The Great Chinese Debt Restructure: The Saga Continues

The past couple of weeks Chinese financial markets have been driven by the stock market boom, bust, and then boom coupled with the massive government debt restructure/bailout.    Why the two are correlated seems to only speak to the rationale of what investors believes drives the Chinese stock market.  The deal went roughly like this: banks would be forced to trade high interest short term government debt in the form of bank loans for long term low interest bonds that would then hand over to the PBOC as collateral they would then lend back out to favored industries.  The unilateral debt restructuring (provincial bailout) is a bad deal for the banks but it could have been worse.  The PBOC accepting the provincial bonds as collateral, with likely no recourse back to the banks if the debtor defaulted, took a lot of the sting out of the deal.

It just got worse for the banks.  Reuters is reporting that trading in the bonds is thin due to lack of demand and prices are dropping rapidly to entice those willing to shoulder the risk of an excessively indebted Chinese provincial government with no legal ability to enforce a claim as even debt contracts will be unilaterally rewritten.  This is bad news for the banks.

This is quite surprising and has numerous interesting implications if this continues.  If this is true, this is imposing significant capital losses on Chinese banks already struggling with rising (even very generously defined) non-performing loan rates.  While Chinese banks and regulators adhere strictly to the international “mark it at whatever we feel like today even if they haven’t paid us for a year” accounting standard rather than GAP or IAS, even by their own standards bonds available for trade should be marked to market.  Banks may not be trading the newly issued bonds due simply to the fact that this would require them to recognize significant losses that are at the moment not explicit but would become explicit if the bonds are traded or available for trading.  Furthermore, given their funding costs, this essentially gives the banks a near zero margin on government debt straining their resources when they can least manage it.

Another possibility is that there is some short term delay in using the loans as collateral with the PBOC as promised.  Given what was announced about the overall debt restructure and the time lag, it is distinctly possible that final details of the PBOC collateralization have yet to be finalized and debt essentially moved onto the PBOC balance sheet.  Due to the lack of trading and drop in price, it seems likely that banks will hold on to the debt for sometime or wait for the PBOC to open the promised lending facilities required to redeem the provincial bonds.

There is one more worrying and counterintuitive possibility here.  It is possible that after the banks swapped the short term high interest debt for the long term low interest debt, with the promise of redemption at the PBOC, the PBOC has decided to opt out and not accept the bonds as collateral.  I assumed based upon the PBOC accepting the new provincial bonds as collateral that banks would receive the bonds turn right around and give them to the PBOC.  Given the fact that this appears to not be happening raises the very real specter that the PBOC is getting cold feet.

If the PBOC is not having the printing presses running late to monetize the dubious debt on offer, this itself raises a couple of issues.  First, given the history of enormous money creation by the PBOC, this seems like an odd time to turn the printers off.  Both textbook economics and the shrinking money supply in China from a variety of factors like capital outflows indicate this would be a time to pump money into the system which the PBOC is appearing increasingly reluctant to advocate.  Second, the PBOC as prudent bankers seeing what the bankers see may be just as reluctant to act as a bad debt repository.  The PBOC may execute their political orders like good soldiers, but they are also smart economics and finance guys who see the risks they are being told to incur.  It is quite possible they are dragging their feet or refusing to uphold their side of the bargain in accepting this bad debt as collateral.  Third, if the PBOC is dragging their feet or backing out of the deal to accept provincial debt as collateral, this sets a bad precedent for all the debt that Chinese banks are going to be asked to swap.  If the bankers were in near open revolt over the forced debt restructure when they at least could hand it off to the PBOC, think of what will happen when they realize they are getting suckered.  While everyone knows (or should know) that Chinese banks are little more than public slush funds even if they are listed, this simply confirms it.

I am going to hold a verdict in reserve until more information comes out about what the PBOC is going to do.  Neither the thin trading or drop in prices should come as a major surprise as everyone knew the banks were not receiving a yield commensurate with the risk.  However, this was all predicated on the PBOC promise.  Your move PBOC.

