Is China Deleveraging Revisited

Probably the biggest question facing China and international investors is whether China is deleveraging.  The Chinese debt and fixed income markets have changed though to the point that people can see almost anything they want. You choose to see China is deleveraging or is still leveraging up, and you can make a case for that.  Let us go through the data so we can see how I reach my conclusions, but then how data is being obfuscated, omitted, or not considered.

  1. Total bank loans in 2017 was up 12.7% with nominal GDP up 11.2% representing a small boost in total leverage. Stock aggregate financing to the real economy was a bit lower than bank loans at 12% but still representing a small additional leveraging to the debt to GDP ratio. In fairness, this aggregate number is solid.
  2. What is noticeable about the Chinese debt numbers is how the sub-categories diverged so significantly. Put another way, how China arrived at those aggregate numbers is interesting and instructive.  In short, some (not as much as some people argue) but some financial deleveraging took place, some corporate deleveraging took place but households and government blew up their debt levels.  What is notable is that the “deleveraged” sectors did not see absolute falls in debt, they just saw slower growth rates below nominal growth so they remain decidedly weak. The government and household sectors appear to be rapidly looking to match the indebted corporate sector so that the enormity of the corporate debt load is matched across all sectors of the Chinese economy. This matters at it makes it that much more difficult for the government or household sector to play a larger role if so needed. We are not at those levels yet, but rapidly moving towards them.
  3. In the corporate and financial sectors, there actually was progress made on deleveraging. Claims on non-financial institutions in 2017 rose a paltry 6.3% and are up only 32% since 2014.  The current corporate debt sector problems are due more to the explosion of debt between say 2009-2014 (rough divisions). Debt growth has slowed but given that the slowing is let’s say roughly in line with or moderately beneath nominal GDP growth in any one year, the corporate sector debt level has remained elevated in absolute terms.
  4. It is important to note, in my opinion, that 2017 was likely an outlier in terms of debt growth and industrial profitability. The story of 2017 in China was entirely and completely the growth in basic input commodity prices like coal and steel but more broadly related inputs, primarily metals like tin and aluminum. To put this in perspective, if we remove the impact of metals processing from manufacturing profits, profit growth drops from 6.6% to 3.9%.  Put another way, 42% of the growth in manufacturing profits can be attributed to areas like ferrous metals. Add to this the fact that mining and related sector profit was up 151% and in reality the 2017 boost to profits and corporate deleveraging due primarily to a very narrow group of industries. On average, outside of this narrow group, profit growth was quite low. Liabilities in mining and ferrous metal smelting actually declined in absolute terms but grew slightly faster than revenue in other industrial sectors. I say all this because “deleveraging” and industrial profit growth in 2017 China was driven almost exclusively by financial market driven commodity price gains engineered by Beijing. For so many reasons, expecting triple digit price gains to drive the economy is risky at best. 2017 was not a broad based economic recovery in China. On the downside, these numbers are very unlikely to go up definitely nowhere near previous rates. On the upside, Beijing seems intent on establishing a price floor to keep these firms profitable.
  5. What is notable is where the debt growth is occurring. Government and households have seen debt grow rapidly. Even more noteworthy is that while this has gained increasing attention, this is not simply a 2017 phenomenon but a multiyear explosion in debt growth by the government and household sectors.  Bank claims on government grew 27% in 2017 but grew 98% since 2015 and 207% since 2014.  A similar phenomenon is playing out in the household sector.  Total official household debt has grown 21%, 50%, and 75% in aggregate over the last three years.  What is important to note is that while the non-financial corporate sector remains the largest individual line item for banks, it is no longer as dominant a line item as it once was. The other bank line items like financial lending, investment, households, and government are now larger that straight corporate lending.
  6. This paints a larger story that China is attempting to reign in corporate debt levels, mildly albeit, but to continue to hit growth targets they are using various fiscal stimulus and household debt to prop up the economy. This also paints a story of continued additions of net leverage which I would expect to continue to rise over the next 1-3 years for reasons which I will get into later. One of the enduring stories in recent Chinese economic history is the never ending assurances that they do not worry about growth targets and can deleverage anytime but they never seem ready to accept the inevitable tradeoff between reducing all debt growth and lowering GDP.
  7. There has been a decline in financial leverage but here I think this change has been overstated. Much of the financial deleveraging that has taken place has simply moved into other instruments. Consequently, while financial to financial lending is effectively flat, banks have increased their holdings of “portfolio investment” domestically by a healthy 9.3%.  Bank to bank WMPs decreased but this was largely offset by higher retail sales of WMPs.  The primary point here is that while there has been a slowing of growth in financial leverage, let’s not overstate the change.
