On the Recent RMB Strengthening

There have been questions raised in the past few weeks about the state of the RMB.  Questions have focused on why the market is not reacting more strongly to continued depreciation, whether the PBOC is engaging in active price manipulation, and the direction of the RMB.

These questions at their heart revolve around why the RMB depreciation path seems to have halted and even reversed in the past 1-2 weeks.  In fact, the RMB has strengthened recently which seems to have caught many off guard.  We believe there are clear and straight forward answers for what we are seeing the RMB FX market.

First, according to my esimates, the RMB against the CFETS basked has been relatively stable over the past month with small strengthening over the past 1-2 weeks.  My model shows slight strengthening of the RMB against the CFETS basket whether measured in 1 or 2 week increments even over the last month.  In other words, if the RMB is generally following the CFETS basket, the RMB should have strengthened which is what we see.  This is the spot rate and the Wind estimate of the CFETS but mine and other replications of the CFETS show similar strengthening.

As many have noted previously, there is an asymmetric pattern for when the USD weakens.  The RMB is stable against the basket when the USD strengthens, but when the dollar is weak, the RMB maintains stability against the USD.  Consequently, when the basket is generally strengthening against the USD, the RMB will see mild strengthening which is what we have seen.  The past few weeks therefore, should not come as any type of significant surprise.

Second, the fixed nature of the RMB makes the RMB much more prone to exogenous shocks.  Given a relatively rules based regime, whether moving directly inline with the CFETS basket or with some flexibility to the USD, the RMB tracks other global currency movements rather than building its own internal market that others respond to.  As global currencies have stabilized over the past few weeks and months, it does not come as a surprise that the RMB has stabilized.

Third, there remains overwhelming evidence that the PBOC either directly or via proxies is heavily involved in the market ensuring pricing it wants.  For instance, spreads after factoring in all costs continue to predict a strengthening of the RMB over the next 1-12 months.  Looking at the swaps market, even as the spot price has depreciated, the swaps price post August 11 has tightened considerably.

This is fundamentally counter intuitive.  Before August 11, when there was no expectation of future weakening, the spread was large.  Post August 11, when the market almost uniformly expects depreciation, the swaps price has narrowed so much it actually predicts RMB strengthening.  Spreads on various futures products remain tight even as markets continue to expect longer term depreciation.  Traders continue to report difficulty executing trades at posted prices for various products.  Liquidity appears to remain tight or potentially worse indicating less than normally functioning market.

Fourth, the long term trend remains for continued depreciation.  Capital continues to move out of China at a relatively steady rate over the past 3-6 months and slower than its late 2015 rate.  As previously noted, there is strong evidence that the PBOC is enlisting other parties to prop up FX reserves and slow their depletion, but given the ongoing outflow of capital out of China it seems clear the trend remains to expect further depreciation.  It is worth noting that the RMB outflows have slowed, but still continue.  Foreign inflows are down significantly and net bank payment and receipt surplus is only slightly behind the total for all of 2015. There is pressure within China to allow further depreciation and the continued net outflows necessitate further depreciation.

As the markets have become distracted with Brexit, US elections, and Japanese easing, focus on the RMB has eased as expectations have changed.  However, all factors seem at play to expect ongoing steady depreciation barring some large exogenous shock.  The PBOC has learned how to better manage market expectations and we believe ongoing depreciation should be expected.

Robots and Trade from BloombergViews

I wanted to follow up to my piece from BloombergViews on robots reshaping international trade and development strategies of emerging markets.  As usual, start there and then come here.

