China’s Economic House Of Cards Is Collapsing | Brian McCarthy

Banks in China are making what McCarthy calls 'black hole loans' to property developers to finish unfinished apartment buildings; these loans default economically even if they are rolled because the underlying projects are fundamentally uneconomic

“you mentioned the the they're making loans to property developers to finish buildings but the property developers have already been paid for those apartments and lost the money so that those are literally black hole loans those Lo the banks are making”

China has accumulated approximately 2 trillion dollars of presale real estate liabilities (prepayments by home buyers for unfinished apartments); if developers stopped building, millions of households who paid in advance would be left with nothing

“I think it's a couple trillion dollars of pre-sale liabilities among all the developers that if they just stopped people who paid for apartments would be out of luck so they don't want that they can't have that”

Last year China issued 1 trillion yuan in special bonds to push the official 3% deficit to 3.8%; this year they again issued 1 trillion in special long-dated bonds off-budget; the expected new stimulus package of 2 trillion yuan would approximately match last year's extraordinary measures.

“last year uh you know they set the official government central government deficit at 3% last year they came in about this time they did an extra trillion of special bonds to push it to 38 uh which was I believe the first time since the global financial crisis that they came in late in the year with a little extra there um you know this year they did do a trillion uh special bond the the was it 40y year 50 year whatever they did a long tronan yeah they did a you want in Long dated debt that like that's like off budget they're not even counting that so they've done an extra trillion already”

China's local governments have dramatically reduced off-balance-sheet debt issuance as part of government transition toward discipline, but this has created a collapse in local government spending which is currently down 3% year-to-date through August, creating a contractionary fiscal dynamic.

“spending on a Consolidated Central local government basis is down like 3% year-to dat through August the local governments are sucking wind so so the last year when they issued the trillion special bond they gave it to local governments and you know they'll do the same because they're trying to wean them off of this off-balance sheet debt craziness”

China's augmented budget deficit (including central government, local government, and off-balance-sheet spending) is already 11-15% of GDP annually by IMF estimates, meaning the theoretical ceiling for additional fiscal support is limited.

“the augmented deficit if you include Central local and local government off balance sheet by IMF estimates is already like 1112 it's been as high as 15 they could go% of GDP yeah okay annually already already right”

The key difference between fiscal policy (government borrowing and spending more than taxes) and monetary policy (central bank balance sheet expansion) is that monetary policy alone can 'push on a string' in deflation without generating inflation, but fiscal policy creates real aggregate demand and must be paired with monetary policy for maximum effect.

“the difference between fiscal and monetary policy fiscal is the government they they uh basically borrow money they spend more than they tax and then monetary policy is the central bank”

There is no way to escape debt deflation without extremely reflationary monetary policy (QE, helicopter drops), and there is no way to achieve reflationary monetary policy while maintaining a currency peg against the dollar, which China currently has and seems unwilling to change.

“there's just no way to get out of a debt deflation without Rel without extremely reflationary monetary policy whether that's some kind of QE helicopter drop or whatever and there's no way to get to a really reflationary monetary policy stance when you have a currency Peg against the dollar which is you know pretty strong in the scheme of things”

If China pursues fiscal stimulus while maintaining the currency peg, it will mechanistically sterilize or offset any fiscal easing to prevent currency depreciation, rendering stimulus self-defeating, as demonstrated by Japan's 1990-2005 experience where government deficits rose from 8-12% while private credit declined, leaving total credit flat.

“if they really Goose things with fiscal it will create downward pressure on the currency that they will have to offset with some tight tighter monetary policy in some dimension in other words they will sort of mechanistically have to sterilize or offset any fiscal easing to avoid having the currency fall”

China announced six separate measures (rate cuts, RRR cuts, mortgage refinancing, mutual fund lending, corporate buyback lending, local government real estate support) all at once to make the stimulus package appear large and powerful when individually weak, like firing a machine gun's pea-sized shots rather than a single bazooka.

“how many things do you think you just mentioned there from the PBC is it six or eight six six okay why do you think they announce six things at once because they're all really powerful uh because six sounds like a lot and they right right if they had something really powerful they would just do and announce something really powerful they kitchen and syn it to make it all sort of look like a bazooka and it's a bunch of peash shots”

China's Ponzi scheme is unwinding rather than collapsing, characterized by an ongoing nonlinear slowdown in the Chinese economy and accumulation of debt that will continue until China delinks its currency from the dollar.

“the Chinese Ponzi scheme I guess the word I would use today is unwinding... this is just going to be an ongoing process of slowdown in the Chinese economy accumulation of debt in a nonlinear fashion... that will continue basically until they delink the currency”

China's announced stimulus in late September is mostly window dressing; the PBOC rate cuts were ineffective (existing mortgage rates already fallen, refinancing does not move the dial on growth), and funding facilities to mutual funds and stock buyback programs will have marginal impact on economic growth.

