fixed investment is still 46 or 47 percent of overall GDP. Let’s say that the service side grows 10 percent.
Let’s say that the fixed investment grows 0 percent. That means that you get maybe 4 percent growth. It seems unlikely but in order for that to happen, China needs to build the same number of roads, railways, and empty buildings as it is today.
If we assume that the fixed investment economy declines going forward because they’ve overbuilt too much capacity in too many parts of the country, even if they’re growing the service side 10 percent per year overall growth would be 2 percent, 3 percent maybe.
The other thing is that a lot of Chinese wages are tied to overall sales levels. A lot of employees have their bonuses or their wages tied to the level of sales for widgets or haircuts or whatever business they’re in. So as sales decline on the industrial side it does feed through on the service side and we are seeing services, while they’re still growing, grow at a decelerating rate.
Epoch Times: What’s your prediction for 2016?
Mr. Lorenz: I think growth will continue to slow down. It’s difficult to say if there’s a financial crisis. Barring a sudden stop in the financial system, they may be able to kick it down the road as growth slows. Barring a financial crisis, I think they'd just go to slower and slower growth. If a financial crisis does happen it’s hard to predict just what will happen.
I think the currency will grind lower. They will have to devalue. I do think they will fight it as long as possible for what we spoke about earlier. That said, I do think a devaluation at this point is inevitable, it’s just going to happen.