  8. Within this there are a number of big picture moves playing out that I do not think are getting the necessary attention in how all of this fits together. First, because 2017 is such an outlier due to the price boost of commodities (which is a statistical issue worthy of exploration by itself) we would be mistaken to just carry that forward in how we view the range of variables we look at.  In reality, as you will see, I think it much more accurate to view 2017 as the year when China did not address the problems facing it in the good times preparing the expected slow down. Second, PPI finished 2017 at 6.3% and it is quite likely to finish at least 2% lower. That means that nominal GDP should finish distinctly lower meaning leverage will likely increase more in 2018.  China got a nice, likely one time, inflation bump in 2017, but the prices right not do not indicate a similar bump is likely to come in 2018.  Third, the real concern is that corporate debt levels remain very worrisome even if they have not worsened and now the debt levels of other sectors is rising offsetting the ability to address any shocks.  They word I have chosen to use it increases the “fragility” of the system. Household and government sector are rapidly consuming their slack to assist the corporate sector should we need a recapitalization.
  9. Then I think there numerous specific mechanisms that have not gotten enough attention. First, financial deleveraging and base commodity prices that drove the nominal GDP rebound are intimately tied up.  If China is going to attack financial leverage, this is going to put significant pressure on commodity prices. Though many believe that prices have gone up due to capacity cuts, this simply is not true. Total capacity in virtually all metals has continued to increase in absolute terms. It seems highly unlikely China will be able to keep commodity prices buoyant and have significant financial deleveraging. These two and too closely linked.
  10. The problem with 2017 is not what happened but what did not happen.  For instance, in a good economic year, NPLs did not decline.  We know they will go up if the economy slows and yet no progress was made in 2017.  Actual debt to equity swaps executed were a small fraction of the announced number and bankruptcies by any standard remained quite low.  Given that nominal GDP is likely to fall by at least 2% in 2018, it seems like a missed opportunity to accomplish little in the way of actual clean up.
  11. This matters because I believe a mountain of evidence indicates the underlying foundation of the Chinese financial system continues to erode. For instance, in 2017 banking new loan to new deposit ratio topped 100% and since 2014 this number has totaled 90.2%. This implies that the lending binge from 2009-2014 is not returning the necessary cash to pay back the debts and increase the deposit base to make new loans because there are large ongoing capital write offs.  If we add in the additional investments banks have made, this number far exceeds 100%.  This is not the sign of a healthy banking system.
  12. This is showing up in the unsexy assets a bank holds. While total banking system assets in China have grown about 45% in the past three years, this has come at the expense of cash, central bank deposits, and reserves.  Over the past three years, as bank assets grew 45%, bank cash, deposits with the PBOC, and reserves grew a total of 9.7%. This pushed down CDR (cash, deposits, and reserves) from 27.1% of assets in December 2014 to 20.5% in December 2017. The last time this number was this bad was in 2006 at the tail end of the bank restructuring. A drop of almost 7% in three years is significant and must slow before stopping. That number will likely continue to decline weakening the ability of the Chinese banking system to manage shocks.
  13. However, it is not just banks working to prop up the Chinese economy but the PBOC as well but not necessarily how you think.  In 2017, PBOC depository corporation and “other” assets grew 31% and 187% from December 2015.  Excluding “foreign assets” such as exchange reserve, these two line items comprise nearly the remaining one third of PBOC assets so this is not starting from a small base.  To put the absolute size in perspective, this amounts to roughly 15% of all lending in China.  In 2017, total banking system assets increased 19.3 trillion RMB and PBOC assets grew 2.8 trillion RMB.  There are couple of important implications.  First, financial deleveraging was replaced by PBOC asset purchases not systemic reductions. Second, what is notable is that the PBOC is not classifying these as government claims which seems puzzling given their previous declarations they would accept local government bonds on repo. However, for the moment let us assume these are at most LGFV debt. Third, it clearly belies Beijing claims about desiring deleveraging as this was a clear policy channel that is being used to boost credit and meet growth targets.
  14. I don’t think we have strong evidence that Beijing is producing fraudulent systemic bank data the same they do for other areas of the economy and financial markets though they are clearly working to hit headline numbers while letting the underlying numbers continue to erode. I think you have to be quiet suspicious of financial data in China so I am not about to defend its accuracy, but what is more readily apparent is that China is clearly focused on achieving the top line objective for targets like to debt to GDP even as loan to deposit ratio goes on rising and CDR to assets continues to fall.
  15. There are two overarching economic problems I see. First, Chinese assets are wildly overvalued. This stems in my opinion from a money supply that is vastly in excess of the size of the economy.  The differences are enormous. In nominal exchange rate terms, the US economy is nearly 50% larger than the Chinese economy.  However, Chinese RMB M2 is effectively twice as much as the USD for what is effectively the global currency.  When put against the size of the economy, the numbers are even more striking. There is more than twice as much Chinese RMB as there is economy. Conversely, there are actually 30% few USD than there is against the size of the economy.  This of course translates into enormously higher asset prices.  This translates into lending against overvalued assets which is why the PBOC is so worried about keeping asset prices high whether it is commodities or real estate. Beijing cannot seriously delever without accepting significant pain from lower asset prices.
  16. The concept that remains with me is this idea of improved headline numbers but continued hollowing out and increased fragility. Corporate debt relative to assets and revenue has stabilized at very high levels but now debt is growing rapidly in other sectors. This makes the future increasingly fragile and vulnerable to shocks.  I think headline numbers have not necessarily improved but they are worsening at a slower rate.  However, many of the underlying numbers continue to worsen significantly increasing the fragility of the system and ability to respond.

