February

7, 2016

BKCM LLC
340 Madison Ave
New York, NY 10173
212-220-9249

China RMB Devaluation Likely in 2016

China has at most 5 months before a currency crisis.

Chinas FX reserves are inadequate relative to the size of its
economy.
China reached a Minsky Moment in 2014 that could keep the
asset prices depressed until 2019.
We expect a devaluation of the RMB on the order of 25%+ in 2016.

China is in the acute phase of a deleveraging process that is causing

remarkable volatility across financial markets. China must make hard
decisions to avoid crisis and move onto the second, more benign, phase.

Chinas debt binge has been well documented and now the inevitable
deleveraging occurring. Much like the US in 2008, China now faces tough
choices. The political leaders in Beijing must engineer a deleveraging
either through recapitalization, currency devaluation, economic growth, or
outright default.

The probability of outright default is quite low. China has enough
resources to absorb much of the bad debt, while a default risks political
and social unrest. It is doubtful that the Chinese leadership would choose
this path. Choosing default, as the solution to its debt problem is a last
resort, its possible but not probable.

The next least likely solution is engineering economic growth. The debt
buildup since 2008 created tremendous excess capacity in virtually all
economic sectors. Ghost cities and zombie factories are a few of the
observable outcomes of this excess capacity. The economic impact of
excess capacity is stagnation at best and recession at worst. Therefore, the
probability of another China growth miracle is also quite low.

Over the last year, the Chinese government attempted and failed to
jumpstart its public equity markets. The plan was to fashion a vibrant
equity market that debt-laden firms could use to recapitalize via IPOs. The
debt burden would have been shifted from corporations to equity holders.
Alas, the only thing that Chinese leaders were able to generate was a stock
market bubble and subsequent crash. In order to halt the crash, officials
were forced to suspend IPOs. In effect, this has shut the stock market to

any firm looking to recapitalize.

Currency devaluation is Chinas last and only realistic choice, in our view.
A currency devaluation of 25% would stimulate export growth and foster
inflation that could ease the deleveraging process. Of course a devaluation
of this magnitude would send shockwaves through financial markets, but
in the medium to long run it appears to be the most probable path.

On the other hand, there is a long-term argument for a stronger currency,
especially as China shifts toward consumption. A stronger Chinese
currency would give Chinese citizens more purchasing power that could
increase consumption of foreign goods. In our view, it is this competing
argument that has caused China to commit a monetary policy error.

The competing arguments on the proper direction of the Yuan, coupled
with capital flight have forced China to defend its currency. By defending
its currency China is actually conducting quantitative tightening (QT) and
this contractionary policy has created an ugly deflationary deleveraging.

The term ugly deleveraging was coined by Ray Dalio of Bridgewater and
in our view accurately describes the current situation. In an ugly
deflationary deleveraging very few asset classes do well, typically
commodities and equities fall while bonds rise.

You may be asking yourself why China matters to the US stock market.
After all the US is a relatively closed economy that generally benefits from
the deflationary forces currently swirling around the world. China matters
to investors because most of the companies in the S&P 500 have growth
models that center on China.

In a recent report, Oleg Melentyev of Deutsche Bank, laid out a few stats
about the importance of China to the global economy:

Smartphones: 70% of all sales are coming outside of North America and
Europe, 45% are sold in BRICs countries;

Big pharma: 43% of sales are outside of US/EU/Japan;

Education along with travel and thus retail contributes 1/4 to all US
services exports, the single-largest line-item; 62% of all international
students in the US are coming from China;

Social media Facebook, Google and Twitter receive about 1/3rd of
their ad revenue from EM countries;

Media the movie industry only breaks out international sales, which

are 65% of total but its reasonable to assume that this being a smallticket item, the proportion of EM sales here could be close to EM share
of world population, which is 85%.

Most of these goods and services sold internationally do not register as
exports from the US as they are assembled/provided, delivered, and
booked by non-US subsidiaries of multinational corporations. As an
obvious example, if all such revenues were booked as exports, Apples
sales in China alone would account for 1/2 of all US exports to that
country, services included!