  1. I am an international trade professor by specialty though I teach other subjects and the importance of this first hit me when I was reading Tyler Cowens Marginal Revolution a while back about Foxconn threatening to automate its plants. He made the point, why do they need to manufacture in China as a robot costs the same to employ whether in China or the United States. This hit me like a lightning bolt.
  2. Now some have pointed out, and they are correct, that even if a robot costs the same to employ the world over, there are other factors involved in relative costs. This is entirely true but there are a couple of important caveats to this. First, this still equalizes a large portion of the cost differential. In the US labor captures about 2/3 of GDP so that is a pretty large amount.  In many of the low skilled industries like garment manufacturing, labor represents a not insignificant slice of the cost differentials.  I am in complete agreement that it does not equalize all costs and productivity, but it has a large impact.  Second, many of the related productivity inputs are better situated in countries that already have large productivity advantages or can be reshored easily.  Not all industries for sure but it is very difficult to see how this is not the general case.  If we take the iPhone, with components from all over the world, other than building the factory, there do not seem to be a large number of impediments to shifting production someplace else.  Even garments seem to have little fundamental attachment to location as long as the manufacturing cost is similar.  Even many of the related aspects that impact production cost seem to be better placed in developed economies. Whether it is ease of transport, infrastructure, or high skilled labor, developed economies seem better placed to benefit from robotic development.
  3. It also seems much more likely that this will exacerbate inequality. Think about it like this.  Computer scientists and industrial engineers in developed countries will be taking jobs from low skilled peasant migrants in developing countries to make garments.  Even the capital needed to build these plants will come from well paid bankers and other investors.  In other words, this seems very likely to increase both across and within country inequality as the low skilled get displaced by the high skilled.
  4. Rather than trade policy being a driving factor, human and financial capital agreements seem to the new agreements. If you want to leap frog, you need to attract global talent and capital to build these plants.  That is a very different thing than the detailed trade agreements we have today.

Taking it a little bit easy right now in the summer but hope to post some more things soon.

Bloomberg and Left Behind Children

I am enjoying some down time in the States but still bouncing around doing some work so over the summer, I may not update the blog as much.  Baseball games, fireworks, New York City, and middle America are all on the docket for me this summer.

I wanted to write some follow up notes to my BloombergViews piece on left behind children in China.  As usual, start there and come here for follow up.

  1. So often, people that study China, outside observers, and even those of us that live and work there think of China as a developed country. However, and I do not mean this in a critical way, it is not and we too often forget that. Lost amidst the new airports and high speed rail is the fact that nearly half of the population is still only slightly above subsistence farming.  Again, I do not mean that as a critique as China has made enormous strides over the past few decades, but as a recognition of fact.
  2. I’ve gotten a couple of emails asking why I’m picking on China and let’s assume that I am, I don’t think I am but let’s assume that I am, issues like left behind children are a long run inhibitor to Chinese economic development. This cognitive and mental problems impact nearly 1/3 of Chinese children.  The gap between rural and urban children is enormous and will impact the ability of China to meet its long term economic objectives.  I may be critical of China but it needs to solve these problems to become an advanced economy.
  3. What astounds me is that this is essentially driven by a government policy that almost requires splitting up families. I find this a personally abhorrent policy.  What government creates and accepts a policy that encourages families to be divided?
  4. Even beyond the left behind children, the status of rural vs. urban children is amazingly different.   These are major issues for China.

Some Random Thoughts for China:

  1. July data is very weak.
  2. Credit is practically the only driver of the Chinese economy.
  3. GDP data remains incredibly suspect.
  4. FX data is incredibly difficult to reconcile.
  5. Worrying that credit explosion having so little impact on real economic activity.
  6. Decline in exports and imports is not just related to low global demand and anyone who says so is lying.
  7. Corporate revenue in Chinese industry is bad in 2016.
  8. Retail numbers are bogus.

I’m working on a more detailed piece about Q2 GDP which I hope to release next week.  It’s coming.

For now, I’m off to start drinking some good old American craft beer.

How PBOC Making FX Reserves Look Better Than They Really Are

The PBOC has released foreign exchange reserves data and the results are puzzling.  Even major investment banks releasing their notes on post-FX reserve analysis have expressed various degrees of bewilderment at the results.  Fundamentally, it is becoming increasingly difficult to reconcile the stock value of FX reserves and the flow changes we witness every month.

There are numerous pieces of data that form our picture of the whole as to why we say this. Let’s break this down piece by piece show why there is increasingly contradictory evidence.