Christmas Blessings from Shenzhen

Since I spend so much of time talking about the failures of Chinese economic and financial policies, data fraud, and some of the other negative aspects, I wanted to spend a small amount of time at Christmas talking about why I have lived in China for almost nine years. I think I criticize Chinese policy for fair and valid reasons, but I have lived here for nine years and am thankful for that opportunity.

  1. I think Tyler Cowen has it right when he says China is the story of the globe right now and for the foreseeable future and I get a front row seat with popcorn. Longer I’ve lived here and delved into what happens in China, more I’ve come to appreciate that China analysts who drop by for a week once a year simply do not have the depth of understanding. There are some smart people that fall into this category, but it is truly the difference between reading a physics text book and being in the lab running those experiments.  I have a colleague that said it well once “China can drive you crazy but I wouldn’t want to be anywhere else right now.”
  2. You get to meet amazing people doing all kinds of amazing things. From young Chinese students to foreign expats, there is a buzz in southern China that any and everything is possible. People believe industries that do not currently exist can be huge in a few years.  Things that do not exist can be created out of nothing.  There are potential downsides to this attitude, but it is invigorating that so many people talk about a vision they see of where they want to go and want to achieve.  When I visit the US I see a lot more of the Tyler Cowen complacent class and complaining.  The mood in the US has been sour for a long time, while in China there is talk about what people can accomplish and create. Yes, some of that is state media influence for sure but a lot of that is the broader mood. Yes, there are accompanying problems like the blindness to risk and other issues, but it is invigorating and you do get to see all kinds of amazing things and meet amazing people
  3. My family has been blessed with wonderful friends foreign and Chinese and schools that have made Shenzhen a great place to live. I always tell people Shenzhen is the best major city in China to live.  So many people that do not live in Shenzhen have never been here are shocked at my assertion but it is true.  In addition to being a very comfortable city to live, especially compared to Beijing or Shanghai, the entire vibe and culture of the city is radically different.  Shenzhen is an immigrant city where everyone is thrown together.  Consequently, I find people all over the city much more welcoming, open, and friendly.  My kids have made friends with their classmates and their parents have always been willing to help the foreigner Mom and Dad who really have no idea what is going on.  I know we will never really be accepted as foreigners in China with a constant wall between Chinese and foreigners, but we are thankful for the friendship of a variety of people for ourselves and our children.
  4. I suspect 2018 is going to be a year of change but just a couple things from me. First, I have started working on a book about China which I hope to have finished by June or so. I’m excited about this book as it explores new areas and ideas.  With all the different outlets for writing, I stay pretty active but when this idea and how to structure it landed, I decided I had to go ahead and write a book.  It is about China and in the business/finance/economics realm, but definitely goes into new areas in ways that I do not believe have been explored really by myself or others. No idea on a release date yet, but the book is on target to be finished about the end of Q2.  Second, I have a big project announcement date set for some time probably in March.  Trust me this is going to be very cool and something I’ve been working on for a while. I can also tell you, it will be nothing you are expecting. Hopefully will be ready to announce in March, but this is something you will never guess but will be very cool.

In this period of hope, peace, and joy, I sincerely hope your world and the world we live in is filled with more of both in 2018.

Grab Bag of China Thoughts Before Christmas

I have been too busy to update the blog for quite a while, a subject about which I feel bad, but I have been too busy for a variety of reasons, but at the end of the year, I wanted to put a variety of thoughts out there.  A lot has happened and is happening, so here are a collection of thoughts on a variety of China economic and financial topics.

  1. The China deleveraging story is more complex than it is made out to be. Unfortunately, partisans on both sides can point to evidence that supports their point.  On the corporate side, debt growth has slowed so it is a little beneath nominal GDP, the most widely used metric.  This is positive but let us not overstate this. Heavy industry, the primary sector of worry, remains heavily indebted with debt to equity ratios only ticking down slightly. Debt growth was still robust at almost 10%.  The relative picture did not worsen, but given the outstanding stock really only ticked down slightly.  Household debt, both short term (covering everything from credit card, consumption, and hidden real estate investment) and long term debt grew rapidly at about twice the rate of nominal GDP.  What is important to note is that this is no longer an irrelevant slice of total Chinese indebtedness at a little more than 25% of major bank line items.  Additionally, Chinese households are very indebted.  Due to Chinese data issues, we cannot say with absolute certainty, but if you extrapolate official Chinese data, Chinese household debt would be about 100% of household income.  There is a good chance it is lower but in reality, it is probably between 70-100% of household income putting it on par with basically the developed world already when it comes to household debt. Household debt strains will become increasingly evidence in the years ahead which do not have the SOE advantage of not having to repay loans. Additionally, the shadow banking system assets investments in shadow banking grew about the rate of nominal GDP maybe a little faster.  There was no pull back broadly speaking from “shadow banking assets”.  Combined, household and portfolio investment in financial institutions is now larger than corporate lending so when these two are growing so rapidly, any slower growth in straight corporate lending cancels out. Focusing strictly on the corporate debt picture doesn’t even capture half the picture.  Finally, the only reason aggregate leverage ratios flattened was because of rapid commodity input price increases that in some cases hit triple digits pushing up PPI and nominal GDP.  New debt growth was actually up robustly over nominal GDP with the stock growing basically on trend. It is a very fragile hope and not indicative of any restraint to hope that commodity inputs will achieve triple digit gains year after year.
  2. Unless there is a financial crisis, the RMB will not liberalize by 2020. Fact of the matter is, and Beijing knows this, they absolutely cannot liberalize the RMB.  Beijing is currently operating under near draconian capital controls and they are bumping along with slightly negative outflows every month.  If you have a closed capital account and you are bumping in the slightly negative territory, imagine what it would be like if you opened it. Asset prices in China are wildly distorted so any opening of the capital account would push towards an equalization meaning significant asset price depreciation.  Foreigners are not investing in China at nearly the same rate, meaning China can’t invest abroad very much as the realized cash flow from a trade surplus is quite small for various reasons I have gone into before.  Unless China is willing to allow outflows, which they do not seem willing to do so, this essentially limits their options of foreign investment. For all the headlines you see, Chinese investment abroad in nominal terms remains pretty limited and net Chinese foreign bank assets actually declined in 2017.
  3. A term that I am increasingly drawn to describe the Chinese economy and financial markets is fragile. I must emphasize this absolutely does not mean that I am predicting any type of crisis. What it does mean is that even though everything looks fine on top, you can see the increasing weakness underneath.  Let me give you a few examples.  Real estate prices have held up pretty well in China, but the real estate market is astoundingly weak in reality.  Unit turnover is hovering just above zero so that prices are being set at the extreme margin.  Many major cities in China would take more than 100 years to turnover their housing stock at current transaction rates. “Prices” may be high but there is almost no turnover meaning the market is very fragile. At some point prices will adjust to begin clearing the market.  Nominal GDP jumped over real GDP in 2017 due to strong commodity price gains.  This is a very fragile basis around which to claim deleveraging is proceeding and will continue. Another is that debt is now being spread around much more widely throughout China. Debt in corporations did not grow as strongly, but it grew strongly elsewhere. This increases the total systemic fragility. If everyone is excessively indebted you cannot tap other sectors if there is a problem. What I see is increasing fragility to the overall system.
  4. Watch the Fed. If you would have asked me last year if the Fed would hike three times and the USD would fall by almost 10%, I would have said you are crazy. However, that is exactly what happened.  If 2017 is any guide, if the US hikes another three times, that would push rates over 1M for even the highly secure money markets, close to 7%.  Additionally, the USD even moves to erase last years losses, above average probability of mean reversion, this will put a lot of pressure on China, the RMB, and interest rates.  This would also have an large impact on Chinese FX reserves and pretty quickly take them under $3 trillion.  However, just as I would not have predicted a 10% USD decline given three rate hikes, markets like that are strange things. However, we have to assign a higher probability to a USD increase after a nearly 10% decline, then add in more rate hikes and to me this makes the probability increase even more.  One of the overlooked factors is that for many years US and China ran correlated economic policy, but now they have increasing need to run divergent policies and how that process unfolds will be very interesting to watch.  China for all its bluster follow the Fed because it has to.


