Updated: Aug 23
“How did you go bankrupt?"
Two ways. Gradually, then suddenly.”
― Ernest Hemingway, The Sun Also Rises
August 22, 2023 | This week, The Institutional Risk Analyst is on the west coast, spending some quality time with one of the leaders in the world of jumbo mortgages. Over the weekend, we got a classic note from a longtime reader named Alan, who knows a few things about markets and also politics.
“China is melting” was the headline. “The yuan is looking like it is about to collapse,” he continued. “That makes all the raw materials China imports more expensive.” We agree. But notice that the yuan is hardly a freely-traded currency, as shown in the chart below from FRED. That flat blue line running along the bottom of the chart is the yuan.
Markets and media are fussing about an active “defense” of the yuan mounted by the People’s Bank of China, but the Chinese currency is as stable as a cold dead corpse lying in Tiananmen Square. Compared with the Japanese yen or the dollar, the yuan is an irrelevancy. And there seems little question that the yuan and China are greatly overvalued.
Operating behind what is effectively a fixed currency, China has been on a debt-fueled journey over the past decade. This is a familiar process to students of China. The communist nation absorbs resources from overseas during a period of supposed “opening,” followed by an equally long period of political retrenchment and economic contraction as access to foreign finance is withdrawn. Offshore investors are the dupes in this narrative.
The yuan is monumentally overvalued given the true hidden financial and economic weakness of the Chinese state. China's debt $14 trillion in debt as a percentage of GDP is 3x the United States and, more important, has exploded over the past year, increasing over 40% during 2022. But here's the key question: How big is the Chinese economy, really?
Over $100 billion of China property debt has defaulted over the past two and a half years, according to JPMorgan (JPM). Prior to Country Garden, CNBC reports, China's property sector already chalked up $109 billion in defaults since the beginning of 2021, which is 94% of total defaults in Asia during that period. Note that Beijing is defaulting on the dollar debt, but supporting local currency debt.
Our view is that China has experienced a debt crisis since before the collapse of HNA, an allegory for Chinese society today under communist party misrule. In “Great Leap Backward,” Liu Binyan and Perry Link wrote 30 years ago in The New York Review of Books:
“Most of the good news from China during the Deng Xiaoping era concerned the country’s economy. It grew at an average annual rate of 10 percent from 1981 to 1991, and 12 percent from then until 1995. Average personal income more than tripled in the 1980s, and doubled again in the first half of the 1990s. Some Westerners were dazzled. In November 1992, The Economist referred to “one of the biggest improvements in human welfare anywhere at any time,” and six months later Business Week told of “breathtaking changes…sweeping through the giant nation.” Foreign corporations, eager to be part of the China boom, poured investment in at record rates. China’s foreign currency holdings soared.”
The creation of HNA in 1993 came in the same year as the start of the Three Gorges Dam project, a massive state initiative that showed the power of the Chinese Community Party to direct – and misdirect – economic resources on a global scale. But the growth of HNA into a symbol of Chinese economic power also involved the active assent and permission of the CCP. Beijing opened the currency window to foreign direct investment on a scale that would make even the most reckless Tokyo speculator blush.
Back in 2017, when we resumed publication of The Institutional Risk Analyst, we focused on HNA because of our previous experience at Kroll Bond Ratings. About a year before, a new aircraft lessor called Avolon had arrived on the doorstep, seeking to be rated for the global market in secured aircraft leases. Based in Ireland, Avolon was a copy of the proven celtic model for aircraft leasing, but was owned and controlled by HNA.
Around this same time, HNA started opening offices around Manhattan and hanging their logo on the sides of office buildings. In fact, HNA put their logo on an office building across Third Avenue from Kroll’s offices. HNA purchased a large corporate conference center across the Hudson River in Nyack. HNA officials hosted vast parties in the most expensive Manhattan eateries.
In 2017, there was little information about HNA other than the fact that it was from China and at least indirectly supported by Beijing. The fact that the Chinese company was acting in such an ostentatious, ill-considered manner suggested instability, but at nobody in the world of finance seemed to care. Like fascist Nazi Germany a century before, authoritarian China was the wonder of the world and its corporate progeny could do no wrong.