What China is Doing to Join the IMF

After all the rumblings about China seeking to join the IMF it seems somewhat strange to engage in this discussion as they lack one of the most important factors: a convertible

After all the rumblings about China seeking to join the IMF it seems somewhat strange to engage in this discussion as they lack one of the most important factors: a convertible currency.  While I do think it is important that the rmb ultimately become a reserve currency for the SDR at the IMF, at this point in Chinese development it is really hindering Chinese development more than helping.

China has witnessed rapid growth in outward investment.  As those Chinese companies grow and evolve, so will their supply chains to meet growing demand and building brands outside of China in other developing economies.  Chinese firms looking to expand outside of China need the flexibility to convert RMB for investment purposes when needed rather than when allowed.  According to a study by the Economist, 94% of Chinese firms are planning on expanding their supply chains in other emerging markets.

What China doesn’t realize or is unwilling to admit is that demand for the RMB exceeds its willingness to provide it.  For all the domestic complaining that the RMB is being oppressed for the IMF and the US, freeing the RMB will ease its movement into SDR reserve status but also benefit Chinese firms, the ones that export and those expanding abroad.  As Standard Chartered at the from a series of studies with The Economist Intelligence Unit at their website Growth Crossing points out, RMB usage is competing heavily for invoicing business throughout south-east Asia.  However, this remains primarily offshore RMB usage that will benefit greatly from continued liberalization.

Despite my concerns over Chinese economic and financial risks, the policies and controls are mostly harming Chinese firms and their ability to expand overseas and build brands. Unless these capital controls are relaxed and risks addressed, Chinese firms remain reluctant to expand overseas and manage the risks and position themselves for success.

Why Greenpeace Leads Us to Believe Chinese GDP Growth is Low

One of the great intellectual puzzles for me as an economist living in China is why so many smart people obsess over official Chinese GDP growth data.  Given that there is extensive research demonstrating how Chinese GDP data is managed and even Li Keqiang in his much touted index has warned against reading too much into it, people continue to read every decimal point as an indicator of good times or impending doom.  Chinese GDP data is kind of like the latest Hollywood comic book tent pole, full of special effects that leaves us entertained and wanting more.

The problem, however, lies in finding alternative measures of Chinese GDP growth.  Every alternative measure of Chinese GDP growth that I am aware of, has used some variation of the Li Keqiang Index using electricity and goods traffic as a proxy for economic activity with a few additional measures thrown in for good measure.

These are good attempts to produce better data but run into two significant problems.  First, they are using either fragmented or imperfect data.  This may be from industry groups or other sources that have good data sources but it typically has the very real potential of omitting or missing observations.  Second, if they use more comprehensive data it typically relies on some government or quasi-public data collection agency.  However, this creates a battle of the wits scenario.  If government statisticians are smart enough to manipulate GDP data they are smart enough to manipulate secondary data especially after Li Keqiang made his well known observation.  They know that you know, so clearly they cannot leave this economic variable untouched.  In other words, attempts to estimate GDP data using any public or quasi public data in China suffers from a positive bias.

Greenpeace has released a report (make sure to click through to the underlying links) suggesting that in the first quarter 2015, YOY CO2 emissions and coal consumption have fallen by 5% and 8% respectively.  If true this staggering and incredibly important for our understanding of the Chinese economy.  There is one important caveat.  Greenpeace is utilizing Chinese government data, which as I just noted, is notoriously unreliable.  As one article about the Greenpeace report notes, China has previously reported large drops in coal production only to later adjust the numbers back up enormously due to producers simply not reporting output.

While we need to proceed cautiously in interpreting these numbers, for the reasons noted, I believe we can make reasonable interpretations of this data.  Let us consider a couple of scenarios and the subsequent interpretations.  It seems unlikely that Chinese statistical agencies are purposefully upward biasing the fall in coal and electricity usage.  By that I mean, if Greenpeace is reporting that coal use in China fell 8% based upon official data, that it actually fell 12% but is biased upwards.  Furthermore, the China Electricity Council, electricity growth in the first four months of 2015 grew YOY by a total of (wait for it) 0.2%..  I don’t think even the most concerned about the Chinese economy would be predicting falls in coal and electrical consumption even larger than what is being reported.  Therefore, I consider it less likely that these numbers are manipulated upwards in any meaningful way.