I think 2018 will be another interesting year in China

Technical Follow Up to Hidden Chinese Debt

There have been some questions posed about some semi-technical issues regarding my last blog post on how large are Chinese debt numbers.  Let me note a couple of things before with hit the good stuff. First, regardless of how much we advance the knowledge base, there is vast amounts of unknowns here.  We are literally talking about a nearly $40 trillion USD pile that the PBOC dropped into conversation. There is a lot of information that needs to come out about what this means.  Second, I am willing to change my mind but at the same time, I telling you what I think based upon what we have been told this means.

  1. Is there really a difference between the on and off balance sheet assets? I would argue based upon the evidence we have now that yes, the on and off balance sheet assets refer to two separate assets or pools of assets. I say this for a few reasons. First, the PBOC calls them different pools of assets. The PBOC is most definitely drawing a distinction between the two groups of assets in labeling some as on balance sheet and others off balance sheet.
  2. Second, because they are labelled as on and off balance sheet, there is a legal distinction between an on and off balance sheet asset. Using simple examples, if a bank loans money to a company that loan is on balance sheet. However, if that bank arranges an asset management product where lots of investors buy a 90 day fixed income product which channels money to another company, financial or non-financial, the originating bank does not bear the legal requirement to bear that loss. This seems to fit both the requirement of legal difference for an asset to be considered on or off balance sheet but also matches the scant data we have given that roughly 65% of off balance sheet assets are asset management. Now it is unclear whether banks directly hold those assets using accounting rules trickery to ensure they are considered off balance sheet or if banks were acting as the originator and distribution entity and would consequently face significant pressure should defaults occur. Given bank asset holdings, they are likely holding some of this but it would necessitate enormous amounts of onward sales rather than acting as the primary investor.  This would also seem to match a point of confusion in the Chinese version of the FSB report where it refers to the “off balance sheet business” rather than assets.  Business here might imply that the banks were selling products presumed to have bank backing by investors even if there is not a legal obligation.  In all probability, off balance sheet assets here are some combination of both bank owned assets held off balance sheet and bank products sold to investors that banks would be expected to stand behind.  This also matches a CBRC document sent to me by Andrew Polk.  From Google Translate, the CBRC says this about off balance sheet obligations and products:

Article 2 (Definition of Off-balance-sheet Business) The off-balance sheet business referred to in these Guidelines refers to the business done by a commercial bank that does not include real assets and liabilities in accordance with the current accounting standards, but which can cause the current profit and loss changes

Article 3 (Classification of off-balance-sheet business) According to the off-balance sheet business characteristics and legal relations, off-balance sheet business is divided into guarantee commitments, agency investment and financing services, intermediary services, and other categories.

According to this, banks can engage in off balance sheet activity that matches the two basic types of off balance sheet activity we have defined as the Enron SPV or the investment intermediation.  In short, the PBOC is telling us these are two separate asset pools and the CBRC has defined legal distinction between the on and off balance sheet asset.