“it's mostly just window dressing”

Chinese government authorities likely regret overheating the equity market rally and are concerned about repeating the 2015 bubble experience; they realize the tail (equity market) cannot wag the dog (real economy) and that bubble creation is self-defeating.

“my contention would be that the authorities on holiday last week were sitting there and saying oh my god what have we done we've overshot we've overcooked this this is not what we wanted we we we don't and and it was like a a massive rally in Hong Kong while China was out and then all these shares get handed to the domestics”

Chinese retail investors are not stupid, but they are momentum traders without information advantage; in a propaganda state with fake news and fraudulent financials, price action is the only reliable signal, making momentum trading rational for domestic investors.

“the Chinese investors are momentum Traders and I I don't blame them for that right it's a propaganda State the news is fake in many case the financials are fake like what do you have other than price action at least the price action you know it's real you have it there on the screen”

Japan should not have been collecting income taxes for decades; people willing to lend Japan money at negative rates suggests the country could have issued perpetual bonds instead, keeping money in the economy—this represents a policy solution that Japan failed to pursue

“Japan should not not have been not have been charging income taxes like people want to want to lend you money at a negative rate why are you taking money out of the economy just issue bonds so so they can always do that right that that would always work it's just a question of political will and some other perceived problems they think they're they're causing”

Chinese equities action over the past few weeks is the stupidest thing McCarthy has seen in 35 years in financial markets, with banks up 50% in three weeks literally pricing as if there was no housing bust, creating dangerous irrational momentum trading conditions.

“I'm sorry Jack I'm going to tell you this action in Chinese equities is the stupidest thing I've ever seen in 35 years in financial markets the banks were up 50% in three weeks literally pricing like there was no housing bust”

Large Chinese tech companies like Alibaba face headwinds different from US tech giants: their cloud services are underperforming (Alibaba cloud 'sucking'), and unlike US firms, they cannot monetize data because the Chinese state claims ownership and control of data.

“big part of Amazon valuation is their cloud services and like I think alib Baba's cloud services like sucking went that's so so there's also the issue of monetization of data where I think us big Tech firms are going to have much more scope to make gobs of money off the data they collect uh relative to the Chinese Tech firms where the state has basically said we we want to own and control that data”

Assuming a 7:1 exchange rate (7 yuan per dollar), 1 trillion yuan in stimulus equals approximately $140 billion, or roughly 5% of the US 2020 stimulus package of $3 trillion; even a 10 trillion yuan package would equal only $1.4 trillion, less than half the US 2020 stimulus

“important to ground for our viewers Brian you talking about Chinese Yuan which right now remond B Chinese Yuan CNY how you many different names but it is at seven to the dollars so one trillion Chinese Yan sounds like a big stimulus but it actually is $140 billion a huge amount of money no doubt but just to put it in in perspective the Bazooka stimulus in the US in 2020 was $3 trillion so $140 trillion is is a you know what 5% of that”

The banks' equity cushion as a percentage of assets is less than 10% (Tier 1 capital ratio), meaning banks have limited capacity to absorb losses without government recapitalization or deposit writedowns

“they could issue a bunch of government debt and use it to invest in the banks or to invest in entities that buy the Bad Assets um but let's let's go go back to the fiscal point so you threw around one trillion of stimulus uh there was a leak to the Reuters of two trillion of stimulus some people the think tank are going as high as 10 trillion important to ground for our viewers Brian you talking about Chinese Yuan which right now remond B Chinese Yuan CNY how you many different names but it is at seven to the dollars so one trillion Chinese Yan sounds like a big stimulus but it actually is $140 billion a huge amount of money no doubt but just to put it in in perspective the Bazooka stimulus in the US in 2020 was $3 trillion so $140 trillion is is a you know what 5% of that”

David Tepper's CNBC statement about 'whatever it takes' regarding China stimulus was misinterpreted by markets as a signal of unlimited stimulus, but Tepper was actually discussing only the specific equity purchase and stock buyback facilities, which McCarthy views as having questionable efficacy.

“frankly David teer went on CNBC and said whatever it takes you know Pang gong Shang said more more more more more no no no no no not what he said it's not what he said he was talking about these liquidity facilities that are lending money to the mutual funds and he said we can do 500 billion and if they need more we'll do more and if they need a third you know maybe we'll do more again”

Chinese local governments spent money on wasteful infrastructure projects (multiple airports in tier-3 cities, unnecessary projects) at egregious rates for an extended period, destroying capital efficiency and justifying the government transition toward 'high quality development' and reduced spending.

“the first first airport they built in you know a third tier city was great now they're like now the plans are there for the third one they don't need it so you know the marginal you know Returns on these infrastructure Investments by everybody can see has been collapsing so they've been wasting money for some period uh pretty extensively”

The Chinese banking system has not written down Evergrande's 260 billion dollar loan exposure because doing so would require public acknowledgment of losses; instead, the system is rolling the debt while Evergrande limps along as a zombie company with government implicit backing for ongoing operations.