  1. According to our model, which is similar to other estimates of PBOC reserve composition, and general FX reserve holdings, the PBOC USD value of foreign exchange reserves should have remained essentially unchanged between May and June 2016. The rapid rise in the JPY in June should have largely been offset by the rapid fall in GBP.  While we cannot know the exact weighting of the three primary non-USD currencies, given a range of reasonable parameters would leave this portion of the basket fluctuating around no valuation change. The only plausible method to arrive at a material USD valuation change between May and June in the non-USD portfolio is to assume extreme parameters in EUR, GBP, and JPY assets.
  2. Even if we extend this basic valuation change back to the beginning of the year, there should be a relatively minimal change in the USD value of the non-USD asset portfolio of PBOC FX reserves. We estimate the non-USD portfolio, absent non-USD depletion, to have benefited from an approximately $30 billion valuation increase.  Foreign exchange reserves however through the first six months of 2016 have only declined $26 billion.  Absent other valuation or unrecorded inflows changes, this would imply total net outflows between $55-60 billion.
  3. However, just according to official SAFE data, the YTD bank receipt less bank payment for international transaction reveals a net outflow of $145 billion USD through May. If we add in the expected value for June, this would give us a forecast net outflow from bank transactions of $170-185 billion USD nearly on par with all of 2015.  Given the estimated valuation increase and the official decline in PBOC reserves, this would leave an approximately $115-130 billion USD that we cannot account for in our calculations.
  4. Even if we look at the net flows by currency type, the numbers tell a story of similar outflows. Looking at just the top two currencies, we see that USD net flows were in surplus by $52 billion while RMB net outflows totaled $106 billion in USD terms.  HKD, JPY, EUR, and all other currencies summed to the previously noted $145 billion net outflow.
  5. Breaking it down by currency however actually gives us a clue as to what is likely happening. The $106 billion RMB outflow in USD terms is leaving China for international transactions.  Theoretically, this should result in ever expanding offshore liquidity.  Conversely, we actually see quite the opposite happening in offshore centers with RMB trading and deposits.  Where RMB deposits have been shrinking, specifically in the primary offshore center Hong Kong relatively rapidly.
  6. Bank buying of FX from non-bank customer through May totaled $661 billion USD while sales of FX totaled $541 billion USD for net purchases by banks of $120 billion USD. Given the previously mentioned net outflows from bank payments of $145 billion and the approximately $25 billion in revaluation over the same period, we are able to reconstruct the numbers through May relatively closely.
  7. This conclusion though has a very important implication. This means that commercial SOE banks are essentially acting as a central bank purchasing surplus RMB either on the Mainland or in Hong Kong to prop up the RMB.  It is worth noting that the Bank of China acts as the primary settling bank or cross border RMB and takes a small fee for all offshore RMB remitted to the mainland.  Given that spreads between the bid and ask is less than the fee BoC takes for remitting offshore RMB back to the Mainland, it is likely they are essentially operating a large churning operation propping up the RMB.
  8. We actually see evidence of this in the Bank of China Q1 2016 report. They list a 31% drop in “Net Trading Gains” which they attribute to “decrease in net gains from foreign exchange and foreign exchange products.”  What makes this so interesting is that even though BoC is the primary settlement bank for the PBOC of international RMB transactions, FX market turnover was up 20%.  It seems difficult to understand how with a market up 20% the near monopolist firm see revenue drop 30%.  The most likely explanation is that they are essentially acting as a central banker, soaking up the liquidity at the spread, profiting from the repatriation fee, and churning.  Though much of their purchases are offshore, forcing them to incur a loss, the repatriation fee compensates them harming their margin but upholding the national interest.

We need to keep an eye on this especially as we move forward and BoC trading revenue and matching up the outflows to the SOE/PBOC churn.

Revisiting Chinese Balance of Payments and RMB Pressures

Despite all the attention focused on the credit woes of China, and there are a lot, the state of the RMB remains my biggest concern.  China has chosen a policy that significantly limits its policy movement reducing its flexibility exactly when it needs it most.  Most people continue to focus on the headline FX reserves held by the PBOC, which as I have noted many times, simply are not the best metric here for a variety of reasons.

China has just released additional data from the Balance of Payment and the International Investment Position datasets which give us insight as to what is happening with capital flows and pressure on the RMB.  The story continues largely unchanged as net flows continue to decline but with additional detail to help us better understand what is happening.