  1. Is it possible that the on and off balance sheet assets are double counting the same assets on both sides? Quite possible to a small extent but that does not change the fundamental conclusion and actually, most likely makes the situation even worse.  Let’s walk through an example of how might an asset be counted on both the on and off balance sheet side and how that might actually make it worse before turning to whether or not there is evidence of this happening.  Assume for a minute Asset A is held in an off balance sheet entity. For that asset to go from off balance sheet to on balance sheet, that means the on balance sheet entity is incurring a liability. As a real world example, assume a bank sells a wealth management product to investors that gets counted as an off balance sheet liability. The WMP is actually just channeling money into the banks on balance sheet asset base. In this case, moving the money from off balance sheet to on balance sheet creates a liability from the on balance sheet entity to an off balance sheet entity. In other words, this would raise the on balance sheet liabilities if the off to on balance sheet transfer was actually recorded.  This would all reverse banks were moving on balance sheet holdings into off balance sheet holdings.
  2. On a slight tangent, it would then help to know whether banks are looking to move assets from off balance sheet to on or from on balance sheet to off. This is semi-speculative, anecdote and nothing more, but probably both but in a way designed to make banks look better than they really are. Simple example, bad debts are siphoned off into off balance sheet holdings while capital disguised as deposits is moved on balance sheet. Net result is to make the bank look better.
  3. Before we turn to the empirics of whether the assets might be double counted, let us look at why it is almost worse if they are not. Let us assume there is 250 trillion in underlying assets banking system assets. For any number of reasons, now let us assume that the asset is held off balance sheet and circulated on balance sheet (or vice versa). This implies that there is effectively much higher leverage in the banking system than recognized. Take a simple example of how this might work. Assume a bank has 100 RMB in deposits and makes a loan for 90 RMB. They want to make more loans so they turn the loan into a structured WMP and sell it through their asset management division to private investors. That loan is now off their balance sheet and the 90 RMB in cash comes back and they again have 100RMB to lend. If, and this is the key part, if the bank just holds cash on the balance sheet instead of relending the money, there is no net change in risk. If the off balance sheet product collapses the bank can cover the losses. However, if the bank then relends the cash which they have done according to financial data, this means, in our simple example, that there is now another 90 RMB loan made by the bank for total loan assets of 180 RMB (90×2) and 10 RMB in cash lowering the capital reserve ratio if on and off balance sheet assets are counted. The beauty of this explanation is that it matches what little we know about these off balance sheet assets. The scary part is that means that the Chinese banking system leverage is enormous. To provide some perspective, the official capital adequacy ratio for banks is bouncing between 11-11.3%. Now it should be noted for various reasons, the CAR in China excludes a lot of loans made by banks, which Chinese banks know and use these loopholes to boost their CAR. Some research has been done by different people that if off balance sheet items for instance are counted, many small banks especially see their CAR fall dramatically. If I take a simple metric of commercial bank net capital of 15.5 trillion RMB and divide it by on and off balance sheet assets of 485 trillion, this gives the Chinese banking system a net capital to total asset ratio of 3.2%. Should be noted this is not a strict apples to apples comparison. However, it does clearly illustrate what happens if we claim that there is some double counting. One final point about the double counting issue. Let’s assume that all assets overlap or are double counted. Because an asset cannot simultaneously be held off balance and on balance sheet it must be either or, the only way this does not dramatically increase leverage is if the Chinese bank is holding cash offsetting an off balance sheet asset.  This would imply that Chinese banks are holding mostly cash or cash like instruments. Well we know that Chinese banks are not holding mostly cash so this leads to the conclusion that Chinese banks have used off balance sheet transactions to further lever up and make their on balance sheet assets appear safer than they really are.
  4. This track to find double counting gives us a method to follow the bread crumbs of how we might find evidence of double counting. The primary asset class we are going to focus on are flows to/from banks to other financial institutions or other asset holdings. There is a simple reason for this. Again, take the extreme example that on and off balance sheet assets are the exact same assets. In this case, the on balance sheet financial data should be a record of those assets churn between on and off balance sheet. That would mean that the entirety of official bank data is fraudulent. By that I mean, to take a simple example, the category of lending to household is completely fraudulent because all bank assets are channeled through off balance sheet vehicles prior to consumers. That means all numbers should be recorded differently as being channeled through off balance sheet vehicles and not going to consumers. So the key question then is what is the flow between financial institutions and other financial institutions and or categories that might represent this type of vehicle? For instance, we are going to exclude household consumer bank assets or liabilities assuming that banks are recording loans to consumers as a consumer loan. The primary data source is a PBOC monthly dataset of depository corporations balance sheet.  We add up Claims on Other Depository Corporations, Claims on Other Financial Institutions, Claims on Other Resident Sectors, and Other Assets. We then do the same for the corresponding liability line item.  According to this, Chinese depository corporations have 106 trillion in assets under these line items but 54 trillion in liabilities for a net holding of 52 trillion.  Let’s start with the most generous of parameters by assuming that all 106 trillion in assets here are held in off balance assets so it is effectively double counted. That significantly reduces the 253 trillion we started with to 147 trillion in uncounted off balance sheet assets but that still leaves us with an enormous amount of uncounted assets. Next let’s use the slightly more conservative net asset number of 52 trillion assuming that is entirely double counted assets.  This still leaves us with 201 trillion in previously unknown assets.  Other datasets which cover financial institutions and depository financial institutions on sources and uses of funds provide smaller corrections, so I will not use those here.  If we use the primary line items that would correspond with off balance sheet activities and be very generous in our interpretation, we still are left with a very large amount of uncounted assets.
  5. There are a couple of enormous problems with the double counting theory. First, is what I will call the flow mismatch. An asset is categorized on balance based upon where it is deployed. Assume a bank makes a loan to a coal company, that is categorized as a bank asset as a loan to a non-financial corporate. Even if we generously assume all assets from multiple potential line items are deployed as off balance sheet assets, this still leaves us enormously short of double counting even a majority of off balance sheet assets. To claim that all or most all balance sheet assets are simply double counted, you are subsequently required to believe that all on balance sheet financial data is false. Consumer loans should be recorded as loans to consumers. If a bank makes a loan to an off balance sheet SPV that makes loans to consumers, that should be recorded as a loan to a non-bank financial institution or as a portfolio investment depending on how the deal is structured. Remember, roughly 65% of the off balance sheet assets are held in asset management structures which is not how Chinese banks record holding their assets. These do not match. The balance sheet flows and categorizations simply do not come close to matching. Second, is what I will call the size problem.  The only way the double counting theory makes a significant difference is if we assume effectively that all on balance sheet banking assets somehow move through off balance sheet banking channels before reaching their final destinations. This is also the only scenario I can think of that doesn’t drastically raise the risk level.  In this instance, Bank A makes a loan to Bank A SPV who makes the loan to the end customer. If the off balance sheet SPV makes loans to consumers, the on balance sheet entity records the loan as being made to consumers rather then to a non-bank financial institutions or portfolio (WMP) investment. Is this possible? Given it is China we are talking about who just disclosed nearly $40 trillion in previously undisclosed assets, anything is possible. However, this has never been discussed even anecdotally, requires us to believe all on balance sheet financial data is wrong, and that the entire Chinese banking system is engaged in a systematic asset obfuscation and diversion scheme. Possible? Sure. Highest probability explanation? Not even close. Therefore, if we take the Chinese banking data we have, believe consumer loans are made to consumers and so on, even if all asset classes we can remotely presume to be in off balance sheet vehicles are in off balance sheet vehicles, we simply do not come close to reconciling the outstanding unexplained assets.  I am quite willing to believe there is some immaterial level of overlap here.  For instance, assume 10% of the off balance sheets are already counted on balance sheet that would reduce the unknown by roughly 25 trillion RMB (which let’s just stop right there and say that is still an enormous number) to about 225 trillion. 225 trillion RMB or $34 trillion USD is still an enormous amount of unexplained assets.  Based upon all the data we have, it seems highly unlikely that a large majority of the on and off balance sheet assets are simply double counted.
  6. How was China’s last figure of financial system assets totaling 833% of GDP estimated? The FSB gave the total financial system assets for China across Central Bank, Banks, Insurance, Pension, Public Financial Institutions, and Other Financial Intermediaries at the end of 2015. To estimate the financial system assets as a percentage of GDP at the end of 2016 with the new PBOC data required the following steps. 1) change the FSB 2015 bank asset to 2016 PBOC on and off balance sheet asset total 2) total PBOC assets at end of 2016 3) Estimate 2016 growth rates for asset growth rates like insurance using conservative growth rates of 10-12%. Insurance for instance grew at 22%. (Worth noting inserting PBOC data from on and off balance sheet asset into FSB table comprises 80% of financial system assets). 4) Sum estimated total financial system assets for 2016 from FSB with new PBOC data and divide by IMF total nominal GDP.