It seems somewhat more likely that the numbers are downward biased.  However, a willful downward manipulation is not completely satisfactory explanation for a few reasons.  First, given the widely recognized existence of the Li Keqiang Index even within China, downward manipulation would seem to needlessly invite speculation about the health of the Chinese economy.  Second, drops in domestic production of energy producing commodities are matched and even exceeded in relative terms by imports.  Given the difficulty in manipulating trade data, which two countries participate in, the general trend of the data seems matched by international data.  Third, this data is broadly matched by domestic Chinese data that is strongly correlated.  For instance, there has been widely reported flat or falling production of coal and electric intensive industries like steel and cement.  This also is matched with similar falls in international commodity trade and prices.  Fourth, given that China has told the world that its CO2 emissions and coal dependency will continue to rise until 2030, there seems little incentive for it to manipulate the data downwards now.  Fifth, nor do the numbers appear to be falling due to a shift in the Chinese portfolio of energy production.  The speed necessary to produce a shift of this magnitude is simply enormous and while hydropower production surged in 2014 due to higher rainfall, new electricity production remains overwhelmingly coal based.  In short, the secondary data fails to support the idea that this data on coal and CO2 emissions is significantly downward biased.

What seems like the most likely scenario is that these numbers are broadly representative and accurate.  I should note that doesn’t mean the data is perfect and unmanipulated, only that appears most likely to be generally representative of coal, CO2 emissions, and electricity production.  In my opinion, Any significant manipulation would require actual electricity growth to come in upwards of at least 2-3%.  In short, much of the data matches close enough that we can feel comfortable that any manipulation is either well coordinated across independent actors or telling a similar story.

If these numbers are generally if not perfectly accurate, this has one very important implications: real GDP growth in China is nowhere near 7%.  In other words, electricity consumption was flat.  Producing GDP growth of 7% with total electricity growth of 0.2% would require electricity efficiency gains never before seen in modern economic history.  If this number is generally accurate, this would imply that Chinese GDP growth is in the low single digits.  A plausible guestimate, based upon electricity growth between January to April 2015, would be GDP in the 1-3% range.  There is simply no way you can have zero electricity growth and manage 7% GDP growth.

The low growth of estimated GDP would further explain many of the strong actions taken by Beijing to support GDP growth such as the “call it anything but stimulus” stimulus to the bailout of indebted provinces.  Maybe Beijing knows something the rest of us don’t?



Musings on Chinese Debt Concerns

The Financial Times at Alphaville has a great piece on how recent policy changes surrounding the nascent provincial bond market are being interpreted covering a range of thinking, even if I am labeled the resident crank a role I accept with relish.  They do raise some very valid issues which deserve attention.

Anything Deutsche Bank says about China should be read skeptically as it acts as little more than a public relations arm and recruiting ground for the PBOC.  However, more specifically, DB makes two illogical arguments about Chinese debt and the economy.  First, it argues that the slowdown in the Chinese economy is attributable flat government spending.  Considering DB was overestimating Chinese growth by more than 1-2% recently, the fact they even say slowdown is remarkable.  Second, DB believes that even more provincial led investment through additional debt, either by LGFV or bond sales, will continue to drive the Chinese economy.

Even mathematically it is difficult to reconcile the DB claims.  LGFV investment, which is responsible for 20% of the national total according to DB, has contracted so enormously to cause the national slowdown.  With  YOY fiscal spending, again according to DB, essentially flat at -0.2% it is difficult to see how this would cause the national slowdown when it was up only 6% last year.

Additionally, the flat spending conveniently overlooks the fact that local government revenue is falling.  Nationally land revenue to local governments is down 30% and given that on average about 50% of government revenue comes from land sales, this significantly impacts spending ability.  This tracks with something else in the FT piece that estimated growth, by one calculation 5.3%, is significantly lower than official estimates.  Finally, provincial borrowing is only implicitly allowed for LGFV and not operational spending of governments.  Lending guidelines should have minimal impact, according to Chinese law, on general spending.

If Deutsche Bank research economists believe this is such good policy and the financial risks are low, then may I suggest using DB capital to purchase some of the newly issued provincial bonds?

