- FT Alphaville has a great piece on the latest Michael Pettis note about the essential profusion of central banks in China. FT Alphaville quoting Pettis write that “Almost all credit was being treated it seem, as if it were sovereign credit.” FT Alphaville continues writing for themselves and quoting Pettis again that “what we get, if you buy the Jones-Pettis thesis above about a China ‘with potentially thousands of mini-central banks’, is a China with thousands of sources of private money with ever greater powers of money creation…”. I want to add something to this conversation which is I must emphasize is purely anecdotal from conversations with people throughout the banking industry. Though frequently thought of as centralized monoliths, most major national Chinese corporations are relatively divorced from the operations of the same company in other provinces. For instance, rather than China Telecom being run as a centralized entity throughout China, a better way to conceptualize what takes places is that the Beijing office of China Telecom sits on top of the Guangdong head office, the Fujian head office, and so on. This means that Beijing has much less control over the head offices throughout China than is frequently believed, with local bosses making their own decisions about what to do. In banking, the implications are stark and we return to the thousands of central banks theory. Regardless of what the home office, the CBRC, PBOC, or Beijing says about financial regulation, the local bank will decide what they want to do and are responsible to the local Party to meet GDP and other development targets. There is a very real sense that the local branches throughout China believe that either the main office in Beijing or the government will rescue them should there be a failure. Even worse, there is every indication that Beijing head offices do not know much about their branch operations across a range of financial and operational measures. Consequently, provincial managers operate almost independently and Beijing has little understanding of what is really on their books. Investors behave as if all banks are essentially central banks. In short, there really are thousands of central banks in China.
- There is a great piece from yesterday on one of the PBOC lending programs called Credit Asset Relending Program (CARP). This may seem like arcane stuff but Beijing has become very smart. They will not use phrases like “quantitative easing” and “stimulus” for fear of the implications people will draw. Like with their structuring of RMB reserve swaps that allow them to maintain control of RMB pricing but allow the RMB to be labeled FX reserves, the CARP accomplishes a similar function. Banks can take loans to the PBOC who will lend against the loan based upon some discount formula. Though hard details are hard to come by, there is a not insignificant probability that this is some form of bad loan repurchase in order to stimulate further lending especially at a primary type of loan mentioned are SME loans which are officially higher than average NPL rates. Minutiae to pay attention to going forward.
I wanted to add few follow up and more tangential thoughts to my BloombergView piece on China is what’s preventing the RMB from being a real global currency. I add them here because they simply are more tangential or too long to put into that specific piece.
First, believe it or not, I want the RMB to become a global currency, believe it will be good for China, and the world. Do not confuse my criticism of the very real technical and policy short comings with my larger world. It is internally contradictory and delusional to believe that the RMB is a freely and widely traded international currency as of late 2015. However, that does not mean that the RMB should not become an international currency and the very real benefits that would bring to global finance.
Second, Beijing cannot make the RMB international without essentially abandoning the USD peg. With all the ways that Beijing is actually restricting RMB internationalization, it is taking these steps to avoid losing control of RMB pricing. For instance, the PBOC is providing swap agreements to other central banks to facilitate trade but not the physical RMB. By signing swap agreements, Beijing maintains control over the pricing of the RMB. However, if central banks were free to trade RMB with either each other or the market, this would essentially sideline Beijing as the price setter. This would send a lot more RMB into the global market place and set a second price for RMB. They are having enough trouble fighting constant skirmishes with the offshore RMB in Hong Kong having to intervene almost weekly to reduce the CNY/CNH differential. Imagine the difficulty they would have if there were trillions of RMB around the world. It would essentially break the RMB/$ peg and that is a step Beijing is simply not prepared for yet.
Third, it is important to note that Beijing is taking very subtle ways to internationalize as the headline but underlying that are enormous restrictions. The central bank reserves are the best way to highlight this trend. Most central banks do not actually hold or have an account with RMB. They have a swap agreement where they set aside some currency in there reserves that they can swap for RMB when needed, for instance to pay for Chinese exports, but they do not possess RMB. This does internationalize the RMB to a very small degree but most people enormously over estimate the degree and fail to grasp the importance of the financing structure.
Fourth, I am very sympathetic to the very difficult position that Beijing and the PBOC find themselves in. Whenever a country releases a currency, even in the best of times, there can be large movements. Now imagine you are essentially ending 70 years of financial repression, assuming they adhere to their 2020 timeline, against the backdrop of slowing growth, rickety banks, and profound political sensitivities to liberalization. Furthermore, never before has an economy the size of the Chinese liberalized its currency. When this eventually happens, RMB internationalization will ripple throughout the global economy. Beijing is acutely aware of what they are up against and I am profoundly sympathetic.
Fifth, what Beijing continues to fail to grasp is that international investors want a robust, transparent, and predictable market mechanisms. Investors understand that prices go and down, frequently for no reason, but the absolute embarrassment of Chinese financial regulation has caused every investor to pause. Investors and CB’s have distinctly less appetite for assets if they question the regulatory structure, whether they will be able to access their assets, whether the rules will change retroactively, or what the rules everyone needs to follow. If Beijing wants to gain international confidence in the RMB, it needs to stop the absolute embarrassment that is its financial regulation.
