Thursday, October 24, 2013
Q&A With Kyle Bass
By Robert Stowe England
October 24, 2013
Below is the transcript of a recent interview with J. Kyle Bass, founder and principal of Hayman Capital Management in Dallas, and Richard Howard, managing director and global strategist with Hayman.
Q: In you letter to investors in June, you talked about the rapid growth of credit in China and how that was driving the economy and how they couldn’t go on forever increasing loans – and a lot of that is in the shadow banking system. Is that really reflected in official numbers of bank lending – that is, the growth of lending in the shadow banking system?
Richard Howard. I think the growth in Total Social Financing [in the central government’s official data] comes the closest to capturing all that shadow banking activity
Kyle Bass: Which is a number they do release.
Q: You cite in your letter that Total Social Financing is now growing at nearly 22 percent a year as of April – and that the total size of Chinese credit system is 256 percent of GDP. You described this as “three times the total credit system growth experienced in the United States at the peak of the bubble in 2006.”
Howard: And that is the broadest category that they release. We don’t consider it 100 percent reliable, but is nonetheless helpful from a trend point of view.
Bass: For the record, we don’t deem anything coming out of China to be reliable, as far as data is concerned. You can look at aggregated data. You can look at, like in this case, the [People’s Bank of China] has a depository survey which is based on the four largest banks in China. So, anyway there are data sources that are homogenous throughout time, but they definitely aren’t all inclusive or comprehensive.
Q: It’s been four months since your wrote in your letter to investors that you talked about a likely recession next year in China. Do you still feel the same way about your outlook as you did then?
Howard: I think that what we were trying to outline in that letter is that if you saw a significant drop in the expansion of credit then you would likely see a pretty aggressive drop in economic activity as well. We were questioning the utility of that credit expansion because the rate of economic growth had seemed to disconnect and detach itself from that increase in credit expansion. So, we were concerned that if you can’t even generate particularly strong economic activity with such high rates in credit growth, once the high rates of credit growth started to mitigate and to decrease, then you would likely see an even more aggressive downward impact on economic activity. Now, it’s become apparent at least from the data that is being released that there has been a pickup in [economic] activity over the course of the last couple of months since we made those comments.
Q: There’s been more bank lending?
Howard. Well, there’s been a little more bank lending but there’s also been a pickup in economic activity. As Kyle mentioned, we take all that data with a healthy sense of skepticism. It certainly conveniently fits within the policy path that’s been set forth by the new Chinese Administration. So, we are, as I say, somewhat skeptical. But at the same time, it’s clear that we are seeing a pickup in some level of activity across the rest of the non-Japan Asia region, which suggests that there is certainly some movement in China.
Bass: And there’s another point that we were trying to make in that letter that is important. When you talk about the shadow financing system, that’s really a non-bank phenomenon. And when you look at prior credit booms busting it is when the banks stop lending to the nonbanks. And beginning in June, you saw that the nonbank lending was not jumping onto the banks’ balance sheets at the end of the quarter, like it always does. That’s really what led us to believe that you were starting to see the banks not trust the nonbanks and the nonperforming loans start to pick up a little bit.
You have 250 to 300 percent of GDP in bank assets in China. To compare that to the United States, we have about 100 percent of GDP or a little less in our banks today in bank assets. So, can China put another turn of GDP with bank lending? Well, yeah, because they control the spigot. Basically they can make the problem infinitely worse by continuing to force the banks to lend. And I think that’s what we’ve seen happen in the last 30 or 40 days.
The short answer is that you don’t know when the government finally stops, but when they do, nonperforming loans will spike to more than 20 percent and the loss revenues will be 100 percent on those loans.
Howard: And also on top of that, as Kyle mentioned, part of the thrust of the letter was that we were trying to suggest that the marginal return for each additional unit of credit that was being extended was diminishing. And that means that if there is a natural limit to how much credit can be extended, then we got to approach the impact that it has on the growth of economic activity would be even faster [and sooner] than it would otherwise be.
Q: Thus economic growth would likely slow even if they kept lending.
Bass: That’s right.
Q: So what does this outlook in China mean in terms of Hayman Capital’s investment decisions?
Bass: We don’t invest per se in China. But we do invest in the economies that are some of their biggest trading partners. We currently have an investment in New Zealand, in their government bonds and their interest rate market place. From time to time, we invest in the Australian sovereign market place. As you know, we have a significant focus on Japan. All the peripheral nations will feel significant repercussions if China slows down. So, we follow China as closely as we can, but we have a real problem investing there.
Q: How confident are you that China will slip into recession next year?
Bass: That’s like asking me if we know when [China’s President] Xi Jinping is going to cut off the spigot. The best we can do here is be a coincident indicator and say well, if the banks aren’t trusting the banks and the Chinese won’t lower the reserve requirement at the banks, well then lending is going to contract, nonperforming loans are going to show up and they are going to have a problem. If the government wants to go for broke and continue to expand the banks’ assets – the old adage we use here is that the rolling loans gathers no loss – [they can]. And I think that’s what they are doing today.
Clearly, when any of those loans go bad, they are going to lose 100 percent of their capital. So your question is how aggressive will the leadership of China get to try to starve off a significant recession and contraction. And the answer is pretty aggressive. So, we don’t know.
Q: Since you don’t invest in China you really would not have an opinion on what this means for people who do invest in China I’m guessing.
Bass: For people who invest in China I just don’t know how they believe the numbers are the numbers. Even in the Wikileaks you saw that our attaché to China said China keeps two sets of records. It’s clear you’re not seeing the real numbers. You’re seeing the numbers they want you to see. So, as a fiduciary, I don’t know how you invest in that environment.
See also these stories on Kyle Bass:
Institutional Investor's Alpha, October 16, 2013: Japan
Institutional Investor, October 22, 2013: J.C. Penney