When Hollywood brought “The Big Short” to the big screen, the book’s author, Michael Lewis, was as surprised as anyone. A film about debt going bad? Seriously? But in filmmaking, as with investing, timing is everything. What makes the movie so timely is its role as primer for what’s afoot in China.
There’s little about China in Lewis’ 2010 best-seller. And, frankly, the Brad Pitt-starring screen version can feel dated given the cacophony of world events since Wall Street’s 2008 drama. That is, until you consider the $23 billion dilemma now facing Beijing, and, by extension, the hedge-fund dynamics Lewis chronicled.
This column has examined China’s $28 trillion problem, which relates to its post-Lehman Brothers credit explosion. A more immediate one is the roughly $23 billion of offshore debt rated just one small step away from junk by major credit-rating companies. The second biggest economy has a devilish assortment of so-called fallen angels. Any sudden rash of downgrades could trigger the next bout of turmoil in global markets.
Hence the big Chinese short amongst global hedge funds. It’s no coincidence that one of the stars of 2008, Kyle Bass of Hayman Capital Management, is now shorting the yuan, Hong Kong dollar and other Asian currencies. While Bass did less well with his bet against Japanese government bonds, he made $500 million from the U.S. subprime-mortgage crash. Another JGB shorter, Greenlight Capital’s David Einhorn, is betting on a depreciating yuan.
These trades irk President Xi Jinping’s government to no end, as recent attacks on George Soros indicate. Admittedly, it’s a highly sensitive moment for Beijing. As Xi’s team works to accelerate a transition to consumer-led growth and rein in a heavily indebted financial system, the last thing it needs is speculative attention. Yet Bass, Einhorn and others are highlighting risks that could spill over into markets and gross domestic product trends around the world. The yuan is on the front lines of negative Chinese sentiment.
“No other source of policy uncertainty has been as destabilizing,” former International Monetary Fund chief economist Kenneth Rogoff wrote recently. “Since 2016 began,” he argued, “the prospect of a major devaluation of China’s renminbi has been hanging over global markets like the Sword of Damocles.”
That sense of impending doom is hitting the Dow Jones Industrial Average, the Nikkei and other major bourses. China’s woes are slamming commodities markets and property prices, too. In Hong Kong, for example, property transactions are at a 25-year low with home prices down almost 10 percent since September. No wonder investors are testing Hong Kong’s dollar peg as the rising U.S. currency adds to deflationary pressures. Singapore and Sydney also are feeling the pain as Chinese buyers suddenly become scarce.
There’s every reason to look the other way as Chinese markets slide, and indeed some of this decoupling is afoot. Stock markets are bad reflections of fundamentals in the most developed economies, never mind China’s casino-like bourses. Beijing is paying the price for inflating a giant stock bubble. Each hissing sound from froth escaping has economists downgrading GDP prospects.
Yet even the most nuanced of China observers have to worry about a domino effect of credit downgrades. So far this year, S&P has cut ratings for at least 13 mainland companies (it’s upped one rating). That, according to Bloomberg News, is the worst ratio in a decade. As more companies fall into junk status, global funds may reduce Chinese holdings. Also, the need to do more research legwork on a notoriously opaque corporate system could mean less new investment to offset outflows, increasing default risks. News that even Chinese state media are calling online financing platform Ezubo a “downright Ponzi scheme” could scarcely come at a worse time.
China Inc. is the biggest issuer of international debt in Asia, with outstanding bonds approaching the $400 billion mark. Servicing those IOUs will become harder amid the slowest growth since the early 1990s and a currency experiencing downward pressure. Downgrades will make for some ugly headlines, reinforcing the narrative that a hard landing may be inevitable. That, in turn, would have Beijing accelerating sales of its $3.3 trillion of foreign-currency reserves to defend the yuan.
The panic that ensues each time Beijing lets the yuan slide is a curious thing. The Bank of Japan’s embrace of negative interest rates on Friday was a “dangerous escalation” in the currency wars, says Freya Beamish of Lombard Street Research. In a perfect world, the People’s Bank of China would devalue in kind. But, as Andrew Batson of GaveKal Research observes, we’ve settled into an oddly contradictory pattern: a weaker yen is a good thing, while a weaker yuan is a crisis. “Only when the central bank restores its credibility will investors stop treating a weak renminbi as bad news,” Batson says. “Until then, the curious dichotomy of market views about Asian currencies — weak yen good, weak renminbi bad — will remain in place.”
In the meantime, the big-short dynamic in China virtually eliminates exchange rates as a stimulus tool. Even as the PBOC adds liquidity to contain the fallout from $23 billion of potential junk debt, it may take offsetting measures to support the yuan. That could make monetary-policy moves a wash and increase the pressure to let the corporate sector and local governments borrow to boost GDP.
It’s hardly surprising that traders who made fortunes betting against U.S. housing are shifting to an even bigger bubble. “When you talk about orders of magnitude, this is much larger than the subprime crisis,” Bass told the Wall Street Journal recently, figuring the yuan could fall as much as 40 percent over the next three years. Soros, meanwhile, worries the next global crisis — China — has already begun.
Lewis, a Salomon Brothers alumnus, is less convinced. While he worries about “whole Chinese cities no one lives in,” Lewis told the Times of London that Western banks seem more insulated from mainland froth than U.S. housing in 2008. But then the whole point of “The Big Short” was that an iconoclastic few sometimes see what the herd doesn’t. Only time will tell if those shorting China are right. How the system handles $23 billion of possible Chinese downgrades, though, will offer some clues. It could give Lewis, and Hollywood, fodder for the next great market-crash stories.
William Pesek, executive editor of Barron’s Asia, is based in Tokyo and writes on Asian economics, markets and politics. www.barronsasia.com