In closing, I want give a special mention to S&P who once again proving that credit ratings agencies are the embarrassment of financial and economic research world. Credit ratings agencies have a well deserved reputation of writing whatever an issuer wants or downgrading after they’ve filed for bankruptcy. The only reason global credit ratings agencies aren’t the worst in the world is because of Chinese ratings agencies. Yesterday, S&P maintained a stable outlook on Chinese sovereign debt. In maintaining this rating, S&P cites (and no I am not making this up) China’s “strong external metrics”, “support for commercially oriented SOEs will be more limited”, and “credit in China to grow roughly in line with nominal GDP”. Seriously, S&P says that credit in China will grow in line with nominal GDP. What they base that on, other than pixie dust and unicorns, I’m not entirely sure. Leaving aside the absolute factual inaccuracies of these assertions, S&P as the hired gun it is, fails to grasp basic economics. What is arguably the most amazing is that they cite China’s strong external asset position relative to external liabilities. They are essentially saying, China has lots of USD in the PBOC and not a lot of external debt. However, they ignore the contingent liabilities like local government debt Beijing has essentially guaranteed or the FX implications of saying, China has a good credit rating because it has reserves. However, Chinese sovereign debt is almost 100% domestic. The difficulties of using USD to pay off domestic debt in RMB has already been covered but much more problematic than S&P seems to grasp. Really astounding that people pay them for such absurdly poor research.
Something I always tell people is just how bad the basic math on Chinese statistics and very rarely do people believe me until I start giving them examples. Yesterday, I came across a perfect example in retail sales that I saw on WIND but is also apparent on the National Bureau of Statistics China website.
China announced that retail sales for China were up for October from October 2014 by 11% and up year to date compared to the first ten months of 2014 by 10.6%. Here is the interesting part, if you actually calculate the percentage you arrive at very different numbers. For October 2015, China lists 2.827 trillion RMB in retail sales. For October 2014, China lists 2.397 trillion RMB in retail sales. That is an 18% YOY change for the month of October not the official 11% change.
The year to date numbers exhibit the same problem. Through October this year, official Chinese statistics pegged retail sales at 24.435 trillion RMB compared to 21.312 trillion RMB in 2014. The official change in retail sales is 10.6% but if calculate the change in those numbers it amounts to a change of 14.7%. In other words, October and year to date official retail sales numbers differ from the announced percentage change by 7% and 4% respectively.
Honestly, I have no idea what explains the discrepancy. There are two obvious suspects but neither would seem to be the culprit of the discrepancy. First, I thought maybe they are possibly deflating by a retail price inflation measure. However, that wouldn’t be standard practice and would enormously overstate retail price inflation. Second, I then suspected maybe this has something to do with online sales. However, this seems problematic for numerous reasons. If this number is only brick and mortar retail sales, this will obviously and grossly overstate retail sales. Furthermore, there is no indication that consumer product output or total retail sales are growing at 15%. Additionally, the amount would seem to significantly understate online retail sales. In short, the two obvious suspects don’t seem to explain the discrepancy.
I keep saying, maybe the NSBC should get some of those Shanghai math students to double check their work.
Update: Capital Economics has raised the distinct possibility that the NBS is changing what they measure. By that, we mean that there were sales that the NBS did not include sales for whatever reason in previous year. The NBS prefers to say that they have increased the scope of the operations to count more. This is a very distinct possibility but it must be noted and stressed that there is no specific announcement on methodological changes. Consequently, while they publish the raw retail sales volume, they publish only the adjusted annual percentage growth. Why? Who knows, it is a Chinese statistical agency. There are numerous examples of this type of recalibration in statistical methodology, typically with no announcement or explanation about the change. It bears worth emphasizing again that the 11% retail sales is contradicted by a large array of data some of it even published by the NBS so even if this is the explanation, it certainly does not make the data any more reliable.
If there is one area where even the most battle hardened China analyst is left with nothing it is labor market data. Even the most Beijing loving, data believing kool-aid drinkers refuse to defend the accuracy of Chinese labor market data. Even if you believe the long term average is accurate, which in all fairness, I believe there is a reasonable probability that the long run average is somewhat accurate, it is beyond ludicrous to believe the complete lack of fluctuation.
The problem however, is that there is virtually nothing else that people can use for data to look at employment. Even in the data I’ve been able to find, about three to four years ago, industries reported aggregate numbers of people employed and that was stopped. There simply is no good data or even solid proxies for employment. Whatever you think of the Li Keqiang Index and electricity production as a good proxy of GDP, there was very little that could even come close to providing useful insight on Chinese labor markets.
I would like to propose a proxy for measuring Chinese employment. Before I tell you what it is, let me emphasize that that there a numerous shortcomings that I can think of and probably some that I have not, so please do not take this as a perfect measure that is authoritative. However, I do believe it can provide us some useful information and insight that should track some dynamics of the Chinese labor market.