Let me emphasize, and a couple of people have the DMs to prove it, when I first saw these numbers I simply did not believe it because the numbers were so outlandish I thought I had to be missing something. I am still open to changing my mind on this issue. However, the PBOC and the CBRC both appear to be drawing a clear statistical and regulatory dividing line between on and off balance sheet assets.  Furthermore, the asset flows between on and off balance sheet entities simply do not match either in asset categorization or amount.  To believe that the on and off balance sheet asset values double count the same assets means disregarding CBRC regulation, PBOC classification, and all on balance sheet banking system data.  It is worth reminding that the PBOC FSR in previous years mentioned the ongoing build up of off balance sheet assets. In 2016 it amounted to 82.36 trillion and in 2015 it was 70.44 trillion. 2017 changed because of the inclusion of the MPA.

Finally, I think there are so many questions that need to be answered with regards to this disclosure.  I think it clearly says that is roughly $40 trillion USD in previously undisclosed assets which is nothing short of a complete game changer on everything.

Everything We Think We Know About Chinese Finances is Wrong

China has long faced doubts about the veracity of its economic data and concerns about its rapidly rising level of indebtedness.  While defaults and individual incidents raised questions about debt discrepancies, there was no systematic evidence that the financial system faced systemic misstatement. The People’s Bank of China changed that with a few sentences.

By some estimate, the widely watched debt to GDP metric in China has already surpassed 300%. While this is level is worrying given financial stress associated with countries that reached similar levels, this is only half the story.  There have long been suspicions that Chinese debt numbers are not entirely accurate but data that would demonstrate a systemic difference from data has never emerged.  However, every time a company collapsed, there would inevitably come out a mountain of undeclared debt. While this raised suspicions, there was never systematic evidence.

The Financial Stability Board (FSB), formed after the 2008 Global Financial Crisis, aggregates data for major countries that includes a broader measure of assets by banks, insurance companies, and other major asset holders.  According to their data, at the end of 2015, China financial system assets had already reached 401% of GDP.

This put them only 11% (5100 basis points) behind Germany and 200-300% ahead of comparable emerging markets like Brazil, Russia, India, and Mexico.  By this measure, at the end of 2015, China was already worrying and a distinct outlier, but not completely absurd.

China itself, gave us evidence that its financial data is wildly off.  The annual PBOC Financial Stability Report with little fanfare more than doubled its estimates of financial system assets.  In a little noticed paragraph the PBOC noted that “the outstanding balance of the off-balance sheet of banking institutions….registered 253.52 trillion yuan.” To provide some perspective, official on balance sheet assets were only 232.25 trillion yuan.