There are two larger points however that are somewhat acknowledged.  First, in China there is an enormous difference between lip service to addressing a problem and enduring the pain (structural reform) required to addressing a problem.   As GaveKal rightly notes about the nascent bond market, “opening the front door and closing the back door”  was intended to introduce transparent financing and market risk to local government debt.  However, what we have witnessed has been the complete opposite of this.  Banks being ordered to continue lending leaves the back door wide open.  The price on the bonds is not commensurate with the risk, which is why the bankers held out so long.  There is no transparency on the financing as it is all private placement offerings.  Then the PBOC is essentially buying any debt the banks decide not to hold.

Economically this means asset prices need to decline and surplus capacity needs to be reduced.  Given Beijing tacit encouragement of the stock and housing market, it appears they have little interest in reigning in asset prices.  The drive to encourage more infrastructure investment and lending to favored companies or SOE’s indicates they have little interest in addressing the capacity issue.  The rising asset prices and declining producer prices, and the policies driving these trends, will only create additional problems later on.  The fundamental take away here is that there remains an enormous gulf between the press releases and the actions.  The policy itself is fundamentally sound but if there is never an adherence to the policy and the restructuring involved, it is worthless.

Second, there remains no plan to address these problems.  The entire plan, and the only reason the banks are not in outright revolt, is that the PBOC is allowing the banks to use the bonds as collateral to prompt further lending to favored industries and firms.  This isn’t addressing the problem, this is doubling down on the strategy that created the problems in the first place.  Citi, in the FT piece, addresses the issue quite delicately writing that “…if there is no efficiency gain in coming years, some local governments may become insolvent….”.  GaveKal notes the lack of a strategy writing “Beijing will not admit there is a big solvency problem and cut lending to entities who have trouble.  Instead Beijing wants banks to keep lending in the hope that one day the borrowers may get better.”

As I have noted, Chinese banks were able to outgrow some of the bad debt problems a decade ago, however, hoping for the same a second time is an incredibly risky proposition.  As of yet, there has been no plan even floated to reduce the debt burden or impose the type of discipline required to delever.  In fact, it has been just the opposite.  The plan so far has been to increase lending and investment even more and hope that things work themselves out.

In closing, I want to make two final points.  First, I should note that the PBOC and CBRC by forcing the debt restructure have used standard strategies with distressed borrowers whether they be firms or governments.  They are to be commended for taking decisive action.  However, the very real concern is that they won’t take the necessary follow up steps.  Think of a patient that undergoes heart surgery to prevent a heart attack but returns to  a diet of sweets and red meat with no exercise.  The surgery prevented a heart attack but only put off the reckoning without real changes.

Second, I think a financial crisis scenario is much less likely than a zombie scenario.  I have heard from some that I am predicting a financial crisis and I want to make clear that is not what I am predicting for many reasons.  From the political risks Beijing sees in a financial crisis to the willingness to bailout everyone by Chinese policy makers, I believe a financial crisis is not the most likely scenario.  High debt levels with ongoing problems for many parts of the economy is the bigger problem.

The Chinese Bailout is Starting to Bail Fast

After the PBOC and CBRC announced a unilateral change in debt policy that allowed indebted Chinese provinces to swap their high interest short term debt for long term low interest bonds which banks would then present to the PBOC as collateral for cash to use for additional lending, it seemed like the forced restructuring would ease the pressure on local governments for a while.

However, Friday night the Chinese central government through the Ministry of Finance, along with the PBOC and CBRC, jointly announced a policy intended to further aid local governments.  In the words of the Financial Times, the regulation:

“…told financial institutions to keep lending to local government projects even if borrowers are unable to make principal or interest payments on existing loans….(the regulation) explicitly banned financial institutions from cutting off or delaying funding to any local government projects started before the end of last year and said that any projects that are unable to repay existing loans should have their debt renegotiated and extended.”