For the industrial sector, there is a dataset that covers nearly 400,000 firms that will achieve a projected 11-13 trillion RMB in sales revenue for 2015 and manages almost 20 trillion in assets. This is a very comprehensive and large dataset of firms and key financial metrics. One of the variables is expenditures on administrative costs. I would propose that changes in administrative costs will be able to provide us some insight into changes in Chinese labor market dynamics.
Let me explain some of the positives and negatives of this measure. First, administrative costs will be strongly linked to labor inputs. While there are hard administrative costs like information technology, travel, or office space, labor costs dominate administrative costs and are the most variable when compared to the other primary input office space. Second, the internal components of administrate costs will be highly correlated with each other. For instance, if you hire more office workers, you will on average need more office space, computers, and travel budget. This is important, because we are less likely to see negative correlation between the internal components of administrative costs that will result in a funny top line number. By that I mean, if labor costs rise by 10% and the other costs fall by 10%, resulting in no change. That is less of a risk in this specific scenario.
Third, the administrative cost measure does not tell us the initial employment level. Consequently, while we can impute changes in labor market using some base, say 100 at whatever initial time period I choose, it will not tell us the number of people that have been employed or unemployed. Fourth, we can however impute the level of employment, again with some base say 100, based upon estimated wage changes. To take a simple example if, we estimate that wages have gone up by 10% and administrative costs have also gone up by 10%, we can essentially impute there has been no change in the volume of labor inputs. I have never seen academic or popular research on administrative costs, labor, and the other cost components so for now we have to use intuition.
Fifth, administrative costs provides insight but into a narrow slice of the industrial sector. I say this because at this point, I am loathe to project this onto the entire Chinese labor market. I am not saying it isn’t related to other sectors but until I have done more research, I want to recognize it for what it is: administrative costs in the industrial sector. In fact, I am not yet even entirely sure how this relates to workers directly related to product output. For instance, if a coal mine is facing a decline, it is possible administrative personnel will be laid off sooner than miners. At this point, I am simply reserving judgment until more work has been done. It is very unlikely however that the two are negatively correlated so there is most likely a positive correlation.
Sixth, I fully recognize that this is somewhat of a blunt measure. By that I mean, it would be best if we knew how many people were employed and how much they made and didn’t have other cost items in our measure. Even if all other cost measures are perfectly correlated with labor, their inclusion will blunt our understanding and require additional calculations to impute details we are really interested in. However, just as we shouldn’t project the importance of this measure too much, we need to understand that similar to electricity production, this is a blunt proxy.
In the past year, administrative costs in the industrial sector have increased by 5.2%. Now if we take the accepted wisdom that wage are still going up by 7-10% and use the midpoint of 8.5% this would imply declines in overall labor inputs. Even in a best case scenario this would appear to indicate wage growth with no growth in labor input implying some degree of increasing unemployment.
If we venture out a little into applying this the larger industrial sector, we can propose some tentative analysis. First, it would seem likely that there is growing pressure on industrial employment levels but not major decline in levels. Output in most industrial sectors is flat or seeing small declines. The prices of inputs are declining and especially in capital intensive industries where labor will play a smaller role. Given declines in capital and product input will offset some to a significant degree of wage increases, though there is clearly not only significant pressure but some declines in industrial employment. Consequently, it is probable the bigger impact on the labor market is overall declining/flat industrial output and falling prices. This combination is placing a lot more pressure on wages and employment levels, but so far unlikely to cause widespread unemployment.
Second, it is very unlikely that formal service sector labor growth is offsetting changes in industrial employment levels. Financial services, transportation, hotel, retail sales, and real estate (not real estate construction) are not experiencing hiring booms by any means. In fact most have flat or low growth revenue and output. Financial services the only service sector with strong revenue and output growth for numerous reasons, is not witnessing a hiring boom and definitely not enough to offset declines elsewhere.
I plan to flesh out some of these issues but for the moment, just wanted to put out some of these ideas. I think this does provide some insight into the Chinese labor market, definitely far more than anything else out there but please note the caveats.
Tom Orlik of Bloomberg asked a very good question given some of the data that has been coming in from Chinese imports of steel and copper: while China oil and iron import volumes are growing on trend, does this represent stockpiling or robust demand? The short answer is: its complicated. Put another way, yes and no. The NBSC actually maintains data on both production and inventory levels of key products that will actually allow us to at least move in the direction of answer. However, as with many data issues, comparing different data that leaves us with a belief but far from conclusive answer.
Let’s start with gasoline. As noted, oil imports are rising on trend. Gasoline consumption through the second quarter, the latest available quarter with product data, has sales rising 13.2% and inventories declining 9.8%. However, this consumption appears to be driven by historical stock of small passenger cars. Passenger data on highway travel is flat for the year and sales of new passenger vehicles grew only 1.8% with saloon style car sales falling 3.3%. Additionally, inventories on passenger vehicles and saloon cars grew by 33.9% and 30.7%. The picture we get then is this: the mass market responsible for passenger travel and the new market for those looking to buy is essentially flat. Those with passenger cars are still driving them. Remember highway passenger travel, likely from buses, is flat so this would imply the growth is coming from private small cars.