  1. Balance of Payment data continues to obscure the state of Chinese financial flows. According to the official BOP data, China enjoyed another bountiful quarter between January and March 2016 with a total net inflow of 256 billion RMB or $39 billion USD at current exchange rates.  In fact, if we lengthen the time horizon, since the beginning of 2013, China has had only two quarters of net negative outflows with the last one coming in March 2014.  These net outflows total only 250 billion RMB or less than the net inflow enjoyed in Q1 of 2016.
  2. If you have been following the Chinese economy at all over the past 12-18 months what strikes you about these numbers is that they do not match the large outflows we are witnessing and yes, depletion of foreign exchange reserves. For instance, the 256 billion BOP net inflow includes a large 256 billion RMB net error and omissions outflow.  It defies any economic common sense that a country could be running such large and ongoing BOP net inflows while at the same time depleting FX reserves and devaluing its currency.  Cumulative in the past four quarters, BOP net inflows have totaled 1.04 trillion RMB or $156 billion.  In the past two years this amount rises to 2.35 trillion or $351 billion.  If we believe the official balance of payment data, there is absolutely no reason for downward currency pressure.  In fact, we would expect this level of net inflow to prompt moderate appreciation pressures.
  3. BOP data is calculated relying primarily on the official trade data from customs. As I have written about previously, this presents an enormously misleading picture of the trade and currency transactions and the subsequent inflows or outflows of capital.  BOP records a 679 billion RMB surplus in goods trade.  SAFE and Customs report a 694 billion and 810 billion trade in goods surplus.  In other words, official BOP data is highly correlated with other official data like Customs and SAFE data.  However, through Q1 in 2016 banks reported a surplus of only 150 billion RMB or only $22 billion RMB in arguably the most important category when considering net inflows.  In other words, banks are reporting a trade in goods surplus of 78-82% lower than what BOP is reporting.  This matters enormously because essentially all of the reported net positive BOP comes from the goods trade surplus.  If you eliminate the goods trade surplus you eliminate the positive BOP position China reports to the world.
  4. In fact, if you focus on the BOP capital account data, it becomes obvious how delicate the situation is and what is driving these imbalances. First, investment inflows into China, as I have mentioned numerous times previously, are simply borderline collapsing.  In Q1 2016, direct investment inflows into China were down 44.4% according to BOP data.  Portfolio inflows into China were not just experiencing slower growth but experienced negative growth meaning there was net international disinvestment in China by $19 billion from a positive inflow of $17 billion in Q1 2015.  Second, despite all the stories about the flood of Chinese outward investment, there is an important caveat to the overall story.  What is happening is that if we incorporate the International Investment Position data, what we see is not a rapid rise in Chinese owned foreign assets but rather a rebalancing of the Chinese portfolio.  By that we mean that total Chinese owned foreign assets have actually declined from Q1 2015 to Q1 2016 by $156 billion.  In fact, Chinese owned foreign assets peaked twice above $6.4 trillion and most recently in Q1 dipped to $6.22 trillion.  However, within this asset basket, we have seen a significant rebalancing.  The entire growth in outward FDI and portfolio investment comes from depletion of official reserves assets.  As total assets were declining from $6.4 trillion in Q4 2014 to $6.22 trillion in Q1 2016, Chinese owned FDI grew from $744 billion to $1.19 trillion and official reserve assets declined from $3.9 trillion to $3.3 trillion.  These offsetting changes explain the entire growth in OFDI and decline to total assets.  Furthermore, there is absolutely no way you can have the amount of supposed net inflows and at the same time witness total declines in Chinese owned foreign assets.  Those are two contradictory data events.
  5. One question I frequently get asked is about reports like the BIS 1 ½ page brief talking about how virtually all of the outflows are debt repayment. These types of studies focus on official data like BOP data that simply does not capture the reality of what is happening with Chinese outflows.  Furthermore, though there is monthly noise, we see a clear long term structural shift in capital outflows that is simply not reversing.

Follow Up to BloombergView RMB Deinternationalization

So this is my follow up to my BloombergViews on RMB deinternationalization.  One issue that I wanted to address specifically is that I had a couple of people question whether this was more of a short term blip rather than a structural issue.  As usual start there and come here for additional analysis and discussion.

