- On the anniversary of the creation of the People’s Republic of China, I would like to wish China and all of my dear friends here a wonderful day of celebration.
- Though I have significant concerns about future economic and financial risks of China, I have thoroughly enjoyed the six plus years I have already spent living and working here and look forward to more
- I am blessed to work with some very good colleagues and teach very bright students at the best university in China (No Tsinghau, we are still the best.).
- It is inconsistent belief that the Chinese government would control information and manipulate data in areas from the environment, human rights, and even acknowledged economic areas like unemployment but then behave as angelic choir boys in the production of GDP/economic data.
- It is inconsistent to believe that a government that employs 2 million people monitoring the internet, tracking, and limiting speech is at the same time incapable of or too poorly trained to assemble economic data.
- I find it curious that people who so ardently defend Chinese economic data do not actually present official Chinese economic data, rather taking it as a given, to make their case.
- I find it curious that people who so ardently defend Chinese economic data begin by saying “there are significant problems” with Chinese data and close with “but we should believe it anyway.”
- China has a lot more data that allows us to make comparisons than most people realize. However, it takes ingenuity and tenacity to dig in the data trenches.
- If economists are scientists, we should continually seek to verify the data and mechanisms to test if they match the observed empirical reality.
- Accepting numbers because they are handed down from authority figures and using that reasoning as a defense transforms the analyst into theologian rather than data scientist.
- I hate to say it but I like Thai and Indian food more than Chinese food.
- I strongly believe the next few years will be very, very interesting.
- Even in my six plus years, China has changed enormously. The physical standards and comfort of living here continue to increase rapidly in Shenzhen. The severe and increasing restrictions on information, crackdown on academics, lawyers, and journalists is obvious and felt throughout by many.
- Hong Kong is a frog in a pot.
- I am amazed at how fast children can learn a language.
- The goal of increasing innovation is inconsistent with the restrictions on information, thought, and freedom of speech.
- China is facing a point in history where inherent contradictions will seek a more permanent resolution.
Given the widely acknowledged slow down in the production side of the Chinese economy, the question has shifted to how rapidly the consumption and service sector in China is growing. Perma-pandas rejoiced last week when athletic apparel maker Nike reported 30% sales growth in China. Then GoldmanSachs, arguably the most perma of all perma-pandas given among other things their prediction of a 30% rebound back to 5,000 in Shanghai, produced a report comparing the new vs. old China economies. They produce data indicating revenue of new China which they define as leisure, health, and IT increased by 23% and old China defined as property, industry, and mining increased only 2%.
Though I do not have access to their study or data, I downloaded industry and sub-industry data on publicly traded companies in China from WIND to attempt to broadly replicate their findings. There appear to be some similarity from their findings with the data from listed companies but also important points to note about these headline findings from Goldman Sachs and Nike.
- Leisure places as a sub-industry of the Hotel, Restaurants, and Leisure (HRL) industry operating revenue is growing rapidly at approximately 49.6% YTD YOY growth. However, the HRL industry slightly contracted YTD by 0.5% with Hotels essentially flat with a slight decline of 0.3% and restaurants contracting by 16%. Furthermore, the Leisure sector according to WIND represents only 1.4% of the entire HRL sector. While it is perfectly accurate to say that Leisure is growing rapidly, it seems somewhat misleading when discussing it against the backdrop of economic rebalancing in the Chinese economy.
- The broader health sector including services, products, and pharmaceuticals is growing solidly at approximately 10%, but significantly less than 20% cited by Goldman Sachs. It should be noted that there are a variety of sectors within the Health industry growing at or significantly more than 20%. Biotech, Healthcare Equipment and Services, Healthcare Equipment and Supplies, and Healthcare Providers and Services are all growing anywhere from 20-40% YTD YOY. However, the broader industry which includes significantly slower growing sectors appears to be growing at a healthy 10% that is decidedly less than the 20% cited by Goldman. It is unclear if they are referring to the broader Health industry or specific sectors.
- The broader IT an specifically services and software sectors appear to be growing robustly. Whether it is Software & Services growing at 32% YTD YOY or Technical Hardware & Equipment at 17%, our data broadly falls in line with the Goldman top line number of 23%.
- While I do not have access to the Goldman report, one industry appears to be broadly in line with public company data, one industry is moving in the same direction though decidedly slower, and one industry appears to not be match the Goldman data. The most likely explanation is that Goldman cherry picked specific sub-industries that painted a specific picture.
- If we turn to the Goldman definition of China from publically listed companies under the Real Estate sector, we receive some relatively different results. Operating revenue YTD YOY has increased a robust 36%. I have no explanation for the discrepancy.
- Turning to some of the other old China industries the data is also very different from the Goldman data but in a very different way. Focusing on coal, oil, and gas sectors operational revenue declined 23% YTD YOY.
- Metals mining and processing operational revenue declined 12% YTD YOY. This includes industrial, precious, ferrous, and non-ferrous mining and processing.
- If we look at industry, operational revenue is actually broadly flat or slow growth. Comprehensive industry increased 1%, Machinery 4%, and Electrical Equipment at 5%.
- Summing up the old China industry, the data is not uniformly bad but indicates more weakness than Goldman finds when we look at a broader array of old industries.
- Here is the biggest problem with the Goldman presentation of the old and new China which cuts directly to the rebalancing, consumption, and services growth argument being made about China. If we take a broad picture of new China including the Goldman industries then add in others that focus on consumption, and services total operational revenue grows by a healthy 9.4%. If we focus now on the old China definition used by Goldman and include other old industries we find total YTD YOY operational revenue decline of 14%. In a way the “rebalancing” is taking place with new China revenue growing healthily at 9% and old China declining by 14%. Economic activity is shifting.