“the Chinese banking system hasn't said oh we lent evergr $260 billion we're going to write that down hasn't happened so I you know maybe it's in their impaired bucket or you know whatever they're starting to reserve against it but the reserves are impaired”

Retail investors trading Chinese equities in Hong Kong markets while mainland markets were closed were largely international tourists and speculators, not informed local traders; they drove up Hong Kong shares 10%+ into a non-event NDRC meeting, then were forced to sell into mainland Chinese retail buying when markets reopened, experiencing losses

“I see people all weekend in Monday hoovering up Hong Kong shares because China onshore was closed but Hong Kong was open so you can presume that's largely offshore investors I I think the the market was overrun by tourists...not to be critical or anything I mean if you're a macro guy and you're following 50 countries”

Hong Kong and A-share stocks have experienced extreme volatility, with Hong Kong shares up in early trading then down 10% by end of day, and A-shares rallying more modestly, indicating extreme uncertainty in positioning

“so now the Chinese stock market actually opened so foreign uh American depository receipts and Hong Kong shares fell as the a shares local Chinese stocks rallied but rallied less than people thought um”

Two think tank professors, Gia Kong and Lu Shin, have been advocating for 10 trillion yuan in stimulus—Kong for mega infrastructure projects (explicitly accepting waste) and Shin for welfare state expansion—but McCarthy believes Xi Jinping will not pursue either path because returning to wasteful infrastructure contradicts his high-quality development agenda and expanding welfare threatens government control over capital allocation.

“Gia Kong at the uh China Academy of new supply side economics uh said they should do 10 trillion now there were two there was a guy Lu Shin who was um a think tank related with the pboc former MPC member... both of them were reported as advocating a 10 trillion Yuan stimulus okay Gia Kong said let's spend it on Mega infrastructure projects even if they're waste of money”

Chinese consumers will 'continue to suck wind' (remain weak) due to ongoing deflationary dynamics and precautionary savings, limiting the effectiveness of consumption-based stimulus

“I think the Chinese consumer is just going to continue to suck wind”

If China pursues unlimited stimulus (10 trillion yuan), McCarthy expects the RMB to experience significant downward pressure despite any initial rally, because markets would recognize the currency move signals Xi has abandoned his reform agenda and reverted to a broken growth model.

“I think you'd see tremendous pressure on the currency though because again who cannot see that he's returning to what a broken growth model that everybody knows had turned into a dead end because he's crapped his pants and he has no other answers I'd be shocked I'd be shocked”

Even 'gold standard' developer Vanke is not a good credit currently, with stock down 40% despite being the best-positioned developer, indicating the entire sector faces structural impairment.

“but even even like even vankey which is like the gold standard developer is not a good credit right now so so they're they're making black hole loans to get these things done and they were able to push out I know you don't want talk about individual stocks but vany today is is down 40% um it had been up up a lot but”

Chinese equities are in an irrational state driven purely by momentum trading; the market is a 'Keynesian beauty contest on steroids' where investors buy because they expect others to buy, with volumes enormous and price action wild and unpredictable.

“it is strictly a momentum phenomenon I believe... the market is in an irrational State and I would be very careful with it now”

The 300 billion yuan relending facility where PBOC lends to banks at 1.75%, banks lend to companies at 2.25%, and companies use proceeds to buy back stock, will have minimal impact because companies with founders who have pledged their shares (which eliminates a large portion of firms needing capital) cannot participate.

“300 billion you on relending facility with the PB lends at 175 the banks take the money from the PB at 1.75 they lend to a company at two and a quarter so they make 50 basis points”

Market expectations for Chinese stimulus have become completely untethered from any announced policy; 'some guy' named Gia Kong and Reuters rumors of 2 trillion yuan evolved into expectations of 10 trillion yuan based on misreadings of central bank officials' statements about incremental capacity increases.

“by by last week I'm hearing people say they're going to do 10 trillion in stimulus because there's a couple professors this Gia Kong at the uh China Academy of new supply side economics uh said they should do 10 trillion now”

The property stimulus measures announced were notably limited: the Polit Bureau's first and primary statement on property was not about stimulus, but rather 'strictly control the new construction of commercial housing,' which is contractionary rather than stimulative.

“the property the first thing they mentioned with regard to property at the polit bureau was strictly control the new construction of commercial housing right so they're they they first thing they mentioned in propping up the housing market is stop building new okay so Mak sense that it makes perfect sense but it's not stimulative right”

Xi Jinping did not select a 5% GDP growth target (instead choosing this 'stupid' and 'dumb' target), which McCarthy cannot explain because it was obvious a 5% target would prove unsustainable and cause the problems currently appearing, suggesting there is a 'puzzle piece' in Xi's strategy that McCarthy cannot fit into his model.

“he's sticking to that 5% growth Target which was stupid which was dumb they should have done four and a half I don't know they didn't do four and a half it's it's the one thing xiin ping has done in the last couple years that I can't fit it's a puzzle piece sitting on my desk that I can't fit into my whole China story I don't know why he didn't do four and a half because because it was obvious that five was going to cause the problems that there having now”