The picture however with regards to metals is less ambiguous. Through the second quarter, again the latest data available for individual product sales and inventory data, steel output was up 0.6%. Worryingly, inventories were up 23.2%. The NBS does not specifically break out copper output and inventories on its website but rather classifies it under “Ten Kind of Non-ferrous Metals”. Here is where it gets interesting. According to the NBS, sales by ton of the ten non-ferrous metals rose 15% but inventories rose even faster….a LOT faster. Inventories by weight of the ten non-ferrous metals rose by 30.4%. Put another way, while non-ferrous metals sales by ton rose by a vigorous 15%, inventories rose more than twice as fast potentially presenting an excessively healthy picture of output.
There are two final points that need mentioning. First, the inventory data does come from the National Bureau of Statistics China so I would by no means take this is perfectly authoritative and accurate. In fact, when I mentioned rapidly rising metals inventories on Twitter, one reader, I apologize to them for not being able to find the specific Tweet, said that according to their data inventories had not risen. I have not had a chance to look at other data sources and the reader did not respond to a question about what data specifically, so it is entirely possible other data will indicate to the contrary.
Second, the data indicates at best a mixed picture of economic health and really much more economic weakness. Even if we look at the consumption side that would be a primary input for passenger travel, from this narrow vantage point, we wee that people with cars continue to drive them but car manufacturing is sluggish and inventories are rising. Metals provide a similar picture with output flat or declining but inventories rising rapidly. These two issue imply that GDP numbers maybe inflated if production isn’t being sold but just stored. Neither of these specific, and admittedly narrow variables, indicate real strength.
In case you missed it, I have now started writing occasionally for Bloomberg Views which are going to typically do explore some slightly different ideas from what I will continue to explore here. Thanks very much to Bloomberg for asking me and it will take on some more popular issues concerning China and Asia. I will leave the nerdier stuff here on the blog. I wanted to expand on some of the ideas in the piece on how data in changing China.
- China is not nearly as data poor as people believe. It isn’t as data rich as other place for sure, but there is a lot of available data if you have what are generally industry standard data tools like Bloomberg, Wind, or CEIC. I rarely refer to things like electricity, seriously look at the blog all searchable, primarily because there is so much other data to explore and present. Even on the NBSC website, which is still relatively sparse, there is lots of data that allows us to cross check some of the headline data.
- There is a lot of laziness among a significant portion of China economic and financial analysts. A lot of people simply haven’t stopped and looked at anything beyond the Li Keqiang Index in quite some time. I want to strongly emphasize two things though. First, I see this relative laziness with regards to data in people/firms that I both agree with and disagree with. There are people/firms that I agree with that I also believe are lazy in how they arrive at their conclusion and people/firms that I disagree with that I have a lot of respect for who push me to dig deeper prepare better. I say all this only because I don’t think data laziness is limited to what you are ultimately saying. Second, a lot of this laziness is simply path dependence. By that I mean people started using the LKI and stopped pushing the envelope to figure out what was going on. Just as the Chinese market is changing, data variety, quality, and volume is rapidly changing. There have been interesting new data added just within the last year. You can’t be a good China watcher talking about a rapidly changing economy, financial market, and consumer and not stay on top of the flood of data releases and changes.
- A lot of people, especially foreigners who don’t live in China but even some that do, paint suspicion about the data as some foreign conspiracy about the Chinese economy. What is so strange about this theory is that in China, there is almost zero trust in official data, though virtually no one will say so publicly. When I arrive in China it never occurred to me that official data would be anything less than a good faith effort to gather data with the typical statistical errors that accompany any large data. In fact, it was my Chinese students that first advised me not to believe official data. As noted in the Bloomberg article, there are many examples of Chinese not believing official Chinese data and with good reason. This is not some strange theory but accepted fact inside China.
- My primary beef with a lot of China analysts is that they simply don’t look at the data. Get away from top line official data and then tell me what you find. It is no coincidence that the further you stray from top line official data like GDP and Retail Sales the more convinced you become that the economy is much weaker than is being portrayed. Retail sales aren’t growing at 11% annually and GDP isn’t growing at 7%. There are actually GDP estimates where they use they other major top line numbers and arrive at 7%. Seriously, explore the data.
- It is no coincidence that the market has stepped into provide more data. Chinese investors and firms don’t trust the data and are generating ways to find more accurate tools to assess what is going on. You simply can’t have a modern economy using such poor quality data and Beijing while Beijing is trying to make people you can have a modern, service sector, knowledge economy without accurate information or access to knowledge. Think about that contradiction.
Last week I had the opportunity to speak at a conference on RMB Internationalization in Beijing at the invitation of The Asian Banker. Here are an assortment of my thoughts from both my speech and general take aways from my conversations.