Let me say that again just so it sinks in: banks were told to keep lending money even if the borrowers are unable to make principal or interest payments on existing loans and banks are forbidden from cutting, denying, or delaying loans.  While country policy makers around the world have unofficially encouraged excessively loose credit policies and lenders may take such policies in individual cases, I have never heard of a similar countrywide or bank wide policy anywhere.  (If anyone knows of a comparable case please let me know).

Though they are mostly speculative, there are many inferences that can be drawn from this latest announcement.

  1. The local government debt problems surrounding the $3.5 trillion USD are much more widespread and profound than is currently recognized by people outside the Chinese government, the banks, PBOC and CBRC. For comparison sake, imagine Barack Obama and Janet Yellen announcing a similar policy for all local governments and banks in the United States.  If the bad debt was limited to even a handful of provinces or loan types, we would not be seeing these types of policies.
  2. The bankers must really be resisting the new policies. For the last month as news began to trickle out about this policy shift,  we saw how the bankers didn’t want to buy the new bonds, didn’t like the pricing, the duration, and now the regulation tells them to keep lending even current borrowers are unable to service existing debt.  This can only be interpreted as a public and strict ordering of bankers to walk the line set by government.
  3. If debt problems were more limited and bankers were complying this policy would never have been made public in China.
  4. If the bankers are telling you what they think of the debt problems in China by resisting even the early forced restructuring, what is the government telling you by announcing ability to service debt is not a requirement for more lending and forcing banks to lend?  Given the information asymmetries in Chinese financial markets, it helps to judge how those that should know behave.  This policy appears extremely desperate by the government indicating their level of concern.
  5. 7% GDP growth and 1% non-performing loan ratios are both figments of a CCP statisticians imagination. Even in a world where an NPL is only counted after a firm is bankrupt and non-operational for a year, the GDP and NPL numbers are simply fairy tales.
  6. China through a combination of policy and luck grew its way out of the last bad loan build a little more than a decade ago. There are banks that still carry the bad loans from a decade ago and some very large companies have been started out of these assets.  However, even without a significant growth slowdown much less what even the Chinese government touts as “the new normal”, it will be extremely difficult to replicate the debt swallowing growth of the previous decade.  China cannot count on outgrowing its debts again.
  7. Beijing and Shanghai do not represent China. Declaring the health of the Chinese economy based upon trips to these two cities is like visiting New York City and Washington DC and saying the economy looks great.  It is also worth noting that Beijing and Shanghai are two of the most indebted subnational provinces in all of China.
  8. Expect to see a significant portion of the bad debt end up at the PBOC with no recourse back to the bank if the debt goes bad. The PBOC printed enormous amounts of money to keep the exchange rate low and the money supply rising in the past decade.  Their new strategy seems to be to print money to lend out via low credit quality collateral.
  9. The private sector is being forced to bail out the government.
  10. I wonder what bank shareholders will think about their capital being forced to be lent without an obvious path to repayment. No wonder the market was pricing in bad news during the recent stock market runup.
  11. China remains an economy completely dominated by the state. As one economist who argued that the true state share of the Chinese economy was closer to 80% of GDP, just because it is a listed company does not mean it is a private company.  With the exception of Alibaba, there is virtually no major Chinese company where the state does not have, frequently through Cayman shell corps in true capitalist fashion, a major holding in most every company.  Banks as extensions of the state are following the orders of their major shareholders.
  12. While I would definitely be categorized as someone who has significant concern about the risks in the Chinese economy, and I respect many economists who are more sanguine about these risks, at this point I struggle to understand how anyone can see these signals from the Chinese government and not be very concerned about the buildup of financial risk.

I hope I am wrong about what I see as the financial risks as signaled by the Chinese government are extremely large.

The Giant Debt Restructure

Let’s run a simple thought experiment.  Assume a government is drowning in debt.  They can’t raise the money to pay off the debt coming due.  The interest rates are too high and the maturities too short.  Revenues are falling and the banks are reluctant to continue extending credit to the government.  The situation looks dim.

The government and central bank, however, come up with an idea to solve the problem.  The government imposes a debt swap on the banks where they unilaterally turn short term high interest debt into low interest long term debt.  Though there is no write down in the face value of the debt, there would be a reasonable case given the coercion and change of terms, to ask whether this was a debt default.  There has been no change in asset or borrower quality but rather a unilateral rewriting of the debt contract using coercion.  Not wanting to miss out, the central bank offers to accept this troubled debt as collateral should the banks want cash instead, effectively monetizing the bad debt.