- Here is the major and most important point. Old China listed companies account for 78% of operational revenue while New China accounts for 22%. If we weight operational revenue of listed companies of the New and Old China variety based upon their percentage of operational revenue, instead of seeing moderately healthy or slow growing economy, we see weighted operational revenue decline of 6.3%. In other words, an overly simplistic comparison of revenue growth dramatically overstates the relative importance of new China. In other words, operational revenue for most of the Chinese stock market has fallen 6% in the first half of 2015.
A few final notes. First, this is not a replication of Goldman Sachs because I simply do not have their data or know exactly how they classified or divided industries. Second, while my method and data should be broadly similar there are key differences which based upon available information I have noted. Third, the data is not uniformly bad and the nuances need to be understood. Fourth, the negative growth in the large amount of listed companies is concerning. Fifth, while the rebalancing is occurring, it is not happening to the degree or how many believe.
Perma-pandas have pretty much abandoned making the argument that the product economy is growing any where near 7%. Even in a relatively data hungry economy like China, there is simply way too much data indicating that product output is essentially flat. From consumer to manufacturing or commodities, domestic product output is essentially flat in China and imports are collapsing. This is based upon a variety of granular level indicators that I have covered here and elsewhere.
Never discouraged in their quest for the mythical 7%, perma-pandas now argue that service sector growth is driving total GDP growth in China. There are numerous problems with this argument from the factual to the theoretical. First, the perma-panda argument is relying exclusively on top line official data that the service sector. Top line official data is very questionable and especially the supposed shift in GDP structure in recent history. As noted recently here, a wide variety of service sector industries were averaging revenue growth in the low to mid-single digits that began at the latest in 2014, despite official data showing a shift to the service economy. Oddly, even the perma-panda data fails to indicate an increased share of services in the GDP basket despite their argument for its importance.
Second, if we exclude top line official National Bureau of Statistics data, there is simply no evidence of rapid service or consumption growth in the Chinese economy. I want to be clear on this point that service growth does not appear as weak as product output, however, most evidence indicates it is only growing in the low to mid-single digits. I have already addressed certain areas like transportation and telecoms which using year over year year to date growth, are experiencing weak growth. Telecom services appear to be suffering small declines with provider revenue mirroring this change. Transportation and freight appear to be essentially flat, though due to methodological changes in data counting, which have never been explained publicly, passenger numbers between 2013 and 2014 dropped significantly. Consequently, while we cannot extrapolate further than one year, the year over year and year to date passenger numbers are flat and are comparable.
Most recently, I have downloaded data on data related to medical and health services. If the supposed boom in services is happening, it certainly isn’t happening in Chinese health care. Visits to medical institutions, hospital visits, and primary medical facilities are growing at 2.98%, 5.40%, and 1.56% respectively. If Chinese consumers are going to consumer a higher level of health services or consume health products, it is an absolute pre-requisite that their visits to health institutions increase. Furthermore, while I did not test for this econometrically, given the continued aging of the Chinese population, a small increase in visits to health care providers is expected.
Medicine output, both western and Chinese tells a similar story, with a caveat. Traditional Chinese medicine year to date total monthly output is down 15.1%, though this decline is due largely to slowing production in July and August. Through June traditional Chinese medicine output was essentially flat registering a miniscule 0.59% increase. While the year to date number for raw chemical medicine output at the end of August was a distinctly more robust 17.5%, this number comes with a significant caveat. For some reason, this number goes through large intra-year swings. If I reported the number as of June, it would come in at a much more moderate 3.8%. Looking back over the past few years of this category, it is prone to large intra year swings that will move between significant YTD increases and then back to small declines. It is likely that the 17.5% growth will not continue for the rest of the year.
If health services consumption is going to rise we should see higher levels of hospitals, medical institutions, and primary medical facilities. It defies logic that health care service utilization would rise but visits and basic medicine use would grow slowly or fall. Correlated with that, we would expect to see increased primary and Chinese medicine consumption. While neither visit or basic medicine growth is negative, neither are they robust even in the mid to high single digit range, with the noted caveat about the August spike in raw chemical medicine. Low to mid single digit growth in specific health services that would be a comprehensive indicator and consumption that would be strongly correlated with higher health service usage, simple do not indicate the growth necessary to rebalance the economy.
Third, perma-pandas are confronting the laws of mathematics in attempting to defend the increasingly elusive 7%. Let’s take a slightly stylized version of the Chinese economy. Assume they have a 50/50 split between production and services, which isn’t exact but close enough for our purposes. Now let’s assume that production is growing at 2%. It is hard to find any output growing that fast, much less all output, but let’s assume that for the moment. For the remaining 50% of the economy to push total GDP growth to 7%, that would require the service sector in aggregate to grow at, in our somewhat simplified version of the Chinese economy, a total of 12%. So far, if we exclude top line NBSC data, I haven’t been able to find any service sector growing at double digits much less the entire service sector using key metrics. I am not the brightest guy around but I struggle to see how health service provision and consumption can increase in double digits when visits and medicines are growing so much slower. I fail to see how telecom services can positively contribute to service sector growth when virtually all its components are negative. Service and consumption need to grow significantly faster than 7% to push the entire economy up to 7% given the acknowledged slowdown in output and it simply is not merely a flesh wound.
I want to note on specific caveat about the data I am producing as I go through various sectors of the Chinese economy focusing on consumption and services. The metrics I am using, such as hospital room and primary health care institution visits, are imperfect metrics in the sense that are not perfect substitutes for their respective components of GDP in health care service provision. However, they absolutely should be closely correlated with the respective components of GDP. Telecom service provider revenue is again an imperfect measure of telecom services GDP, but when the official statistics claim 23% growth and service providers are declaring flat revenue, this raises serious questions.