- I am quite glad I do not live in Beijing. Wonderful place to visit for a few days in a nice hotel, wouldn’t want to live there.
- General consensus seemed to be that the economy was slow but not collapsing. I did not specifically ask about whether it was 7% or probe about data quality so as to avoid projecting any of my own thinking on them. I would guess however that based upon my conversations the underlying economic conditions are slower than 7% but again not collapsing.
- Did not talk to one Chinese banker or investor for whom the debt build up even registers. It was not even that they expected the government to bail them out but rather that it was not even something that thought about or considered. I not sure if this is due to potential lack of coverage in Chinese media, willful or strategic blindness, or just not taking the time to look at data. I did find it strange however that this issue in private conversations was simply no where to be found.
- I heard talk, and it should be strongly noted that this is entirely unconfirmed though I have heard similar rumors elsewhere, that big banks are padding their NPL numbers by selling off bad loans. Nobody seemed to know who is buying them or on what cost basis, so it very well could just be rumors, but given the previous history of complicated swap and sales arrangements for NPL’s, this is not exactly a stretch.
- Given the title of the conference of RMB Internationalization, the focus was on the impending announcement of the SDR decision by the IMF on including the RMB. Having lived in China for many years, one thing that strikes me is the frequent obsession with symbolism regardless of substance, though in all fairness this is true of many China watchers also. All the attention is on the decision of the SDR and very little on the substance of RMB internationalization. Let me give you a few examples. First, offshore RMB assets have actually been stagnating maybe even shrinking depending on the month for about a year. Whether you look at RMB deposits outside of China, debt assets, or offerings outside of China, these have all been essentially flat for about a year. Whatever the IMF decides will have little to no impact on actual RMB internationalization. To provide some perspective, total offshore RMB assets are probably about $300-350 billion USD or a very small percentage of the really any single financial market whether counting equity, debt, or other asset types. If the RMB was not the Chinese currency, it would not warrant discussion it would be so irrelevant to global finance. Second, people have heralded the rise of the RMB by noting the increased use of the RMB in international trade transactions. However, this is a very biased estimate as it basically only accounts for trade where Chinese firms are on one side of the transaction. That’s fine to measure the impact of Chinese trade but it really has nothing to do with the internationalization of the RMB. There are virtually no trade payments transactions denominated in RMB where both partners are not Chinese. Despite a couple notable cases, there are very few cases where of financial product offerings in RMB independent of China. RMB is rarely used as collateral for derivates trade for instance. While there is significant potential should China actually liberalize the RMB, but the story of RMB internationalization is significantly overstated in reality. Third, inside China there is a persecution complex/conspiracy theory that the world (read the United States and the Japanese) are trying to prevent the RMB from ascending to global prominence. The only problem with this narrative (read mass hypnosis) is that it flies in the face of all factual evidence. Beijing has worked with other central banks to sign swap agreements but not let central banks obtain actual RMB. Central banks around the world would love to increase their RMB holdings but Beijing simply will not let them. Additionally, Beijing has been stepping up capital controls to prevent RMB from leaving China increasing offshore liquidity. This follows a policy of encouraging domestic firms to move offshore financing onshore which has the impact of draining offshore RMB from the fixed pool. Could explore this issue in much greater detail but it is self delusion to believe it is a US/Japan power play to believe that is the reason the RMB is not more prominent.
- One of the most common issues you see in China relations with the rest of the world is similar to the Winston Churchill observation on the United States and United Kingdom: two great countries divided by a common language. Just because China and other countries use the same words, doesn’t mean they have the same conceptual understanding of the words. One word that I heard used a lot was “confidence” but what was strikingly apparent is that Chinese and non-Chinese attached two very different meanings to the word. To the Chinese “confidence” means trust, faith, and belief in Beijing leadership and the economic power of China. Whenever you talk with Chinese actors they in this general area they talk about the rise of the Chinese economy and the importance of Beijing leadership. To most non-Chinese financial types, “confidence” means clear, transparent, predictable rules of the market that will allow them meet their objectives and fulfill their obligations. Investors that want to use RMB or access the Chinese financial markets want to know what the rules are, that they are applied consistently and fairly, regulators that don’t behave like drunk hummingbirds, and that they can access and move their money as they need. Interestingly, Chinese investors will offer up the same complaints but will only say so in hushed tones after a few beers but stress this has nothing to do with their confidence in China or Beijing. The sooner Beijing can realize that investors have confidence in the quality of the market and not the omnipotent brilliance of Beijing, the better for RMB internationalization.
- While the RMB joining the SDR basket will have enormous symbolic importance, in the short term it seems unlikely to have any practical importance. Central bank RMB holdings are almost exclusively held through swap agreements not physical RMB and it seems unlikely that joining the SDR will prompt Beijing to release a flood of RMB even on transaction specific agreements for instance to other central banks. In other words, barring additional announcements, this would amount to little more than an accounting exercise rather than tangible changes. Especially given the bond and bank repatriation we see taking place right now in the market place that is shrinking offshore RMB liquidity, RMB internationalization is going to be nothing more than another nice cliche. SDR membership does not internationalize the RMB.