This scenario isn’t about Greece but about the debt swap imposed by the Chinese government in partnership with the PBOC on lenders holding local government debt.  While no one is saying this is a default, if this same scenario played out in Greece, there would be arguments over whether this constituted a default.  Furthermore, less anyone forget the magnitude of debt, the debt swap constituted only about $160 billion of the estimated $3 trillion.  To put this in comparison, this is a similar absolute number as is being discussed in Greece and still only about 5% of publicly acknowledged local government debt.

There are a number of important points to note about the overall debt swap.  First, the bankers are going along with this not because they think it’s a good deal but because Beijing is threatening them and the PBOC is buying them off.  As with most countries, if the central government tells you to do something you do it.  If the central bank essentially offers to take some risky debt off your hands at face value, you accept and don’t look back.

Second, the bankers are telling you a lot about what they think of the state of local government finances in China.  They wanted nothing to do with refinancing the debt and definitely not at the prices being offered.  Given their knowledge of debt repayment capacity of their clients, this tells us a lot about the state of local government finances.  Especially with land revenue falling by more than 30% annually when it typically constitutes more than 50% of government revenue, the provinces ability to repay is highly suspect.

Third, Beijing did not ask nicely but rather imposed regulations about the interest rate tying it closely to the central government cost of funds.  The interest rate on the debt will drop from typically above 7% to about 3.5% with maturities moved from 1-3 year to at least 5.  The PBOC accepting bonds that the banks can’t wait to unload should also call into question the prudence of accepting such widely acknowledged low credit quality instruments.  It seems unlikely that the PBOC would try to collect capital from banks if the underlying borrower defaults, essentially turning the PBOC into a bad debt asset manager.  This could the Chinese method of tapping the PBOC balance sheet by swallowing bad debts.

Fourth, the banks, after getting cash for the bonds as collateral from the PBOC, are being encouraged to lend out this cash to firms in favored industries.  Given the drop in risk weighted capital from holding government bonds as an additional benefit, this means that banks will have significant new capital to lend.  The rapid rise in Chinese debt, which has even officially surpassed most developed countries, seems bound to rise even more.  I can’t help but think that this seems like trying to sober up an alcoholic by buying him a beer.

While this certainly heads off larger financial problems in the near term, it seems at best designed to put off dealing with the problems and at worst exacerbating the credit bubble.  Most China watchers have been focused on debating whether the PBOC is running QE with Chinese characteristics, but missed the importance of the debt restructuring.

Here is hoping that deposit insurance will never be needed.

Reading Between the Financial Tea Leaves

The big news in Chinese financial markets is that the local government bond offerings designed to refinance off-balance sheet high interest short term borrowing into market based low interest long term products have hit a snag.

Chinese banks are refusing to buy local government bonds at the price on offer.  As the Financial Times noted, the trouble with market based financing is that it doesn’t always do what you want it to do.

There are a number of important issues however, that are largely being overlooked.  First, despite all the sooth saying of Chinese and international pundits that the government is not debt burdened, that is really only partially true.  While the Chinese central government has a relatively low debt load, the real burden is held by the provinces.  Seven provinces have debt to GDP ratios above 80% with Beijing coming in at 100%.  According to the FT, Standard and Poors estimated that half of all Chinese provinces would receive a junk rating.  Just because the official national government debt load is low, doesn’t mean government debt is low.

Second, from the banks perspective, the bond program makes no sense.  Let’s take a simple scenario of what the banks are being asked to do.  The bank has a loan that is paying probably 6-10% (as it is an off-balance sheet project with only implicit government support) with a 1-3 year duration.  They are being told to transform that into a bond with a 5 year duration paying 3.6-4%.  This is a losing proposition for the bank.

Third, there is a major information asymmetry involved between China financial analysts and banks.  Chinese banks which are being asked to purchase the bonds from the same underlying borrower with the same underlying asset as existing loans, presumably have much more information than anything a journalist or professor has access to.  Their level of reluctance reveals their concern about the debt quality from largely existing assets.