I will continue to search for data in various service industries however, having covered transportation, hotel and catering, telecommunications, and now health care services, the granular industry level data simply does not support the story of rapid service sector growth in China. Despite repeating it over and over, there is simply no underlying evidence that service sector growth is rapid enough to make up the difference in flat production output to turn China into a 7% GDP growth country.
Note: Data from the post cited can be downloaded here.
- There is an argument being advanced that the Fed being concerned about emerging markets (read China) opted to hold off on raising interest rates. I actually disagree with this interpretation of events but understand the logic and reasonableness of the argument. I believe instead that the Federal Reserve Board looked at inflation and potential background pressures and opted to leave rates unchanged. While I personally would have voted for at least a 0.25% increase, even the most devoted inflation hawks have a tough time making the case that inflation is rising or the background factors are mounting to spur significantly higher inflation. In short, I believe the Fed looked at the US and doubted the size, strength, and speed of potential inflationary pressures existed to necessitate a rate hike. I mention all this because I want to pass on a market rumor I heard from a couple of unrelated people. The rumor as was told to me was that the August 11 devaluation was a warning shot to the Fed to keep rates unchanged or else the PBOC would let the RMB drop a lot more. I am not ready to believe it but at the same time, it isn’t easy to discard. Here is why. First, if China was hoping to use RMB devaluation to increase exports, 3% is not nearly enough to offset domestic and international currency pressures needed to make Chinese exports competitive. Second, despite China saying this was a move to introduce market pricing, virtually every day since August 11 has seen market pressures on pricing ignored. This was not about market pricing. Third, as I have noted numerous times, the biggest change was the introduction of fear into the RMB/$ peg. In short, as many people noted early on, any economic rationale for the PBOC action was weak at best leaving watchers with a puzzle to try and explain the movement. Again, this is just a market rumor that was passed on to me by a few people and I am passing it on to you.
- I know one thing that is difficult for many to grasp, especially those who do not delve into the bowels of Chinese data, is why I am so skeptical of Chinese data. The simple answer is that the data is so obviously inconsistent because it does not reconcile to itself by a large margin. However, even trained China data watchers, especially those who believe the only thing wrong with China data is a lack of transparency, make this mistake. As a simple example, China data day dream believers will acknowledge questions about GDP data and then use other topline official data to demonstrate their point as if the NBSC will have any trouble massaging those data points. Even this data is obviously problematic. Let me give you an example I just discovered the other day that cuts directly to the heart of the argument that services are rebalancing the Chinese economy. In the monthly data at the National Bureau of Statistics China under the Postal and Telecommunications Services section, the Telecommunications Services is credited with year over year growth of 27% and accumulated year to date YOY growth of 23.2% supporting the shift to services argument. Pretty solid numbers. However, looking beneath the surface at the components of telecom services growth the numbers tell a radically different story. The YTD YOY growth in telecom component services reads as follows according to the NBSC: local calls volume fixed line including IP -12.6%, length of long distance calls of fixed line including IP -7.6%, length of call mobile telephone -1.9%, number of fixed line subscribers -6.5%, urban fixed line subscribers -2.7%, rural fixed line subscribers -15.1%, mobile telephone subscribers 2.6%, 3G mobile phone subscribers -4.7%, SMS services -4.7%, and broadband subscribers 4.6%. All these components produce an unweighted average growth of -4.9%. The underlying component results closely match the revenue results from China Mobile reporting 0.5% telecom services revenue growth (PDF) and China Unicom revenue growth which actually declined slightly 1H 2015 on a YOY basis. There are a few final points. First, I have absolutely no idea how the NBSC arrives at 23.2% YTD YOY growth when all the components are huddled around 0 with a few witness low to mid-single digit growth. I am not even going to guess. Second, this undercuts the argument that China is shifting to a services based economy. Third, firms do not live off of manmade GDP but on the revenue from selling those services and it is clear that firms are not witnessing the supposed rebalancing or GDP growth in services the NBSC and perma-pandas believe exists.
- Many perma-pandas that argue GDP data is accurate have also tried to argue that services are an increasingly important part of GDP growth. However, their own writings contradict this positive assessment. Nicholas Lardy at the Peterson Institute writes a blog post entitled “Retail Sales Numbers are Not a Reliable Indicator for Consumption Expenditure” discussing China retail sales and data. What makes this post so unique is that Lardy supposedly believes that consumption is one of the additive components of GDP, believes that consumption data is inaccurate, but also believes that GDP data is accurate. I’m not going to even try and explain that contradictory logic but instead focus on what his data says about services. In his post on retail sales data and services in China, according to Lardy figure 1 and figure 2, services as a percentage of urban household consumption expenditure is virtually unchanged since 2005. Rural household service as a percentage or household consumption has increased from the mid-range estimate only slightly by approximately 1-2% since 2005. That is not the great rebalancing of the Chinese economy perma-pandas are arguing for, that is the balancing of the Chinese economy. Just to recap what Lardy is arguing: consumption data is inaccurate and can’t be believed but GDP should be believed and that services is rebalancing the Chinese economy when his own data shows the opposite. Perma-pandas keep making arguments with a complete lack of data, data that shows the opposite, or official headline data with underlying component data that shows the opposite.
- The China Beige Book report on the Chinese economy is getting some good play but the headline being used is “pessimism is divorced from the facts”. The actual report which I have read is distinctly more nuanced than that. For instance, they write that “those touting China’s sudden fragility are either exaggerating current problems or have entirely missed the slowdown of the past several years.” They go on to note that while growth is slowing “no collapse is nigh.” They note that revenue gains in the service sector has been modest. I would say in general this is a reasonable assessment of the Chinese economy, as most of the data I have been covering indicates very low levels of growth and that there is no collapse. However, even the Beige Book analysis does not indicate a rebalancing. A rebalancing necessitates that service and consumption outpace other sectors of the economy. Right now all evidence, excluding topline official data, indicates that the consumption and services are growing at best slow to moderately and definitely not enough to shift the structure of the Chinese economy. Even the Beige Book is not arguing for a rosy economy picture.