  1. The RMB is deinternationalizing for a very straight forward reason: if the RMB continues to internationalize, Beijing will lose control of the price and flows. Full stop. Unfortunately, there are no other reasons. Fortunately, this makes very clear predictions and mathematical relationships about when it will happen.
  2. Let’s look at the price. The more RMB that is outside of China the more market participants will trade RMB at whatever price they want to trade it and not at the price Beijing wants.  In fact, a major driver of the reduction in offshore RMB, primarily in Hong Kong, is the continual intervention by the PBOC is propping up the RMB.  To hold the value of the offshore RMB (the CNH as it is known) the PBOC buys RMB in Hong Kong selling USD.  If the RMB really internationalized, Beijing would have to manage RMB prices around the world an actively intervene even more than it does.  Beijing is clearly not willing to give the market any real type of influence in setting the price.  How do we know this? If you look at the CNY/CNH spread the CNH is virtually always trading at a not insignificant discount to the CNY, with clear regular intervention. If the CNY was truly following market indicators, with any real interest, the CNY would be significantly lower than it is today.  In short, internationalizing the RMB means Beijing giving pricing control over the RMB much more significantly to the market.  The RMB is deinternationalizing because Beijing is exerting greater control over the price.
  3. Then there is the flow of RMB. If the RMB is to internationalize, the Beijing will have to enormously relax its grip on the flows of RMB.  I know people have cited a couple of examples but if you will notice these are examples that let foreigners invest in Beijing is more than happy to let money flow in one direction: in. However, all recent measures about outflows are tightening.  Before you even start with talk about M&A and FDI, May capital payments (i.e. outflows were only up 1% from May 2015 and are only up about 10% for the year.  If the RMB internationalizes, Beijing must lose its control over RMB flows.  This is not some speculative musing this is empirical reality.  If RMB is to be widely used either around the world or even for transactions involving China people have to be free to use the currency when, where, and how they choose.  If RMB is to be used around the world and challenge the dollar or even the Danish Krone, RMB must flow out into the rest of the world.
  4. Now the price and the flow issues combine to tell us very real information. If RMB needs to flow into the rest of the world to become an international currency, this means there will be downward pressure on the RMB.  If Beijing relaxes its grip on the directionality allowing the RMB to internationalize, this will place long term downward pressure on the RMB reducing its value.  There is another way to think of this: if Beijing wants to hold the value of the RMB higher, it will continue to deinternationalize the RMB. If Beijing is willing to let the RMB depreciate, the RMB will internationalize.  The only way the RMB can internationalize and rise in value is if the demand for RMB assets significantly outstrips demand for foreign assets.  There are two reasons this is unlikely.  There is an asymmetric relationship in that foreign investors are much more able to hold RMB assets than Chinese holding foreign assets.  In other words, there is a lot of pent up demand by RMB holders for non-RMB assets.  Furthermore, given the law of large numbers, China would have to absorb such a vast amount of world savings and investment in the future to push the RMB higher on a strictly flow basis to render this all but impossible.   In other words, this gives us the pre-conditions under which the RMB will internationalize and what we will see both with flows and with RMB.
  5. For all the talk of RMB internationalization, please explain to me how a currency can be “international” when it isn’t allowed to leave the country and is engaged in such a small number of international transactions? Are you aware that almost 80% of all “international” RMB transactions are with China and Hong Kong? Seriously stop and think about that for one minute. Almost 80% of “international” RMB transactions made between China-China or China-Hong Kong.  Put another way, 80% of international RMB transactions are made with domestic counterparties.  The RMB internationalization talk is the equivalent of playing Xbox World Cup in your Mom’s basement and claiming you are a world class athlete.
  6. There is a very clear markers around which we will be able to tell the RMB has internationalized and not the fake IMF version. So far, the RMB is not even close and is clearly going in reverse.

