The world's biggest hedge fund expects a bust in China

Thomson Reuters

The world's biggest hedge fund firm thinks that China is preparing for a bust.

Ray Dalio's Bridgewater says that China has experienced an "unsustainable buildup of credit," which is "typical of debt boom and busts," according to a private note to investors viewed by Business Insider.

"This rapid expansion in credit looks like it has created significant vulnerabilities in the Chinese financial system at a time when the economy is still near the front end of a material loss cycle," the note added.

That said, the $147 billion firm thinks that China will be able to make it through, largely because the country's debts are denominated in China's own currency.

In other words, Bridgewater is saying that it can print more money if need be to get out of a crisis.

"While we believe that China has the resources to manage even a severe bank loss cycle, in large part because the debts are denominated in China's own currency, how the loss cycle will unfold and how it will be managed will have significant impacts on the Chinese economy," the note said.

The letter was published last week by Bridgewater staffers, including Larry Cofsky and Matthew Karasz, and was in response to stress tests on China's banking system conducted earlier this summer. The giant hedge fund analyzed the stress-test findings and picked out a couple of key concerns in the banking sector: shadow banking and second-tier banks.

"One of the largest risks to the banking system is its exposure to off-balance sheet non-standard shadow banking products such as wealth management products and trusts," the note said.

Thomson ReutersOthers in the hedge fund industry have also sounded the alarm on wealth-management products in China, including Kyle Bass. He said in a note earlier this year that Chinese banks had used wealth-management products to accelerate loan growth and get around restrictions on lending.

China's second-tier banks are also an issue, according to Bridgewater:

"These banks look vulnerable to us; they are large (more than 30% of bank assets), growing rapidly with increasing reliance on wholesale funding, and they are responsible for much of the growth in opaque on-balance sheet assets as well as off-balance sheet wealth management products."

The note added that Bridgewater is "particularly concerned" about the risk of a funding squeeze at China's second-tier banks.

China has long been on Bridgewater's radar. Last year, amid a Chinese market rout, the firm advised investors to get out of China, saying there were "no safe places to invest."

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