Avolon today provides a key dollar financial conduit for China's aircraft market. KBRA notes in a May 2023 surveillance report:
“Avolon is a global leader in aircraft leasing with a fleet of 830 aircraft owned, leased, or committed for the service of 147 airlines across 65 countries as of March 2023. The company is based out of Ireland and has multiple other office locations in the United States, Dubai, Singapore, Honk Kong, and Shanghai. Currently, Avolon is 70% owned by an indirect subsidiary of Bohai Leasing Co., Ltd. And 30% by ORIX Aviation Systems.”
Avolon is still apparently controlled by the Chinese government, which controls HNA. But more important, Avolon is one of the few businesses that came out of the 2020 collapse of HNA that continues to operate. The misallocation of capital and a lot of debt by China’s emerging corporate flowers was monumental, but still pales compared to the economic calamities engineered by the CCP. And our key insight, then and today, is that there is precious little equity underneath these Chinese “investments.”
During the early 2010s, Beijing allowed HNA and other firms to acquire foreign companies including Deutsche Bank AG, Hilton Worldwide Holdings, properties such as golf courses, landmark hotels across six continents and 245 Park Avenue in Manhattan. Think of this shopping binge as imitating Japan circa the early 1980s but with 100x dollar leverage. Credulous western regulators welcomed HNA’s “investment” in the stricken Deutsche Bank, until they realized that the whole transaction was financed with derivatives.
Adam Tan, chief executive of HNA Group Co., told an adviser he thought the conglomerate was growing too quickly in 2017, the Wall Street Journal reports. But in fact the whole of China was growing too quickly and in many cases without a viable plan for the expenditures and related dollar debt. The fact that dollar interest rates were being kept artificially low by the FOMC encouraged even more risky behavior. In many ways, low interest rates in the US may have set China up for a big fall.
By 2017, HNA reported 1 trillion yuan (US$154.8 billion) of assets, with at least 500 billion yuan of debt – much of it in dollars. By the beginning of 2018, the Chinese government seized control of Anbang Insurance Group Co, starting a formal retreat from offshore foreign investment such as the “Belt & Road” fiasco. These debt-fueled speculations propelled China’s offshore investments to absurd heights and also financed internal property speculation.
The financial rot in China is a function of a deeper moral decay under CCP rule. Xu Jilin writes in his 2020 book, “Rethinking China’s Rise.”
“Chinese today are like nineteenth-century Europeans, bursting with ambition, industrious and thrifty, full of greed and desire; they believe that the weak are meat for the strong and that only the apt survive—they are vastly different from traditional Chinese, who prized righteousness over profit and were content with moderation. What kind of victory is this?… We’re like Japan in the nineteenth century, and what we’re seeing is the report card of a student that copied Western civilization. It’s the report card of a seriously unrounded student.”
Our view is that China has been caught in a debt deflation for the past five years, but western media and investors refuse to recognize the obvious signs of contagion. Observers point to China’s large reported reserves as evidence of financial solidity, but this only works if you believe the data released by the CCP. None of the economic statistics in China are worthy of attention, but the western media and investment community seem indifferent to such concerns.
We suspect that lot of that Treasury collateral reportedly owned by China is already leveraged in the offshore market for dollar swaps or stolen by communist party cadres. After all, the whole point of being a member of the CCP, now some 10% of China’s population, is to steal as much as you can and move it offshore… into the safety of dollars.
As China's debt crisis unfolds, finding the offshore cash and assets secreted away by CCP officials will keep the lawyers busy. Perhaps the more important lesson, however, is that the economic growth that has so impressed western apologists for China like Jeffrey Sachs may be a state-financed mirage. It was not so long ago that Professor Sachs himself warned western audiences to beware of Beijing's economic data.
European Central Bank board member Benoit Coeure, in an apparent reference to China, said last year there was a growing prevalence of poor quality data which risks fuelling economic manias and panics.
“Just as there are concerns about ‘fake news’ dominating social media, there is a risk of ‘fake’, or at least poor quality, statistics driving out better quality ones in public discourse,” Coeure said in Paris.
“Actions by economic agents could become less anchored to actual activity and more prone to manias and panics, with obvious implications for economic and financial stability,” he added. China's economy under Xi Jinping is the case in point.
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