KDGF Asset Management

Hedge Funds World Middle East: March 4 2013, Dubai

Risks of a Financial Crisis in China, & How Can This Risk be Hedged?

Topics

1. China’s Fragility

2. What will trigger Crisis, and when will it happen?

3. What CAN China do to prevent Crisis, and what WILL it do?

4. How to Hedge China Crisis Risk

China’s Rise China's dramatic economic rise was built on a very strong combination of cheap labor, productivity increasing investment, artificially low credit costs, and an export boom

Liquidity Boom Investment Boom Massive investment has been fueled by four liquidity sources: 1. FDI: Total inflows of $1.1Tr through 2011, but net surplus

down sharply in 2012 as FDI outflows increased rapidly (up 28% in 2012)

2. Net exports: Have fallen from 10% of GDP in 2007, to 2% now

3. Huge pool of domestic savings: Driven by demographics and Financial repression, capped deposit and credit rates

4. Hot money inflows: Est. $1Tr attracted by an appreciating currency and real estate speculation

Liquidity Growth Drives Loan Growth

Debt at Unsustainable Levels

The liquidity driving China's rebound put China's banking industry assets on track to rise by almost $14Tr from 2008-2012. Echoes of Japan • According to Fitch, total credit to GDP went from 124% in 2008 to 190% now. The real

number is likely much higher, at least 225% • Corporate debt is 130% of GDP. Much of this is quasi-government debt

Huge Credit Increase in recent years

Annual Change in Private Credit, 2009-11 as percent of 2012 GDP

Shadow Finance Problems

• Extremely rapid growth in Shadow Banking is being fueled by debtors who cannot access or roll over bank financing. Risks are high but not understood by Trust investors.

• Enormous duration mismatch in the WMP sector (max 1yr term, but 22% finance infrastructure), which can only be dealt with by bringing in larger guarantors, either banks or the government (likely both)

• This will cause a large and immediate balance sheet deterioration for the banks and restrict the ability to lend more, and also restrict the ability to further deregulate Interest Rates

• Banks being forced to evergreen loans to LGFVs (75% of loans due in 2012 were rolled over) and SOEs. This is restricting their ability to issue new loans. China Beige Book reports that most China banks report that “less than 20% of lending goes to new loans. Most is going to debt rollovers or increases.”

Ultimately the Chinese government will likely have to back-stop these debts, or risk social problems if defaults allowed. Already high government debt obligations are at risk of large one-off liability increases (like Ireland)

Unaffordable Residential Real Estate…

House price to average household income, 2011

…and Huge Shadow Inventory

Only projects “approved for sale” appear in Inventory Statistics

Property owners on average each own 2.1 properties, most of which are empty. By the end of 2014, developers will have built 130m middle class housing units, enough for 400m people

Boom Turns to Bust

Source: Barron’s

Massive Credit driven over-investment that is increasingly less productive has set the stage for a classic Financial Crisis

What will trigger Crisis, and When?

Keys to Monitor: Liquidity & Credit 1. FX Reserves Growth: 30% annual growth from 2000 – 2011, NOW FLAT 2. Net Exports: source of past liquidity (10% of GDP in 2007), NOW 2% 3. Capital flows: hot money inflows turned to Outflows in 4Q11 - 3Q12.

FDI inflows/outflows more balanced now. Capital Outflows nearly Doubled from 2011 to 2012

These are the keys to the liquidity engine. If FX Reserves growth has

stopped, or structurally slowed from 30% to low single digits annually, then ultimately the RMB liquidity and loan growth at the heart of China's growth will stop too, and it simply becomes a matter of time before there is a dramatic slowdown and probable financial crisis.

Bank Sector RRR: Cuts mean liquidity is a problem. There is room to cut and this will buy time, but it will be a clear indication that Capital abundance has turned to scarcity.

Capital Flows Reversing & FX Reserves Flat

Capital Account had $117B deficit in 2012, the first deficit since 1998

Source: IIF – Capital Flows to Emerging Market Economies, January 22, 2013

FX Reserves Growth is plunging

China has been on the brink before, Why is this time Different?

• In 1998, there was a closed capital system, so money could not flee. This time, money can and will flee. In fact, the Balance of Payments turned negative in the 2Q 2012 for the first time since 1998

• Following 1998, China's WTO accession brought in considerable FDI and export revenue, followed by huge hot money inflows ($1Tr). That will not happen this time

• Global economic boom of 2000-2007 unlikely to be repeated

• Debt levels are much higher now

• Competitiveness is lower

• Incremental productivity and efficiency of investment (and therefore debt sustainability) is collapsing as easy gains are gone

Capital Investment efficiency has collapsed

Experts Inability to Anticipate Crisis • "Prospects for a really serious housing collapse that spreads

to consumer spending have diminished substantially" Janet Yellen, US Federal Reserve Governor, January 2007

• Addressing sub-prime threats: "Well capitalized banks and opportunistic investors will come in and fill the gap, restoring credit flows to non-financial businesses and to the vast majority of households that can service their debts.“ Donald Kohn, Vice-Chairman of the US Federal Reserve, August 2007

• "The odds are that the market will stabilize" Ben Bernanke, August 2007

What CAN China do? ANY CONCRETE, REAL, STRUCTURAL REFORM MUST ACCOMPLISH THE FOLLOWING: 1. Stabilize local government finances, which are already tight as

local governments are responsible for social services costs and rely far too heavily on land sales for revenue

2. Increase Consumption and Reduce Investment 3. Prevent collapse of Capital inflows 4. SOE reform 5. Contain inflation As most of these changes will threaten existing powerful interest groups, most real reform will be delayed and avoided until crisis forces action. They will try to take the easy steps first, so:

What WILL China do? 1. Expect China to prioritize developing and broadening the bond

market to attract more global capital. This is the easiest step to take, and will increase financing options and buy some time.

2. Increasing Consumption will be very difficult, as every reform that would lead to this would be directly harmful to many powerful interests, or raises problems of how to finance the changes . This cannot be done without greatly expanding the bond market.

China needs “good” growth and not more “bad” growth. But increasing “good” growth will not be easy, and decreasing “bad” growth will be politically very difficult. More investment growth – as in 4Q12 and January 2013 - will just make the problem worse. Ignore the sell side cheerleaders saying that risk has diminished due to the recent investment led (yet again) recovery.

FX Reserves will NOT save China! Reserves are large in absolute terms, but are small relative to M2 China has one of the highest M2/GDP ratios in the world (190%), and FX reserves/M2 ratio is only 18%.

Just like the number of lifeboats on the Titanic

Where to From Here? China’s solid economic foundations have weakened considerably, and China is at high risk of a financial crisis in the next few years • “Unstable, unbalanced, uncoordinated, unsustainable” – Premier Wen Jiabao, 2007 • As long as large Capital inflows continue, the party can go on, but if Capital

outflows resume, a slowdown will quickly materialize and force a crisis, which will enable necessary restructuring that is being resisted by entrenched interests

• Bank balance sheets are very vulnerable, and real NPL ratio’s are many times higher than officially reported numbers (0.9%!!). Another bank sector recap is a certainty. Where will the money come from?

• China’s FX reserves cannot bail them out!

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