- There is one simple reason for the RMB and SDR policy: Beijing knows very clearly that if they internationalize the RMB, the lose control of the price. Beijing is worried enough about the offshore RMB price in Hong Kong that they have intervened directly buying up RMB to bring it back to parity, further reducing offshore RMB liquidity, as well as engaging is various derivatives future pricing to set future expectations. Beijing knows that if they allow enough physical RMB to leave China and be freely traded they run the very real risk of losing control and the RMB/$ peg will effectively break. This is also why they are more than happy to sign swap agreements where they continue to maintain effective pricing control, but refuse to allow physical RMB to leave or be traded. Again, this is not some international conspiracy but a conscious policy decision by Beijing to prevent RMB internationalization.
- Chinese banks are slush funds to direct capital to preferred companies. This isn’t just conjecture and speculation but legal fact. The four major state banks largest shareholder is a company called Central Huijin Investment which is a subsidiary of the China Investment Corporation (CIC) which is owned by the Ministry of Finance. The previous job of the current Minister of Finance was the Chief Executive Officer of CIC.
- Though we cannot know for sure from current data, it seems very probable that major state owned banks helped propel that the stock market bubble and then helped rescue it as it collapsed. While Chinese banks won’t invest directly in the stock market, they will purchase wealth management products or provide funds to firms for the purpose of creating or leveraging wealth management products. This would appear in cash flow statements as purchases of investment securities. Throughout the year and accelerating in the third quarter, big four SOE bank purchases of investment securities grew rapidly from 2014. In the first quarter of 2015, purchases of investment securities from cash flow were up 63% from the same time in 2014. By the end of the third quarter, this number had spiked by 90.4%. The change in absolute terms is just as amazing. Through the first three quarters of 2015, the big four state banks had purchased 5.4 trillion RMB of investment securities compared to 2.8 trillion in 2014 for a total increase of 2.6 trillion RMB. If we make the simple and somewhat unrealistic assumption that 100% of this money eventually found its way into the stock market, this increase would be equal to at the end of the third quarter, roughly 6% of total Chinese stock market capitalization. Now we do not know what types of securities the banks purchased and it is very unlikely they made direct purchases of stocks but given their increased allocation in the past few years to shadow banking and wealth management products, it is highly likely that a significant portion of these purchases found their way into stock purchases. Even if that actual amount of purchasing that ended up via direct purchases in the stock market was less, that is still quite a sizeable number. This does not even count the indirect ways that bank lending may have ended up in the stock market but rather only direct securities purchases. Furthermore, there are other significant increases in line items that would likely end up in financial institutions that channeled the money into the stock market. Agricultural Bank saw a 33% increase in held to maturity debt security investments, for instance. Construction Bank deposits and placements with bank and non-bank financial institutions increased 84% and 46% respectively. There are likely multiple ways that bank cash was flowing back to support the stock market.
- After the FT Alphaville post on NPL, an astute reader asked why aren’t we seeing higher reported rates of NPL’s? The question specifically is as follows:
“What’s your view on the discrepancy between banks’ interest income and finance costs of corporates? Is it possible that the banks books the revenue but don’t have the cash flows to show for it? Or is it possible that Chinese banks are misreporting (fabricating) their revenues?”
I suspect that firms are paying off the old loans with new loans. I say that for a couple reasons. First, their reported cash flow is close enough to their reported interest income that they seem to match close enough. This would allow them to book the cash flow and report the revenue but not solve the problem. Second, this would explain the interest income at as percentage of loans at 8% while the official lending rate was at 6%. That additional 2-3% is revenue that becomes additional principal. In China, the loan benchmark rate was for most of the past five years set essentially by the government. While it has spent most of the past few years hovering between 5-6% topping out for a little while around 2012 at 6.5%, the big state banks have been reporting interest income as a percentage of loans outstanding at around 8%. If an additional 2-3% of interest due is being rolled into additional principal balance, this would explain an official lending rate of 5-6% but interest income as a percentage of loans being around 8%. Third, there is one more point that fits nicely with this theory is that even as liabilities have been rising by double digits over the past few years, financial costs have only been rising by approximately 5%. If they are capitalizing interest into principal and taking on additional debt, this would explain why liabilities are growing at twice the rate of financial costs.