The PBOC report matches extremely closely official data for the on balance sheet portion of bank assets, but matches no known official data for the off balance sheet portion of assets. Nor does the PBOC provide many clues as to what these off balance assets are holding.  They do note that roughly two-thirds of the 253 trillion is held as “financial asset services” which may mean everything from structured products sold to clients who believe the bank will stand behind the product, special purpose vehicles holding non-traditional assets, or certain types of financial flows.

If we revise our earlier estimate of financial system assets to GDP based upon the new PBOC numbers, China’s position changes dramatically.  The FSB estimate of all financial systems published only in May 2017 jumps from 401% of nominal GDP to 653% of GDP at the end of 2016 for just banking system assets.

If we take the FSB data, add in the new PBOC data, and estimate forward to 2016 Chinese financial system assets are equal to 833% of nominal GDP ahead of Japan at 657% and behind only international banking center United Kingdom at 1008%.

This level of asset accumulation imposes real costs. Where as Japan and Europe have close to zero or negative interest rates, China has significantly higher. If we make the simple cheap assumption that these assets earn the short term interbank deposit rate of return of 3.5%, this would imply a financial servicing cost to the economy of 29% of nominal GDP. Conversely, Japan with financial assets of 657% of GDP but using the higher long term loan rates of 1% instead, would need only 6.6% of GDP to service its asset costs.  Prof. Victor Shih at the University of California, San Diego wrote in a recent report that “Total interest payments from June of 2016 to June of 2017 exceeded incremental increase in nominal GDP by roughly 8 trillion RMB.”

What makes this disclosure concerning is how extreme the numbers are. Even the FSB placed China among developed country financialization and well outside the range of other emerging markets. The new numbers place China on the extremity of all major economies behind only a major international banking center even in front of Japan who has run strongly expansionary monetary policy for years to try and push inflation.

Many analysts have raised concerns about asset bubbles and debt growth in China but even the most bearish would have had trouble believing this level of financialization.  Even the risks are more than hypothetical.  In bankruptcies or defaults, it is common to find enormous amounts of undisclosed debts or asset management products sold by banks to clients they are expected to make good even if technically off balance sheet.

There are a handful of key points to remember:

