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Muddy Waters to Jupiter Seek Profit as Risk Rises: China Credit

June 02, 2013

Muddy Waters to Jupiter Seek Profit as Risk Rises

Workers install Chinese flags on a lamp post on a street in Tianjin. China is taking steps to rein in shadow banking. In March, regulators capped how much client money banks can invest in less regulated forms of lending. Photographer: Tomohiro Ohsumi/Bloomberg

China’s bond risk rose the most in a year in May and investors from Muddy Waters LLC’s Carson Block to Jupiter Asset Management Ltd. are seeking to profit from an economic slowdown as policy makers rein in debt.

The cost of insuring sovereign bonds against non-payment rose 15 basis points in May to an eight-month high of 86, as economists queried discrepancies in the nation’s data releases. Credit-default swaps on State Bank of India (SBIN), a proxy for the nation, fell 6 basis points last month, according to CMA, which compiles data in the privately negotiated market.

Concern that loans will sour have escalated as falling commodity prices point to flagging growth and inflated export data suggest the economy isn’t as strong as official figures indicate. Varying estimates over the scale of borrowing by local governments and the shadow banking system used to bypass loan curbs compound the risk, according to Jupiter Asset.

“The problem is the lack of transparency,” said Ariel Bezalel, who helps oversee about $44 billion as a portfolio manager at the fund manager in London. “No one really seems to know or have a good handle on the shadow banking system in terms of how large, how severe the non-performing loans situation is.”

Bezalel said he’s buying sovereign bonds in Australia, where the central bank has cut rates 2 percentage points in 20 months, to profit from a slowdown in China. While it’s worth keeping an eye on the banking system, “it’s not something that is going to bring down the economic system in China,” he said.

Economic Slowdown

Economic growth weakened to 7.7 percent in the first quarter from 7.9 percent in the previous three-month period. That slowdown came as the government’s broadest measure of credit rose 58 percent from a year earlier to a record 6.16 trillion yuan ($1 trillion) in the first quarter, an indication that lending is becoming less effective in stoking expansion.

The official Purchasing Managers’ Index for manufacturing, released June 1, accelerated to 50.8 in May, beating all estimates in a Bloomberg News survey of 30 analysts. That contrasts with a 49.2 reading for a separate index compiled by HSBC Holdings Plc and Markit Economics, showing a contraction.

The difference between the two indexes may be that the privately compiled survey is weighted more toward smaller businesses.

Trade data is also showing discrepancies. The government reported $145 billion of exports to Hong Kong for the first four months of this year. By contrast, Hong Kong’s figure for the shipments was $76.7 billion.

Trade Statistics

The government limits capital flows, so the disguising of exchange-rate speculation as trade contracts may have affected the figures, according to Lu Ting, Bank of America Corp.’s head of Greater China economics. The true surplus for the first four months of the year may be only a tenth of the $61 billion reported by the government, according to Lu.

Other signs of weakness include an unexpected deceleration in fixed-asset investment and falling commodity prices. The cost of power-station coal fell to the lowest in almost four years, the China Coal Transport and Distribution Association said May 27. Futures contracts for steel reinforcement bars are at an eight-month low.

“It’s been clear for at least several years that China’s official data is unreliable, but many Kool-aid seeking investors and economists chose to minimize or ignore this problem,” said Block, whose reports starting in 2010 triggered $7 billion in losses for Chinese stocks in two years.

Short Selling

The short-seller who runs Isleton, California-based Muddy Waters said last month he bought default swaps on the debt of Standard Chartered Bank Plc (STAN) as a way to profit from a “China unwind.” Block gained fame for his short-selling calls after regulators halted trading in four of the first five companies he targeted starting in June 2010. Hedge fund manager John Paulson sold his Sino-Forest Corp. stake at a loss after Block accused the company of overstating its plantation assets. Sino-Forest filed for bankruptcy protection in 2012.

Holders of emerging market debt are growing cautious as the Federal Reserve signals it may scale back stimulus, driving U.S. currency yields higher. CDS are often bought as a hedge against rate increases. The average yield premium for Chinese dollar bonds over Treasuries climbed 13 basis points last week to 312 basis points, according to an HSBC index.

‘Choose Carefully’

Domestic markets are showing few signs of stress. Yields for 10-year government debt were little changed in May at 3.4419. Similar maturity AAA-rated corporate bonds yielded 5.0434 as of May 31, falling 8 basis points last month.

The yuan rose 0.5 percent in May to 6.1345 per dollar, according to the China Foreign Exchange Trade System. The Shanghai Composite index of shares climbed 5.6 percent.

“China has great companies but you have to choose carefully,” said David Loevinger, an emerging markets analyst at TCW Group Inc., which manages about $130 billion of assets. “Some have too much debt and not enough transparency.”

TCW doesn’t own the nation’s default swaps and isn’t worried about its sovereign risk, said Loevinger, a former senior coordinator for China affairs at the U.S. Treasury Department. “We are looking closely at China’s rising leverage,” he said.

Lending Effect

Surging debt is a threat to growth, according to Charlene Chu, head of China financial institutions for Fitch Ratings, which in April cut the nation’s long-term local-currency rating. She estimates total lending by banks and other financial institutions was 198 percent of gross domestic product last year, compared with 125 percent four years earlier.

Chu calculated total credit by adding off-balance-sheet assets and financing by non-bank institutions, known as shadow banking, to offshore loans by foreign banks and aggregate financing data published by the central bank.

Francis Cheung, head of China and Hong Kong strategy at CLSA Asia-Pacific Markets, estimates total corporate, household and government debt at 205 percent of GDP. The government doesn’t release a figure for total credit.

China is taking steps to rein in shadow banking. In March, regulators capped how much client money banks can invest in less regulated forms of lending. Estimates for the size of the financing range from the Financial Stability Board’s about 2 trillion yuan, published in November, to JPMorgan Chase & Co.’s 36 trillion yuan based on data from the end of 2012.

Authorities have also increased scrutiny of companies set up by local governments to finance roads and bridges. Regional authorities, banned from directly selling bonds, may have more than 20 trillion yuan of debt, former Finance Minister Xiang Huaicheng said in April. That’s almost double the National Audit Office’s 2011 estimate of 10.7 trillion yuan.

“People don’t have a great deal of clarity about the current state of the economy and there’s a fear there could be a more significant slowdown,” said Tim Condon, head of Asian research at ING Groep NV in Singapore. “When people have doubts about growth, because of the importance of China, people just fear that all asset classes are going to be affected.”

To contact Bloomberg News staff for this story: Kevin Hamlin in Beijing at khamlin@bloomberg.net; David Yong in Singapore at dyong@bloomberg.net

To contact the editor responsible for this story: John Liu at jliu42@bloomberg.net


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