- So the Fed has opted to leave rates unchanged and one of the primary, if unspoken, reasons is the global slowdown brought by China. The global slowdown has China at the epicenter through a variety of channels such as reduced demand and prices for commodities which results in lower growth primarily in other emerging markets and downward price pressures. China should be sending Janet Yellen a fruit basket this morning because any raise, would have placed even more pressure on the RMB/$ peg. There is an important distinction here that needs to be made. While the Fed keeping interest rates unchanged does not raise the pressure on the RMB, it certainly does not lessen it. Despite the PBOC assurances, capital continues to flood out of China and show no signs of falling. Just yesterday there was a story that outbound investment from China was on pace to hit $1 trillion USD for the year. I generally view internationalization as a positive. Just keeping up this pace will place enormous pressure on the RMB as foreign investment in China definitely isn’t keeping that pace, with many categories falling, and the trade surplus is not enough to offset the difference. In other words, the RMB will remain under pressure and the Fed should be receiving fruit baskets from the PBOC for not turning up the pressure.
- There is a question I’ve seen arise in both explicit and implicit ways that I believe needs some exploration. Many have noted that capital outflows are not related to economic growth. That is generally true but the truth is more complicated and indirectly untrue in keyways. Let me explain. First, Chinese investors are telling you what they think of the Chinese economy. There is a dearth of good investment opportunities in China. Falling credit quality, deflation in producer prices, surplus capacity in a range of sectors, coupled with an awful investment climate do not inspire confidence in even Chinese investors despite calls for unity and national pride. Second, capital outflows are placing downward pressure on the RMB. That is going to require an implied tightening to maintain the RMB/$ peg which would require secondary loosening. If a devaluation would take place, this would reduce consumption and have minimal impact on exports unless the devaluation was sizeable. Third, an enormously under appreciated part of the China growth story for the past decade or longer was how the money supply simply exploded whether through sterilization of trade surpluses or credit. Chinese M2 growth lags only serial inflators like Russia, Turkey, and Argentina in the past decade despite reporting some of the lowest inflation among all major emerging and developed countries in the world. Reducing the money supply will have an enormous impact on Chinese growth. Fourth, capital outflows will place enormous stress on Chinese financial institutions. Any drying up of liquidity, will place significant stress on institutions with high levels of short term loans that they need to roll over. In other words, while yes capital outflows have no direct impact on GDP growth, the reality is decidedly more nuanced and does have significant indirect impact.
- What is interesting in the debate over the quality of Chinese data and attempting to ascertain the true state of the economy is to watch people hear what they want to hear and disregard the rest. Bloomberg has released a short paper on its opinion of the quality of Chinese data and economy writing that “naive suspicion of China’s growth rate based on a limited set of industry-related indicators is misplaced.” They note that the “default” position of many market participants now is to doubt official data using electricity consumption as an indicator of Chinese GDP growth. They go on to cite perma-panda Nicholas Lardy that consumption and services is holding up well because, movie box-office revenue is up strongly this year. So apparently, replacing electricity growth with box-office revenue is not narrow but an acceptable use of data analysis. The bigger problem with this analysis is it is willfully overlooking enormous amounts of data that has been produced about the Chinese economy. Whether it is retail sales or output data, including consumer products and significant amount of services, Bloomberg is simply choosing to ignore quality work that has been done by a variety of people demonstrating weakness in the Chinese economy and the major discrepancies between top line official data in the granular data underneath it. There are three final points worth noting. First, Bloomberg is flat out wrong on one specific point of fact according to the data I downloaded from Wind. They write that “gains in passenger volumes are robust.” Based upon the data I downloaded from Wind on passenger volumes and distances traveled, this is simply false. Second, Bloomberg and Nicholas Lardy not only provide virtually no evidence to support their rosy scenarios, they fall prey to one of the class blunders in economics: the lip stick fallacy. Lardy and Bloomberg cite rising movie box office sales as proof that consumption and services are strong. However, economists have long noted the relationship between the increase in “affordable luxuries” during economic downturns. It is frequently referred to as the lipstick effect as consumers increase their purchases of affordable luxuries compared to bigger spending items. Think lipstick compared to a new purse. Third, Bloomberg and Lardy rely completely on official NBSC data to support the argument that consumption and services have risen as a percentage of GDP. Given the enormous discrepancies we know exist between underlying data and headline in these areas in the past few years, this is not an assumption to take lightly. To claim that critics of Chinese data are overly obsessed with electricity consumption to track the overall economy is an incredibly poor read of the work that has been done in the market. The market and myself are looking at a wide range of data and finding that the data simply doesn’ fit the 7% growth story and the data discrepancies are much larger and systematic than Bloomber recognizes. There is a reason the new market default position is skepticism.
Note: Here is the output data referenced that was used in the FT Alphaville piece.
While the world has started paying attention to China due to its stock market having the stability of your average reality star, I have always cautioned and continue to believe that whatever gyrations the Shanghai and Shenzhen indexes experience is a mere sideshow. One of my primary areas of concern is the credit market.
I think there is good reason to be worried about the state of the Chinese credit market that move well beyond the standard explanations of excessive credit growth and a slowing economy, which are perfectly valid by themselves. RBS Albert Gallo via FT Alphaville writes that “we estimate peak NPL’s of 5.5% in China” using I believe a reasonable and sound methodology for estimating how high NPL’s will increase from their current state. I think the RBS method based upon credit in excess of credit to GDP trend is a reasonable estimate of how much on average we could expect NPL’s to increase from their current state.