- One of the puzzles of Chinese banking in the past few years has been the use of repurchase lending and borrowing by the dominant banks. In the third quarter, repurchase lending is up a brisk 24% while repurchase borrowing is up in line with asset growth at 13%. There are a couple of interesting points however. First, repurchase lending is in aggregate by the major Chinese banks is more than twice as large as repurchase borrowing. Though not specifically covered here, smaller banks follow a similar pattern raising the question where repurchase lending is going. Chinese banks have looser standards of assets accepted for repurchase and counterparty institutions. It seems likely much of the repurchase lending was made to non-bank corporates covering a variety of less traditional assets as collateral. Second, what stands out in the repurchase borrowing is that three of the four major banks lowered their repurchase borrowing but Bank of China nearly doubled its borrowing. There is strong evidence that Bank of China is experiencing higher levels of funding stress. For instance, the classify nearly 200 billion RMB in liabilities and 230 billion RMB in assets as held for sale both up from 0. Financial investments available for sale increased more than 30% or 230 billion. This seems to indicate the Bank of China was trying to unload assets, liabilities, investments, and secure cash through repurchase agreements. Given its relative divergence from other banks in their third quarter activities, this does raise questions.
- The state of Chinese banks even being generous appears to be overstated. ICBC and Construction Bank saw impairment provisions go up by 90% and 63% respectively. Conversely Agricultural Bank and Bank of China saw their impairment provisions increase by only 27% and 15% respectively. It seems somewhat incongruous that banks with amazingly similar operations, owners and clients would report such widely divergent loan impairment rates. It would seem very likely that ABC and BoC will need to significantly increase loan impairment provisions in the upcoming quarters.
- The worst part is that bank profits are essentially flat. If ABC and BoC had accounted for loan losses as they likely needed to but did not, profits would have been much worse. If BoC had reported loan impairment closer to ICBC and Construction Bank, they would have seen a fall in profit of about 20% rather than flat. Furthermore, given their apparent large sale of assets, liabilities, investments, and repurchase borrowing, their industry beating loan impairment rate stands out even more. Even with technically flat profits, there appears significant under reporting of financial issues.
Too much of the debate about the accuracy of official Chinese data has focused on top line numbers like GDP or retail sales. Just like the bureaucratic obsession with GDP, this obscures important details about what is really happening within the economy and society.
Let us assume for a minute that the Chinese economy is growing at 10%. For purposes of this exercise, it could be 20% or any other large positive number you choose. This simple fact is that GDP growth rate does not matter to individual actors and agents within the economy. Firms do not pay in fictional GDP credits but with cash generated from sales of goods and services.
Even if we assume that 7% is accurate, or 10% of even 20% if you prefer, looking at a more granular level, we see a very different picture of the Chinese economy. If we look at a large sample of more than 375,000 industrial firms, revenue growth for the year is flat up only 0.35%. Various measures of profit all indicate stagnation or decline not just over the past year but over a few years. Conversely, liabilities are up 7% in the past year and have averaged annualized growth of 10% over the past four years.
The flat levels of cash flow are not limited to the industrial sector. Broad based measures of retail sales indicate low single digit sales growth with publically listed wholesale and retail firms declining 1.4% and growing only 0.1% in the past two years. Broad measures of hotel and restaurant revenue growth largely mirror his trend. Hotel revenue and occupancy measures are largely flat and unofficial measures of restaurant revenue indicate double digit declines. Telecom services revenue growth is flat if we look at the dominant telecom services providers in China with even service use growth declining.
Financial services is the service sector that independently shows broad based growth in line with its official number. Revenue growth in the financial sector driven by commercial banks and insurance have seen total revenue growth of 20%+. However, given the accompanying growth in debt levels driven banks and bond offerings, this is not necessarily a reassuring metric.
The danger of this deflationary spiral despite rosy growth announcements is now being noticed. Bloomberg succinctly states:
“As China’s Communist Party leaders began rolling out a blueprint last week to manage a transition to more balanced growth over the next five years, they confront the immediate task of halting the economy’s slide toward a debt-deflation trap.”
Revenue growth in most of the economy is flat while debt continues to go up by almost double digits for firms. This is the definition of unsustainable. Chinese firms simply are not earning the revenue or profits needed to repay the debts they are incurring.
Consequently, even if by some astounding feat, mathematical wizardry, or accounting trick the Chinese economy is technically growing at 7%, 10%, or 20% it simply does not appear to be impacting the firms who drive the Chinese economy. The basic formula can be witnessed in steel and aluminum firms. While they increase exports in the face declining prices, they increase their per unit loss but maintain the cash flow necessary to stay alive. Reuters estimates Chinese prices of aluminum at 10,000 RMB/ton and production costs at 13,000 RMB/ton. Even if we assume that Chinese GDP growth is 10%, that does not in any way reduce the risks of a credit event or aid struggling firms.
Focusing on China, I try to read broadly on the topic and I wanted to point readers to two recent pieces of interest. One is by Gwynn Guilford at Quartz on the long history of data doctoring by Chinese statisticians. If I could write a short piece covering a variety of the ways China doctors statistics, this is what I would write. From now on, when anyone asks for an introduction on the topic, this is where I will refer them.