Fourth, despite some arguing this represents normal financial development, this quite potentially represents something much more ominous.  During the Greece debt crisis that continues to drag on, a key question has been whether a forced duration extension and lower interest on original debt qualifies as a default.  For some the important question here focuses on the level of coercion involved in exchanging liabilities with the same underlying borrower.  The key point here is that there appears to be a fair amount of coercion involved to force banks to renegotiate existing debts from short term high interest into long term and low interest.  The Financial Times sums it up perfectly quoting one analyst saying  “This isn’t really about adding liquidity.  It’s aimed at alleviating debt pressures on local governments and reducing financial risks.”  If we changed the names from Chinese provinces to Greece, we would be discussing whether this constitutes a default.

Fifth, as I have noted, the Chinese response worryingly seems to be to try and sober up a drunk with more Baiju.  The Financial Times writes “China’s central bank is considering extraordinary measures to boost credit flows to heavily indebted local governments…”.  Reuters writes “China’s Ministry of Finance has warned of slowing tax revenue growth and told local authorities to hasten issuance of newly-approved municipal bond debt.”  China’s problem is not lack of credit but firms and provinces with unsustainable debt loads.  This explains the push into long term low interest bonds.

Taken in isolation, this might be seen as standard growing pains.  However, the recapitalization of policy banks, recent defaults, and semi-coerced refinancing paint a grim picture of Chinese finances.

Looking Back at Chinese Finances

The Chinese economy is entering an interesting state.  Producer prices are falling relatively rapidly due to lack of external demand and a supply glut with producer output falling moderately.  A major real estate developer defaulted this past week (though this more likely owes to corruption scandals than financial problems though no one is quite sure) and maybe the biggest news of all a Chinese SOE with a mainland bond defaulted.  Add in the 1% cut in the RRR by the PBOC and while Beijing may not be pushing the panic button but they appear to be making sure it is working properly.

The Chinese economy is under an enormous amount of stress and there are no easy answers.  There are a number of problems.  First, banks and bond markets have tilted heavily to short term lending.  This means that the amount that has to continually be either repaid or rolled over is high.  According to the Asian Development Bank, nearly 60% of corporate bonds are under 5 years with large amounts falling due within the next two years.  Banks have shortened maturity periods with some banks having more than 65% in lending under 1 year.  While it may give some comfort that relatively little external finance exists in China, it should cause high levels of concern over the significantly shortened maturities.

Second, despite the self congratulations be handed out that China has significant scope ease monetarily, this over estimates the economies ability to absorb additional stimulus.  Many industries in China already suffer from surplus capacity,  infrastructure white elephants litter the country, and major firms with access to credit are already over levered (PDF).  Easing monetary conditions is right out of the Macroeconomic I textbook but here it is like trying to sober up a drunk by buying him a beer.

Third, there is very little appreciation for just how fragile Chinese banks are and how poor their history of lending has been.  I have a forthcoming paper in the Journal of Financial Perspectives which details some of the problems.  From banks that only list a loan as doubtful until after the borrower has declared bankruptcy, ceased operations, and been out of business for at least one year to banks that declare losing loan paperwork as a risk to being repaid, there is little appreciation for their perilous state.  Bad loan numbers are, even while amazingly generous in the definition, spiking rapidly and expected to climb.  China has also started recapitalizing policy banks this past week by converting existing loans into equity.  While the official reason is to boost investment in the Silk Road projects, given the conversion of method of existing loans and in the very unknown projects well off in the future, I remain skeptical towards the official reasons.

There are very real risks to the Chinese economy and financial sector and there should be a lot of attention paid to those risks as repayments come due.

Chinese Foreign Exchange Movements

Concern has been raised over the deterioration of the Chinese economy even though growth is officially only set to slow by a few tenths of a percentage point.  The signals coming from Beijing indicate a greater level of worry than the shift from 7.4% to 7%, officially speaking of course.

As I have noted in other writings, despite its reputation as prudent money manager, China and the PBOC have overseen one of the fastest expansions of the money supply in the world in the past decade. Excluding countries suffering from serious or hyper inflation, even after controlling for real economic growth, China has witnessed one of the highest rates of growth in money supply in the world.