The feedback loop between China and US corporations is stronger than a
nave analysis of direct exports would suggest. In the first few weeks of
January, US investors directly experienced the power of this feedback loop.

China is on the verge of its own 2008 moment. China has a choice; in the
short term it must abandon its desire for reserve currency status and its
plan to boost consumption through increased purchasing power. These
are admirable goals, but better suited for after the deleveraging process.

If China does not make the devaluation choice it risks a crisis that could
take years to resolve. During similar experiences it took the US 2 years in
2007-2009 and 1930-1932 before it moved to the second stage of the
deleveraging. Japan also offers a cautionary example of an economy that
prolonged its deleveraging and suffered lost decades.

Until China addresses its debt problem the global economy will continue
to slow and financial markets will continue to remain volatile. There is a
path forward, but recent policy mistakes make it unclear if China will
choose wisely. As this process unfolds, investors need to exercise extreme
caution.

Chinas Minsky Moment

It can be shown that if hedge financing dominates, then the economy may
well be an equilibrium-seeking and containing system. In contrast, the
greater the weight of speculative and Ponzi finance, the greater the
likelihood that the economy is a deviation amplifying system.







-Hyman Minsky


Minskys analysis of credit cycles accurately describes the boom-bust
periods experienced by virtually all economies over time. A Minsky
Cycle reaches its climax when corporations or governments begin to
borrow money to pay interest on existing loans, this is the so-called Ponzi

Finance stage. When this moment arrives the probability of a rapid decline
in asset prices and economic collapse increases.

The Minsky Cycle chart above illustrates the various phases of the credit
boom and bust cycle. The Minsky Moment is preceded by the Ponzi
Finance stage when new debt is used to pay interest on existing loans.

Hua Chuang Securities estimates that 45% of new loans in China are being
used to pay interest on existing debt. Moreover, in November 2015 the
head of fixed income for Ping An Securities said, Some Chinese firms have
entered the Ponzi stage because return on investment has come down
very fast.

In our view China reached the peak of the Minsky Cycle for real estate in
2014 and is now facing the inevitable decline.

We have overlaid the stylized Minsky Cycle on the percentage change n
prices for newly built homes in China. From this perspective it becomes
clear that a Minsky Moment was reached in 2014. Investors must now
decide if the recent uptick in home prices represents a pause in the
downtrend or the bottom of the home price decline.

Given the continued effort by Chinese leadership to restrain credit growth,
our view is that the increase is a pause and the downtrend should
continue. Adding to our conviction is the contractionary monetary policy
pursued by the PBoC in order to defend the currency.

Using the United States experience during the housing crisis we can see
that housing prices had multiple false dawns.



The Minsky Moment for the United States was likely to have occurred
during 2007, yet it was not until 2012 that US home prices began to climb.
This is despite an unprecedented expansion of money supply by the
Federal Reserve. If our 2014 estimate of a Chinese Minsky Moment proves
to be correct we would expect the deleveraging cycle in China to last until
2019.

China Deleveraging
Economist Hyon Song Shin has dubbed the global credit bubble the
Second Stage of Global Liquidity. In a 2013 speech, Shin presented the
following charts using BIS data that show a marked acceleration of debt
issuance by leading emerging market economies since 2010.

This trend has been echoed by the BIS in two reports that concluded the
amount of global debt has increased by 50% since 2010 from $6 trillion to
$9 trillion. Most importantly, Chinas contribution to this debt building has
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increased almost five-fold since 2009.

Capital Reserves Inadequate

The refrain from investors who do not believe currency devaluation is
likely or necessary is that China has amassed the largest foreign exchange
reserves in the world. While this is true, it is not the absolute size of the
reserves that matter, it is the relative size.

There are two ways to determine the adequacy of the foreign exchange
reserves: 1) as a percentage of money supply 2) IMF Reserves Adequacy
Equation.