Here is where I differ, using the current official data on NPL’s in China enormously understates the number of bad loans in China. This is not some conspiracy theory or complicated statistical analysis, the banks are literally telling you their definition of an NPL does not resemble anything that would be acknowledged outside of China. As one paper from economists at Wharton(PDF) wrote in a recent paper:
“…the classification of NPLs has been problematic in China. The Basle Committee for Bank Supervision classifies a loan as “doubtful” or bad when any interest payment is overdue by 180 days or more (in the U.S. it is 90 days); whereas in China, this step has not typically been taken until the principal payment is delayed beyond the loan maturity date or an extended due date, and in many cases, until the borrower has declared bankruptcy and/or gone through liquidation.”
Nor is this a case of conspiracy theories by Chinese and foreign economists. The Chinese banks actually tell you the same thing. In recent bank IPO prospectuses when banks provide a wealth of information such as loan classification systems, they would say essentially the same thing. Huishang Bank for instance, wrote that a major regulatory risk is that “our loan classification and provisioning policies may be different in certain respects from those applicable to banks in certain other countries or regions.”
Amusingly, the next risk identified by Huishang is that “we cannot assure you of the accuracy of facts, forecasts, and statistics derived from official government publications contained in this prospectus with respect to China, its economy, or its banking industry.” In other words, Chinese banks don’t believe official statistics.
Banks that went public in 2014 took risk recognition two steps further. One bank Shengjang wrote that “our historical non-performing loan ratios may not fully reflect the actual changes of our asset quality due to government-sponsored disposals and write-off of non-performing loans in the past that were not in the ordinary course of business….we cannot guarantee that the government will continue to help us dispose of and write off our non-performing assets.” In other words, their NPL ratios were protected due to government bailouts and they can’t guarantee this will continue.
However, it doesn’t end there. The Chinese banks actually say they might not have data on even who they lend money to or any documentation to support their claims (no, I’m not making this up). Shengjing actually writes in their IPO prospectus ““loan is unrecoverable despite a favorable court judgment due to our failure to apply to the court for enforcement before the applicable deadline” or “no loan contract (agreement) has been signed with the borrower, or the original loan contract (agreement) has been lost, and the borrower refuses to confirm the loan…”. In other words, even if they can get a favorable court judgement, they might not have the paper work or information on the loan. Questions about China data from firm to national level are not conspiracy theories but stated bluntly by firms and political leaders themselves.
All this leads into the two specific reasons this matters and why the RBS estimate of 5.5% peak China NPL is an underestimate in my opinion. First, there is a very high degree of probability that we are already at 5.5% with numbers continuing to rise rapidly. Special mention loans plus official NPLs in China are already at 5.13% and has risen 43% in the past year. Given what we know about Chinese loan classification, which Moody’s noted recently going even further noting that loan classification quality was actually deteriorating, it does not stretch credibility to believe that 5.5% is already in sight. The rapid rise of “special mention” loans, the classification before a loan becomes NPL, indicates that banks are trying to avoid reclassifying them which coupled with the rapid rise indicates significant unreported stress.
Second, a significant amount of lending is being conducted in increasingly shorter duration. For instance, Harbin Bank saw nearly two-thirds of its loans in short term holdings under one year and continuing to rise. The shift and continuing rise on short term lending would seem to indicate stress in repayment. All evidence points to mid-size and smaller banks along with shadow lenders having large portfolios of short duration assets under one year and the 4 majors having about 1/3 short term lending with longer term lending flowing heavily to SOE’s and similar type firms. This means that every year large amounts of debt needs to be rolled over or paid off. With these numbers continuing to rise as portion of total debt this seems to indicate unreported stress in the credit market. Couple this with what we known about debt classification and it paints a worrying picture.
While I think the RBS analysis is solid, I don’t believe it is starting from the right base. If we believe that a not insignificant portion of special mention loans will migrate into NPLs, which is not an unreasonable assumption given a slowing economy then adding in a belief about loan classification with Chinese characteristics and we can already see 5.5% on the horizon.
Note: As usual, here is a link to the NPL data I reference downloaded from WIND. Here is a link to a paper I wrote on Chinese banks, NPLs, and repo lending. Anyone that wants the referenced IPO prospectuses just email.
The book that most influenced my thinking about how to approach the Chinese economy is Capitalism with Chinese Characteristics by Yasheng Huang of MIT. More than the factual information, which is great by itself, he imparted a simple lesson: more than probably any other economy, details matter when studying the Chinese economy.
Prof. Huang uses two simple examples from his book to illustrate his point. First, though economists with Chinese encouragement classify private companies based upon their legal classification, this overlooks the importance of government shareholdings. As Chinese banks can attest to today, just being a listed company does not make you a private enterprise. According to his calculations, if we account for these types of distinctions, as much as 80% of the Chinese economy is still managed by the state. Second, many “Chinese” companies that most people have heard of such as Lenovo and Alibaba are not actually Chinese companies. They are registered elsewhere for good reason.
There are many other examples in the book and many others I could provide about the importance of paying attention to the details of the Chinese economy. I by no means claim to have mastered this art but I am continually asking how can we dig beneath the surface of a flashy number or statistic to make sure I am understanding and taking prudent precaution to verify a specific issue. The problem is so frequently, when you dig beneath the surface of Chinese data, you uncover a bunch of dead bodies.
Yesterday, the National Bureau of Statistics China announced that retail sales China clocked in at a solid 10.8% growth. There are however significant reasons to doubt this number. As I have already written elsewhere, output of consumer products in China is flat or falling. However, just because China isn’t producing consumer products doesn’t rule out the possibility that retail sales are going up.
To examine this closer, I downloaded data from the report covering the 50 and 100 largest retail enterprises in China with sales broken out by category. Looking at the 50 largest retail enterprises in a year over year basis, except for jewelry, all other categories are negative. Looking at the 100 largest, jewelry is still the largest gainer at 8.7% with food registering a 4.9% gain. Total retail sales among the largest 100 registered a total gain of 1.5% year over year. Most interestingly about the top 100 year over year retail sales, there is not one category that reaches the 10.8% claimed by the NBSC.