According to State Administration of Foreign Exchange (SAFE) data, net purchases of foreign exchange averaged nearly $300 billion USD annually since 2001.  As recently as 2013, total net purchases of FX in USD terms equaled nearly $400 billion USD.  However, since peaking in late 2013 early 2014, net foreign exchange purchases have deteriorated rapidly on both a monthly and annual basis.

There are a number of interesting conclusions to draw from all this.  First, monthly net foreign exchange purchases as recorded by SAFE have not witnessed such a sustained period of net sales (outflows) since January 2001.  There was a brief period in the middle of 2012 when net monthly purchases turned briefly negative during a couple months.  However, it was smaller, inconsistent, and shorter in duration.  Net monthly purchases are prone to relative volatility, but the overall trend and size are important to note.

Second, if we consider annual purchases on a rolling basis, there is a brief period in late 2012 when the net annual FX purchases by SAFE drop beneath $100 billion.  However, as was noted with the annual purchases, this trend quickly reversed and by February 2013 rolling 12 month purchases were back up above $200 billion USD.

Third, if we consider annual purchases around fixed dates either after Chinese or calendar years, to adjust for potential seasonal issues, we see clearly the magnitude and speed of the change.  2002 was the last calendar year China had net FX purchases under $100 billion USD with a similar result if we adjust the calendar to account for Chinese New Year differences.  From March 2013 through February 2014, China enjoyed net FX purchases of $387 billion USD.  From March 2014 through February 2015, China saw net FX purchases of just $12.6 billion USD a decline of 97%.

Fourth, if we focus on FX purchases since January 2009, the pattern indicates that since about late 2012, gross purchases have grown more slowly while gross sales have continued to grow rapidly.  The net result is that net purchases have declined dramatically.  In July 2010, gross purchases of FX by Chinese banks reached a new monthly high of $114 billion USD.  In February 2015, the latest month with available data, gross purchases totaled $115.6 billion USD.  Conversely, gross sales in the same months grew from $88 billion USD to $126 billion USD.  In other words, while inflows into China have essentially gone flat, outflows have continued on trend.

Fifth, while China is in no danger of a run on the currency or exhausting its FX reserves this does appear to portend a much broader and severe slow down in the Chinese economy.  If gross purchases are essentially flat, this means that both investment in China and Chinese exports are not growing or tepidly.  Given the concern expressed by foreign companies in China over the capricious regulatory environment, anti-foreigner sentiment, and costs, to name just a few worries, this appears to be hitting inflows.

Though too soon to tell if it is a longer term trend, this does appear to be a longer trend than the 2012 phase.  It does however appear to signal much greater weakness in the overall Chinese economy.

China Notes for March 31

China with the diplomatic coup of the Asian Infrastructure Investment Bank appears on a hot streak.  However, the economic and financial problems appear bigger and bigger everyday.

Hainan has admitted to major debt problems.  Haikou, the capital of Hainan, estimates total revenue of 21b rmb with 15b rmb of debt maturing this year.

The McKinsey Global Institute notes that total Chinese debt is 282% of GDP while the debt laden Americans and Germans come in at a more frugal 269% and 258% respectively.  With credit growth continuing to expand rapidly and a loosening of requirements for second homes, there is little evidence of deleveraging.

Now China seems intent on exporting its problems.  The enormous glut of Chinese steel with iron ore prices a long term lows, has prompted some Chinese steel makers to export surplus capacity abroad with scant evidence of demand of size.  Even crazier is that the Chinese government seems intent on supporting this strategy with various forms of financial capital.

Three quick economics lessons for China.  First, if there is surplus capacity globally, moving that surplus capacity from one country to another still leaves surplus capacity.  Second, Chinese subsidies to move loss making Chinese steel producers abroad subsidizes foreign consumers.  Third, steel and iron ore are global commodities.  Chinese steel producers producing in foreign countries still have to compete in a global market.  If the market price is below their break even, they still lose money and the foreign country can buy on the world market.

It seems destined to get worse before it gets better.