According to the most recent data from the PBoC, Chinas FX reserves are
$3.23 trillion (or 21.2 trillion RMB). The majority of these reserves are
held in US Treasury securities with maturity of 5 years or less. Chinas
money supply (as measured by M2) has been growing at 13% for the last
few months and currently stands at 136 trillion RMB. As a percentage of
M2, Chinese FX reserves are at 15%, the lowest level since 2004. As a
comparison during the Asian Currency Crisis of 1997-1998 the Asian
Tigers had reserves that were 30%+ of M2.

By this measure Chinas currency reserves are at dangerously low levels
relative to the size of its economy and money supply. Moreover, capital
flight is likely to accelerate the depletion of reserves.

The IMF Reserve Adequacy formula also suggests that China is perilously
close to a currency crisis. According to the IMF China needs about $2.7
trillion to operate its economy.

This means that China has about $500 billion before it hits the minimum
level of reserves suggested by the IMF. This level of reserve adequacy
places China among the worst in emerging markets with only South Africa,
Czech Republic, and Turkey with lower scores

The following chart compares the weakness in the South African Rand,
Czech Koruna, Turkish Lira and the RMB.

Since January 2014, the Rand has depreciated by 56%; the Koruna by
20%; and the Lira by 35%, while the RMB has only fallen 8%. The
implication is that on a relative basis there is room for the RMB to fall by
another 10-50%.
In 2015, it is estimated that Chinese FX reserves declined by $1trillion, or
about $83b per month. The most recent official data from the PBoC
pegged January 2016 outflow at $99.5b.

In an effort to be prudent and conservative we use the average of $83b per
month of outflows. Based on this level of outflows, China has about 7
months before it effectively runs out of reserves. As the level of excess
reserve approaches $3 trillion we would expect the outflows to become
non-linear. Therefore, the amount of time before China effectively depletes
its reserves is probably closer to 5 months.

It is not unreasonable to expect further capital flight even if China
manages to engineer a soft landing. Chinese citizens are allowed to move a
maximum of $50,000 per year from China. If 5% of Chinas 1.3b population
decided to move this amount it would completely deplete the $3.2 trillion
in reserves. Even more striking is that it would only take 1% of the
population opting to send the maximum of $50,000 out of China to deplete
its $600b cushion before its hits the IMFs lower bound.

Devaluation is the Only Option

There are two options besides devaluation that China may use or that the
market may be counting on: capital controls and SDR reserve reallocation.
In our view, neither of these will be enough for China to avoid a
devaluation.

China currently has capital controls that are famously porous. We would
expect China to use capital controls as a first line of defense as FX reserves
continue to be depleted. However, we do not expect capital controls to
stem the outflow. As an export economy there are many opportunities for
Chinese companies and citizens to continue to use techniques like overinvoicing to send capital out of China.

The second hope for China is foreign buying of the RMB when it formally
enters the SDR in October 2016. Many have suggested that reserve
managers will buy RMB in order to better align FX reserves with the ratios
of the SDR basket. It is critical to note, that SDR inclusion does not require
reserve managers to reallocate into RMB. Given the widespread
expectation for continued RMB devaluation, it is unlikely that reserve
managers will opt to buy RMB before devaluation.

From our perch, the only option China has is devaluation and we would
recommend China devalue sooner than later. The longer they wait to act
the more disruption will occur. As well, with $3.23 trillion in reserves
China would experience a windfall profit from a one-off 25%+ devaluation.

Previous episodes of deleveraging suggest that 25% + devaluation is likely
and needed to reduce the debt burden. The following table shows previous
deleveraging periods and the currency devaluation during that period of
time.

Currency Devaluation
Deleveraging Period

United States 1930-1937
40% devaluation after peg to

gold broken
United Kingdom 1949
Bank of England devalued by

30% in September 1949
Thailand 1997-1997
40% devaluation

34% devaluation
South Korea 1997-1998
83% devaluation
Indonesia 1997-1998
United States 2008
40% devaluation after QE


We expect that a large RMB devaluation could occur in 2016 and we have
positioned ourselves accordingly.

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