If we look at the year to date YOY sales of the top 50 retail enterprises, total retail sales grows by 0.9%. In fact, only one category grows by more than 3%, jewelry which grew at only 4.2%. The short version is that looking at the major retailers of China, there is no evidence to support the official statistics that consumer retail spending is a robust 10.8%. While it is possible that major retailers are registering flat and declining numbers depending on specific category, while China nationally sees such robust growth of 11% is highly unlikely. Furthermore, the retail sales of major retailers matches closely what we know about the flat output of consumer products in China. It is very difficult to reconcile falling consumer output and flat major retailer sales with the official story of 11% growth.
There is however an even more important point that needs to be made. Headline official data of 7% GDP growth and 11% retail sales growth are in most ways irrelevant to a firm. Businesses rely on cash flow to pay for workers, machines, and space. If we look at retail related cash flow for 2014, as it is not yet available for 2015, there is an enormous discrepancy between the official data of 12% retail sales growth and the cash flow associated with retail businesses.
Looking at the “Comprehensive Retail” financials, sales growth for 2014 was only 3.8% with profit growth of 4.4%. Food saw the largest sales growth at 5.7% in a year when China was touting national retail sales growth of 12%. Even if we assume that GDP growth is actually 7% and that retail sales are proving robust at 11-12%, firms are not enjoying the cash flow benefits. A high point of sectoral cash flow of 5.7% is no indicative of firms enjoying robust growth. The slow cash flow growth would indicate that the retail slowdown has been going on much longer than initially believed.
There are a few points of economic analysis worth mentioning. First, we pay close attention to GDP and retail sales because we expect them to be good proxies of economic health and activity. However, firms pay with money not official GDP figures. Consequently, even if we stretch credibility and accept official GDP and retail sales numbers as perfectly accurate, firms are not seeing the related cash flow. Second, it appears that the retail slowdown has been much more prolonged than people realize. I present data here that covers revenue growth for the retail industry for all of 2014 showing sales growth of 3.8%. Again, if we believe the official retail sales growth number of 12%, firms live on cash flows and the slow down appears to have begun no later than 2014. Third, this data directly contradicts the entire economic rebalancing story in China. According to the data consumption is simply not outpacing growth in the traditional drivers of Chinese growth such as fixed asset investment. Fourth, this data comes much closer to matching most other data points we have such as consumer output, electricity, freight, and related data. If we ignore the topline official data, none of the underlying and independent data supports a 7% growth story.
Despite what people may choose to believe or disregard, it is incredibly difficult to reconcile official national statistics with more granular industry data on retail sales. Furthermore, when we also consider the consumer product output data coupled with large retailer sales data, it is difficult to accept official data. The most worrying part is that even if official GDP and retail sales data is accurate, the cash flow required to support the debt and return numbers indicate significant stress at the firm level.
The more we pay attention to the details of the Chinese economy, the more difficult it becomes to reconcile with official data and the more worrying the picture becomes.
Note: You can find all the data here cited in this blog. I apologize you need to download the data, I am having trouble inserting figures into the blog.
For recent readers of this blog, most of my work has focused on China with a not insignificant part of that writing focused on the statistical discrepancies we see in Chinese data. However, this type of statistical manipulation is by no means unique to China. Other countries have similar problems with data manipulation resulting in very large financial discrepancies.
Despite a reputation for clear and technocratic government, there is significant evidence that Singapore public finances present large unreconcilable differences. I have written about these irregularities previously and have completed an update to this working paper that compiles a more complete dataset. For those unfamiliar with the financial irregularities in Singapore public finances, let me briefly provide some detail.
- Singapore owns two sovereign wealth funds the Government Investment Corporation of Singapore (GIC) and Temasek Holdings (Temasek). Singapore has never publicly disclosed the assets under management of GIC but has disclosed the long run rate of return. Conversely, Singapore has disclosed the assets under management of Temasek and the long run rate of return. GIC claims to have earned 7% in USD over the long run and Temasek claims to have earned 16% annually since inception in 1974.
- Singapore publicly declares its financial assets and liabilities in its annual budget per IMF national accounting regulations. We know, or should know, based upon official data what amount of financial assets Singapore and its sovereign wealth funds hold. This helps us match in flows to the financial assets held.
- For many years Singapore has run large operational public surpluses. Since 1974 IMF defined operational surpluses in Singapore have totaled approximately $369 billion SGD or approximately $260 billion SGD at current exchange rates.
- Simultaneously, Singapore has become one of the world’s most indebted countries relative to GDP primarily by public borrowing in a complicated arrangement with its social security scheme the Central Provident Fund (CPF). In the arrangement, citizens pay in mandatory amounts supplemented with an employer contribution receiving a guaranteed rate of return between 2.5-4% for a total weighted return of about 3.5%. The Singapore government then borrows these funds from the CPF providing the government with cash flow that it says it invests. Total public debt stands at approximately $390 billion SGD or approximately 98% of GDP.
- The free cash flow from operational surpluses and borrowing since 1974, the year Temasek was founded, total $822 billion SGD or $580 billion SGD. It should be emphasized at this point, this is simply the sum of yearly free cash flow and does not account for investment returns or known costs such as currency or interest costs.