Politics in Beijing Represent the Bad Economic Choices

The potential of political fight at the top in Beijing has galvanized the attention of Chinese and foreigners alike.  With little actual information or press leaks, we are generally left to try and interpret fuzzy shadow puppetry while placing them in a complex play.  I am not any type of connected political insider and can add nothing about the intrigue or personalities.  However, from everything I have gathered there is a distinct economic element that is being overlooked here, which I believe I can add to the discussion.

The whispered discussions about who is siding with who in the palace intrigue that comprises Party politics, omits any focus on the clear economic dividing lines that separate the parties.  As I have noted on numerous occasions, something that is not frequently recognized about the Chinese economic situation is that the longer this situation continues, the narrower the range of reform options at its disposal.  Currently, not only does China have an increasingly narrow range of options to make meaningful change but those options both come with some type of significant risk.

Let’s take a simple example that is relatively realistic.  Last year, total social financing grew at almost four times the GDP growth in absolute RMB terms.  Based upon the rapid rate of TSF through April, that ratio will have only increased.

Beijing faces a simple tradeoff: a) they want strong economic growth of no less than 6.5% to ensure social stability and that there isn’t a wave of defaults AND b) they want to deleverage and lower the rate of growth of debt.  They absolutely cannot have both.

The economic debate then becomes one of priorities.  Do you want to prioritize growth or deleveraging? There are those that understandably prioritize growth over deleveraging.  The rationale is simple: if TSF was four times GDP growth in 2015, economic weakness would become much more pronounced if debt growth was restrained.  Given the already shaky financial condition of firms, it is simply too risky a time to make deleveraging a priority with the economy in such a weakened state.  If you choose to prioritize deleveraging now, you run the risk of a major economic slowdown.  Imagine what will happen to growth if TSF is significantly smaller. GDP growth even by official standards could easily be in the low single digits.

Those prioritizing restraining debt growth are making the same argument in reverse.  They believe that the rapid growth in debt, what Barry Eichengreen has called maybe the largest and most rapid expansion of debt in human history, poses greater risks to long term stability.  The concern being that either deleveraging will be essentially forced on China or it will ultimately result in some type of crisis or event that will result in a much more painful restructuring.

The fundamental question is this: what do you believe is the greater risk to China? Put another way, would you rather face potential labor instability this year or financial risks later?  In all kinds of professions whether a surgeon or a stock trader, people are always looking at too risks with two potential benefits and trying to determine where their risk adjusted return is higher.  China is faced with in reality a simple decision: which risk factor presents the greater risk?

The decision to pump credit now and try to grow your way out of the problem or deleverage now and try and manage the downturn present clear risks.  Continuing to pump credit keeps growth moving but runs later risks that Beijing may be unable to manage the ultimate credit problems.  Deleverage now runs the risks that social stability may escape Beijings controls presenting a clear and present danger to the Communist dictatorship in Beijing.

The other thing to remember, as in any situation where people are trying to manage or assess risk, is that the risks you and I are focused on are not necessarily the risks the others are focused on.  To me and many China watchers it makes perfect sense to focus on the increasing financial risks.  However, while they are certainly aware of the financial risks in Beijing, that is not necessarily the primary risk (which I am about to explain why).

One of the most common mistakes people make when considering risk is they overestimate their ability to manage either a specific or range of risks.  Many might call it hubris.  Beijing is essentially betting that they can manage the risks even if there is a significant financial or economic event that results from their continued economic incompetence which they have been warned about.  They are telling us, even if there is some type of financial or economic event, they believe they have the tools at their disposal to address the situation.

If we unpack this, it becomes a worrying scenario.  First, it implies that Beijing continues to pump credit, money, and investment to drive growth.  If the level of total credit growth was 4x the level of GDP growth in 2015, imagine how bad it would have been without that level of policy support.  We can only expect this level of distortion to continue to increase.  Even as the rate of expansion of credit has slowed so far, it  still is three times faster than cash flow growth of firms and about 2.5x GDP growth rate.  In other words, we should continue to expect more of the same policies that will build up the risks facing the Chinese economy.

Second, when the eventual problems come, and they will come, you can expect a brutal and harsh response by Beijing.  This entire policy of credit expansion when it has already risen faster than probably any other credit expansion in the history of the world in a country littered with bad loan examples with asset prices at eye bleeding levels depends entirely on Beijing’s belief that it can manage the downturn.