I also want to direct your attention to a piece by Peter Larsen on the futile search for Chinese retail bellwethers. On the heels of robust Apple and Alibaba numbers in China, Larsen sums up the problem writing:
“Take Apple’s last quarter, in which China revenue doubled to $12.5 billion. Chief Executive Tim Cook sees no evidence of any slowdown. But he also points out that, excluding the iPhone, Chinese bought fewer smartphones. Apple is not even a bellwether for its own industry let alone the economy. Alibaba is another unreliable guide guide. The value of transaction on the e-commerce giant’s websites grew a healthy looking 28 percent in the most recent quarter. Yet if online orders are just replacing conventional offline purchases, the overall economy may be no better off.”
Let me build a little on that point on Alibaba. The real mistake people make about Alibaba is when placing it within the larger whole and specifically the substitution effect. Alibaba is growing because it is providing more choice at a lower price. It is expanding its business by innovating and increasing transaction volume by lower prices, exactly what a firm should do. Alibaba is taking market share from brick and retailing companies, which is a good thing. However, the real impact in Alibaba is not its GMV about but the marginal amount of additional product they moved by lowering prices. What I mean is this.
Assume Alibaba sells something at the same price as a brick and mortar place and each business sells 100 units for a total of 200 units sold. Now assume that Alibaba lowers the price by 10% and for simplicity sake, let’s assume that they sell 10% more units. They would sell 110 units and for simplicity sake again, let’s assume that their competitors sold the same amount as before 100. That results in a 10% gain for Alibaba and a 5% gain for the market. Though I don’t know and don’t have the time to calculate the price elasticity of Alibaba consumers, I can’t imagine it is incredibly high. By that I only mean that does a 1% price decrease increase sales 10%. My guess would be probably in the neighborhood of 1.5-4 meaning a 1% price decrease would result in sales increase of 1.5-4%. With Alibaba GMV numbers this would imply a price competitive advantage of about 8-20% which is probably reasonable. If you want to look at the impact of Alibaba, looking at it sales growth is a poor metric as this will capture most the substitution effect. The real impact on Alibaba will be the consumer surplus of how much more they buy due to lower prices.
In case you missed it, I had a piece on FT Alphaville about the amount of bad loans in the Chinese banking system. The key take away is that banks are recording 3.7 times the amount of revenue that firms report paying in interest.
One astute reader pointed out some of the discrepancy could stem from the capitalization of interest in large investment projects specifically in the real estate industry. This is a reasonable and valid question but one that does not impact the results.
- Firms can capitalize interest and count it as the cost of goods sold in certain cases. However, the cases are limited to cases where there is an extended construction or manufacturing period. Let me give you a couple of examples. If a real estate developer is building an apartment building for two years and they will sell the apartments in the third year, while the building is under construction for the first two years they count the accruing interest into the cost of the building. However, during the third year after the building is complete they must count any additional interest accrual is a financial cost. Another example, a steel mill decides to build a new plant and it takes two years to build. During the two year construction phase, they can capitalize the interest charging it to the cost of the building. A key point here is that when they move in and begin production they have to count the loan for the building as a financial cost. If the firm uses or holds the asset they should charge interest as a financial cost. One final example, a t-shirt manufacturer takes out a line of credit on Monday manufacturers t-shirts all week and sells them on Friday and pays of the line of credit. The t-shirt manufacturer cannot capitalize the interest expense and count that under the cost of goods sold. This should be a relatively limited exception.
- The data that I have covered here both in listed and unlisted firms goes well beyond real estate. From the listed firm data, the real estate sector comprises 15% of total liabilities and the industrial dataset covering nearly 378,000 firms does not even cover the real estate sector. This covers lots of in garment, chemicals, tobacco, and publishing but not the real estate sector. What is notable about this is that most firms across sectors demonstrate a similar pattern. Publishing, printing, and media topped out at 2.6% financial cost as a percentage of liabilities for the full year ending 2014. 7% for textile and garment firms. 2.4% for pharmaceutical manufacturing. 1.9% for liquor beverages and tea. In other words, this pattern is not in any way unique to capital intensive firms. These are firms that should not be capitalizing interest and should be recording higher financial expenses.
- Let’s take it one step further. Even if every new loan was 100% capitalized for three years because it’s a big new construction project, that would still imply that the bank was receiving 5.5% in interest payments and capitalizing 2.3%. for the total 7.8% that they report. That still leaves a significant discrepancy between the 2.1% firms report paying and the 5.5% they would be paying. In other words, even if every new loan is capitalized for three years more than enough for the vast majority of projects, that would leave a very sizeable discrepancy between what firms should be paying and what they report paying.
- With all of that said, I actually believe most firms with bank agreement are capitalizing the interest costs adding to the principal balance. However, that is not a good thing. Basically, they are building up the amount of money that they must pay but can’t because they simply aren’t generating the cash flow necessary to pay the balance. I believe this actually partially explains why the bank reported interest income as a percentage of loans outstanding is a relatively high almost 8%. The base corporate lending rate in China should be lower but if interest is being capitalized into the principal, recorded as revenue, this would explain part of that amount.
- Even if interest is be capitalized increasing the loan balance, this is simply rolling over the debt into more unsustainable levels. It goes against all accounting principles that this much debt should be counted under the cost of goods sold. Neither scenario is positive.