- It should be noted that Singapore claims that a significant portion of their operational surplus is not allowed by Singapore law to be spent. They argue instead that it is part of the national reserves that gets invested and should not be considered part of the yearly surplus. While this is an accurate interpretation of Singaporean law there are a couple of factors to note. First, it is included in national accounting as part of the operational surplus because the IMF considers land sales operational revenue not financial capital income. Essentially, land is not a saved financial asset. Second, regardless of how it is counted, land sales revenue becomes investment capital that should be invested and earn capital income. To make a simple comparison, if a person created household spending rule that they would only spend the money they made in weekly salary but save all of their yearly bonus check, an analysis would still find their yearly savings was equal to their yearly bonus check. The spending rule they created for themselves does not change the end result. Also, how much they earn in future capital income is dependent upon how much they save now. Money has to be spent or saved. If it is not spent, then it must be saved.
- Including data on government debt interest rates and currency rates given the financial results reporting of GIC, we can now reconstruct the expected investment results of Singapore. In other words, we have yearly cash inflows, annual investment results, associated costs such as debt and currency changes, and balance sheets for ten years which allow us to compare the expected assets to the reported assets under management.
- By a range of plausible estimates on cash holdings allocation and the rates of return on cash holdings, the discrepancy between reported financial asset holdings and expected financial asset holdings ranges from $650-850 billion SGD or $459-600 billion USD. To provide some perspective on the discrepancy, the sum of free cash flow from net incurrence of liabilities and operational surpluses since 1974, the year Temasek was created, is $822 billion SGD. In the most recent reporting period, Singapore financial assets of $834 billion SGD. Given reported rates of return from GIC and Temasek of 7% in USD and 17% in SGD with debt interest costs significantly lower, this is a significant financial discrepancy. Based upon the annual free cash inflow, this would provide Singapore a post cost rate of return of 0.1% annually.
- There are numerous additional irregularities that are too lengthy and detailed to mention in a blog post. I have compiled an extensive data set on financial asset holdings, public finances, and methodology that recreates their expected asset holdings against their reported holdings for those that wish to delve further into the matter. I simply cannot come close to reconciling the $650-850 billion SGD difference between reported and expected assets based upon free cash flow and investment returns.
The PBOC released FX reserve data today revealing that official FX reserves only declined $94 billion to $3.55 trillion. There are a couple of points that need to be emphasized. First, $94 billion is definitely a little better than expected but at the same time nothing to rejoice about. $94 billion is still $94 billion which even by Chinese standards and relative reserve standards, is big money. Second, declaring a $94 billion drop in FX reserves a good month is like saying “it’s merely a flesh wound.” Enough of those flesh wounds can be mortal. $94 billion is still an enormous amount of defense by the PBOC. Third, the evidence indicates not that the market is settling back down but rather that the market is betting more and more against the RMB stabilizing. Capital appears to be flowing out at a faster rate with Capital Economics estimating August outflows at $130 billion up from $75 billion in July. As I have noted, this number has been regularly increasing for a while now and shows no signs of slowing down. This is placing downward pressure on the RMB so much that China is tightening capital controls. What is amazing is that some people the possibility of Beijing implementing further capital controls as evidence of their control of the situation. Beijing implementing stronger capital controls will demonstrate nothing more than a complete loss of control of the financial situation and investor confidence. Furthermore, the offshore rate is widening its divergence with the onshore rate to now about 1.5%. This is not indicative of a currency that is stabilizing or a central bank that is gaining investor confidence. Fourth, China doesn’t have years of FX reserves. Even at the rate of $100 billion a month, using the IMF baseline, it would have 9 months of FX reserve depletion. Assuming it went further, it would have 18-24 months. China does not have the cushion many people assume. Fifth, due to the tightening from RMB purchases, Beijing has been recycling this liquidity into the domestic system via reverse repos and related methods to the tune of approximately $180b. Do the math: let’s say $100-120b was taken out via FX sales but $180 injected. That means Beijing is providing $60 billion net liquidity to domestic financial institutions. Banks are much tighter on liquidity than understood. Sixth, pretty sure I was referred to as a “doom monger” today. I’ve always wanted a cool nickname.
- GaveKal has a good piece on what they think is happening in the Chinese economy and focus on the RMB. I generally like their work, but think they are too sanguine about the risks here. Chen Long of GavelKal Dragonomics writes “if a 3% devaluation in China’s currency can trigger a global rush for the exits—as it did last week—a 20% drop could shake the world.” This is an accurate assessment, but also overlooks the highest probability scenario that a 20% drop in the RMB just has not been recognized in the pricing yet. What I mean by that is this: virtually all indicators point to the conclusion that the RMB is probably at least 10% over valued and in all likelihood 15-25%. Evidence abounds to support this conclusion. First, central banks don’t spend $150 billion every three weeks, or about $200 billion a month, to support a currency that is close to appropriately valued. Even by Chinese standards $50 billion a week is big money and there is no evidence the capital required to prop up the RMB is dropping. (See Update below). Second, if you look at a list of major currencies and their move against the dollar over the past year, China is the extreme outlier in that the RMB has only dropped 2% compared to most currencies which have lost 10-30%. If China is even on the low end of a fall relative to the US dollar, it would need to drop at least 10% and a middle of the pack fall would require it to drop about 20%. Third, if you believe strongly in information asymmetries then Chinese firms and government agencies assuming an RMB/$ value of 7 tells you that a nearly 10% drop is coming. In fact, not only are the basing assumptions on 7, but using 8 by the end of 2016. Given the typically excessively positive outlook of Chinese government agencies, I would consider these figures the absolute baseline for what to expect. That means expect at a baseline a 10% devaluation by late 2015 early 2016, and a nearly 30% drop by the end of 2016. GaveKal is right however, these movements will truly shake the world.