The stock market rescue is both a good and poor example of how Beijing will act.  Good in the sense that it shows Beijing will throw any amount of money at a problem regardless of how misguided the policy and no matter how poor the result.  Bad in the sense that rescuing the stock market is relatively easier that say the real estate market or preventing panic with a bank collapse.  The fundamental point is that Beijing will go to virtually any length to prevent or bailout a financial or economic event regardless of cost, either financially or otherwise.

The politics of who supports what merely reflect the basic divide over economic decisions that are increasingly narrowed down to “which bad option can you tolerate”?  How Beijing is handling the current problems should give us pause to consider what comes after?

 

 

Focusing on Obscure Chinese Data: The Importance of Banker’s Acceptances

Yesterday was money and credit data release data in China.  Most of the numbers grew robustly, as is always expected with this specific release, but there were two numbers that I wanted to highlight because of what they mean for other issues.

First, new RMB loans in China were up 9% YoY and 16% YTD YoY.  This represents the ongoing rapid expansion of credit in China that at best seems unsustainable at worst reckless.  Despite talk of restricting credit expansion, credit is growing more than twice as fast as GDP in percentage terms and four times faster in absolute terms.  There are significant concerns about the ongoing sustainability of this rate of credit expansion.

Second, the most unexpected number was the collapse of undiscounted banker’s acceptance notes.  To put the size of the decline in some context, since this specific data point has been collected beginning in 2002, there has never been a decline of this magnitude.  As another point of comparison, New RMB Loans were up 937 billion RMB while banks acceptances declined 507 billion RMB.  This would represent 54% of all loan growth or 77% of aggregate financing to the real economy.

I believe this number is distorted to this magnitude for a couple of reasons which have very real implications.  Banker’s acceptance are used in China in primarily two ways, both of which could be targets for regulators.  One way they are used to disguise the true level of debt by making sales then using banker’s acceptance to access liquidity.  It is not uncommon for sales to be fake, returned at a later date, used for other forms of capital, and a variety of other issues.

If banker’s acceptances fell by such a large amount, this would imply wide spread repayment by firms of their outstanding banker’s acceptances.  If this is what is happening, which I do not believe is the most likely scenario, this would imply that cash flow throughout the economy has dramatically improved as the year has progressed.  While I noted what appeared to be continuing stabilization and some increase of output, the size of this drop appears much larger than I would expect from output gains.  Further, given the continued increase in aging of corporate receivables and payables, it is difficult to see how this would match that number.  While it is possible BA’s may be collapsing due to improved cash flow, liquidity, and real economic activity, I believe this is the less likely scenario.

The other primary way BA’s are used is to facilitate international trade and most importantly capital outflows.  Just as with the previous method, many trades that present BA’s are non-existent, overstated, or misinvoiced to name a few ruses used.  However, now there are additional layers of complexity added.  To take a simple example, the Chinese exporter may move capital Hong Kong to either arbitrage between the CNY and CNH or deposit it in a higher interest rate instrument before returning the RMB back to China.  More worrying however, is when the capital is designed to leave China permanently.  In this case, a BA is used to pay for, in this instance, $100 of imports that either non-existent or overstated and the BA is paid off with domestic capital allowing quasi capital flight.  Given the widely acknowledged discrepancy between Customs and Bank reported imports, this is not an insignificant problem.

Therefore, the drop in banker’s acceptance means not that credit is suddenly falling but more likely that banking regulators are cracking down on capital flight into and out of China.  Given the narrowing of the gap between Customs and Bank reported imports, this seems the more likely scenario.  Anecdotally there are increasingly widespread reports of inability of firms to engage in standard business transactions that involve international payments.  Finally, there is clear evidence that the PBOC or state run banks, actively sitting on FX trading and related derivatives with a specified price target.

Given the rapid increase in outflows YTD in 2016 with the accompanying collapse in inflows, this would imply that Beijing is giving increasing priority to trying to reduce this divergence and prevent further RMB price pressures.  Given the wealth of data, it is more likely the continued drop in BA’s related to capital outflow worries rather than repayment of payables.