- Given what we have learned we about China FX policy, we also need to revisit PBOC reserve adequacy. The most recent numbers placed them at $3.7 trillion. Since then, that number has probably dropped to between $3.4-3.5 trillion given the scale of intervention. Furthermore, we need to reduce FX reserves by an additional $200 billion as this is actually money owed to the PBOC by the China Investment Corporation currently held as overseas assets. This is not nearly as liquid as the cash and US Treasury holdings by the PBOC. That moves us down to about $3.2 trillion. I’m going to make one large assumption that I believe is perfectly reasonable and plausible, but one that I am sure some people will disagree with. I believe we need to reduce usable FX reserves by about $1 trillion. My logic here is simple and straight forward. China will not exhaust every last dollar of reserves to defend the RMB, but will preemptively release the RMB giving them a cushion the continue facilitating international trade. I would peg that cushion at around $1 trillion, but that is really only a guesstimate of the point where they would release the RMB if forced. If we take all this into account, that leave China with about $2-2.4 trillion in FX reserves. The IMF actually pegs the amount of reserves China needs at a significantly higher $2.6 trillion. That means at current rates of USD depletion from the reserves, China has 10-12 months of RMB defense left before it floats if we use my $1 trillion baseline. However, if we use the IMF $2.6 trillion baseline, China only has about 3-4 months left if draining $200b a month to defend the RMB before it would need to float. As a final note to this, numerous measures of market belief indicate the market is betting on more devaluation despite official China protestations that the RMB is stable and appropriately valued. No one believes what Beijing is selling. The shaking of the world could very plausibly come much sooner than anyone expects.
- Is it possible that I am wrong about the strength of the Chinese economy? Yes, absolutely it is possible, but I don’t think that is the most likely scenario. I have gotten some questions like this and without revisiting the discussions about why I don’t believe Chinese GDP data, let me explain my philosophical approach to studying the Chinese economy. First, I try to find consistency across data points. This doesn’t mean the data is uniform or reconciles perfectly, but that I see data moving in a similar direction. 7% GDP growth is inconsistent with flat or falling corporate profits and output. Flat or falling output is consistent with flat or falling corporate profits. Second, I try to focus on what is the most likely explanation. As an example, if we look across a range of goods and services comprising nearly 70% of Chinese GDP we see output is flat or falling. Believing that the Chinese economy is still rapidly growing based upon what we know already about nearly 70% of the economy would require taking large leaps of faith. For instance, that the remaining 30% of the economy is growing extremely rapidly. If we take a simple scenario where two-thirds of the economy isn’t growing and one-third of the economy is growing, to achieve a 7% total growth rate would require the sector that is growing to grow at 21%. While it is technically possible it is less likely and furthermore, this would violate our first idea of looking for data consistency in a bimodal distribution. There are numerous similar examples. While it is possible, it is definitely not the most probable explanation. I honestly fail to understand how anyone can believe that current GDP is the most probable outcome given all data issues. Again, it is possible, but far from the most probable.
- One of the unexplored problems surrounding the Chinese slowdown is the relative lack of fiscal stimulus to play a meaningful role. Even leaving aside any discussion of credit and borrowing, though local governments being bailed out is never a good sign, it is unlikely that attempting to stimulate the economy on the fiscal side would have even a minimal impact. Stimulus capacity is exhausted in China. Corporately, firms are over leveraged with massive surplus capacity. Governments are also over leveraged with rapidly falling revenues and burdened with white elephant projects from the 2009 stimulus led building and credit orgy. The government would be better advised to simply drop money from helicopters than try and kick start the world’s second largest economy by pushing on string. Think of China as being near the zero bound of fiscal policy.
- While there is much more scope for monetary policy intervention, China and the PBOC appear to be doing their best to destroy any appearance of competence by policy makers. First, China needs significantly lower interest rates. Producer price deflation which is in its fourth year is nearly 6% causing real interest rates for even the best firms to be north of 10%. Second, due to PBOC dollar selling, RMB is being sucked out of the economy quite rapidly. This implies increasing liquidity in a variety of ways is of the utmost importance. So far, the PBOC does not appear to be reinjecting RMB liquidity back into the economy. There have been small policy measures like reverse repo or other lending facilities, but these are both short term and not nearly large enough to make up the difference being drained from the system. What makes the problem with monetary policy so unnecessary is that China is inflicting this strait jacket on itself, spending about $200b a month on a policy even it knows will have to change sooner rather than later. By pegging the RMB it has to keep interest rates artificially high and spend dollars to buy RMB reducing liquidity. China is choking its own economy to peg the RMB to the $. There is only one scenario under which this policy makes real sense. If Beijing believes that (dirty) floating the RMB and releasing capital controls would prompt a flood of capital out of the country that would drain liquidity from the financial system prompting a banking crisis, this policy makes some sense. It definitely doesn’t solve the problem and only delays the day of reckoning, but that is undoubtedly a worse outcome and may help explain the current policy. Given the slight tightening in capital outflows we have seen, this would seem to make some sense. In other words, while China may be causing itself some pain by keeping interest rates high and tightening liquidity in a weak and slowing economy, the other obvious option might, as the hypothesized Beijing trade off goes, precipitate a currency and banking crisis. Beijing is choosing the lesser of two evils though this isn’t all that comforting for the rest of us.
- Watch the opening. Now that the parade is over and with a few days off, don’t be surprised if the markets are under real pressure.
- ICBC and BOC are the canaries in the coal mine. It’s coming.
- Fact of the day: China has seen more PE fund liquidiations 2015 YTD than all of 2009.
- Update: PBOC released FX decline for August today where they report a $94 billion decline to $3.56 trillion. Given that Barclays Research had estimated a range of $86-122 and Deutsche Bank had estimated a post August 11 decline between $98-145 billion, the $94 billion is right in line if a little on the low side. The decline is a little less then anticipated and while this is positive, I would be careful against rejoicing. All indications remain that capital outflows continue to accelerate, the offshore rate is diverging from the onshore rate by almost 1.5%, and the PBOC continues to intervene enormously to prevent further devaluation. I doubt the market will see this as stabilization. I would expect intervention to maintain similar levels in September.