  1. We do not know what these assets hold other than three broad categories comprised of guarantee, commitment operations, and financial asset services which even then only comprise 79% of the total 253 trillion.
  2. These are not simply bank to bank flows. It is likely this number includes some financial to financial flow, but significant amount clearly out in the real economy.  The PBOC includes under these assets entrusted loans as well as guarantee operations both of which indicate real economy activity.
  3. Even if the off balance sheet assets are just bank to bank flows this actually makes the banking system worse. This happens because that means official bank borrowing is much higher than official data indicates lowering already strained capital adequacy rates to very concerning levels. Total on balance sheet bank capital is 15.5 trillion or 6.1% of the 253 trillion in off balance sheet assets.  If any sizeable amount of the 253 trillion in off balance sheet assets is lent to the banks for on balance sheet activities, this destroys the banks capital base.  In fact, depository corporations in China only list 28.6 trillion in liabilities to either depository or financial corporations.  So either the off balance sheet assets are not flowing to banks in large amount or official on balance sheet financial figures for China are wildly wrong with disastrous consequences. I personally lean to the idea that most of these assets are not flowing to banks but do want to emphasize that if you are going to make the counter argument, the implications are probably even larger and worse.
  4. There are two primary ways in China that assets end up off balance sheet. First, the Enron model. In this scenario, accounting sleight of hand is used so that SPVs are used so that an entity does not have to consolidate finances of entities it effectively controls. It should be noted that this does not mean that the bank or other institutions have done anything technically illegal, only that while control may legally lie elsewhere and finances are not consolidated up to a known parent, the financial risk never leaves.  Many bad debt management schemes are where a major bank acts as manager but holds less than the controlling amount so that they can claim the debt is off their balance sheet.  In some instances, they work with other banks who contribute the capital required to ensure the manager is not aggregating financials upwards.  I even know of some instances where the banks are buying debt from other banks where the clients who are the bad debtor are contributing the majority of capital as the bank buys bad debt from other banks as the manager of a fund.  The key point is that Chinese banks are technically meeting accounting requirements to move debt off balance sheet but not transferring the risk.
  5. The second most likely source is banks selling asset management products to other clients. These products are widely spread throughout the economy from corporate China looking to store cash for 30 days, wealth management firms, or individual bank clients.  What is important to note is that in this case, the bank typically does not technically/legally carry the legal risk of the product purchased by clients.  Most of the products are unguaranteed.  However, pragmatically, this simply is not an accurate assessment of the reality.  Take an extreme example.  Assume a significant portion of these off balance sheet assets sold, even say 10%, defaulted and went to zero.  This would cause a major problem.  Where we have seen large losses attempt to be imposed on retail type investors, they have almost always been bailed out.  Beijing and defenders can claim all day long that neither Beijing or the state owned banks guarantee these products but when Beijing starts imposing large losses on investors rather than bailing them out, then I will believe it. To date, that has not happened.
  6. It is important to note that given the size of these off balance sheet assets, this obfuscation of financial data has been occurring for many years. Even China does not go from 0 to 253 trillion RMB in one year. This implies that we need to rethink the entirety of Chinese development and finance since probably about 2000.  One truism has been that when true pictures of financial health are obtained, typically in a default, there is always enormous amount of undeclared liabilities.  We can no longer exclude that these are not isolated cases but as the PBOC has admitted, the norm rather than the exception.
  7. We do have some scant evidence of how rapidly this off balance sheet side of the banking system has growth. In the 2015 FSR, the PBOC listed off balance sheet assets at the end of 2014 as equal to 70.44 trillion RMB or equal to 40.87% of “Chinese banks aggregated balance sheets”. In the 2016 FSR, the PBOC said it was equal to 82.36 trillion RMB and equal to “42.41% of the total on balance sheet assets.”  The reason the 2017 exploded to 253 trillion was because “Starting in the first quarter of 2017, the PBC would count the off-balance-sheet wealth management products in banks’ total credit in the MPA framework, which would urge the banks to strengthen off-balance-sheet risk management, so that the macroprudential framework would be more effective when conducting countercyclical adjustment and guiding the economic restructuring.” Put another way, it knew the risks were there before but it was not reporting them. This means that we can assume the on and off balance sheet assets are two distinct pools of capital/assets and not overlapping as it might be rightfully asked.  This means the on and off balance sheet assets for Chinese banks total 232 trillion plus 253 trillion.
  8. The absolute size and growth of assets imply there will be enormous (as in Biblical) costs to deleverage. Let me give you a simple example. Let’s assume a flat rate of economic financialization by which I mean that nominal GDP and systemic financial asset growth are equal.  For our case here, I’m going to use similar but round stylized numbers.  In our world, financial system assets are equal to eight times nominal GDP.  Now, let’s assume that both financial system assets and nominal GDP grow at 10%.  In this stylized but similar world, financial system assets will have grown by an amount equal to 80% of GDP. If this both nominal GDP and financial system assets grow at 10%, by 2025, China will have financial system assets equal to approximately 1,900% of nominal GDP.  Because total banking system assets are so much larger than nominal GDP, simply growing both at the same pace will continue to lever up the economy.
  9. This might actually explain one unique data point which no one has a good explanation for, including myself. For a number of year, fixed asset investment in China has been above 80% of GDP.  Through the first three quarters of 2017, it is only3%.  It has been puzzling to many how FAI could top 80% of GDP even with the growth in debt that we saw. That was simply an amazing number.  Well if there was unseen asset growth of equal to twice official banking system assets, this would explain how FAI could comprise that amount of GDP.  However, this implies that China has been much much more dependent on credit and money growth to drive GDP than anyone, myself could have believed.
  10. This further implies that much of this economic boom has been driven by a hidden expansion of money and credit. As research has noted, it is much easier to stimulate activity with hidden monetary loosening than with expectations.  If the numbers the PBOC note are real, this would imply many years of hidden loosening.
  11. This further implies there is a large (read Biblical) asset bubble. At first glance this seems to match the data.  If we look at the data on the major asset for households, real estate in tier one cities is the most expensive in the world and even the average tier two and tier three city has higher per square foot price than most of the United States.  The median price in the United States for real estate is $139 per square foot. Tier two cities in China are currently $170 with Tier three cities a more pedestrian $110.  Using conservative extrapolations of national housing prices in China yield a current average price per square foot of $191 per square foot.  To provide some perspective, residential real estate in China is 38% more expensive on a price per square foot basis but nominal per capita GDP in the United States is 608% higher.  We could point to a variety of other assets which appear vastly overvalued but given the increase in financial assets appears prone to a significant asset revaluation.
  12. This also has significant implications for foreign exchange policy. It implies that China will maintain strict capital control measures in place for the quite some time. Let’s take a simple example that we could expand to other sectors of the Chinese economy. Assume that markets have pressure to equalize prices. Chinese citizens and firms have a very real interest in switching into similar foreign assets while foreigners have very little interest in switching into Chinese assets.  I have long noted that there is fundamentally, absent controls, a much larger structural non-cyclical interest in purchasing foreign assets by Chinese than in purchasing Chinese assets by foreigners.  Unless China is will to accept a much lower value for the RMB, they cannot allow change to foreign exchange policy.
  13. Though I am always loathe to bring politics into discussions about Chinese economic and financial policy because politics is too unknowable in China, I think there is a little worth commenting on here though this is mostly speculation. This nugget of information was dropped in the middle of a report in an almost off handed way.  However, the magnitude of the revelation is akin to saying over dinner “I just killed five people before I arrived would you mind passing the salad dressing?” The reason this matters is that PBOC head Zhou has been making the rounds talking about a variety of things like Minsky moments and slowing corporate debt growth. I don’t think it was any coincidence that this nugget of information was dropped into conversation as Zhou appears to be heading out the door and making the rounds using language he knows will raise concern.  While it is fair to question his reformist intent, how long he will stay, and other issues, he clearly knows that discussing these issues in this manner and dropping this piece of information raise concern. If I can speculate, it appears Zhou is trying to raise the pressure to reform, without burning it down.  It does make one think that the information was released to pressure Beijing.

There is way too much we do not know about the details of this revelation. However, it is without a doubt the largest and most altering revelation to come out of the Chinese economy probably this decade. It will require a major rethink to what we think we know about the Chinese economy, how it developed, and what the future holds.

I would like to thank Chris Aston who originally Tweeted about this in July from the website and the appropriately named Deep Throat blog who wrote about this topic and does great work on  a variety of issues who drove me to revisit this issue.  I originally chose not to write about this topic because the numbers were so outlandish I figured I had to seriously missing something that caused them to be much more normal.

Is China’s Import Surge Real?

People frequently assume that I believe you can reduce every Chinese number by some percent to arrive at the true number. However, what I tell them is that you have to dig beneath and understand the dynamics to arrive at a reasonable conclusion about what that number means and that it may be over or understated. Chinese import data is a case and point.

Chinese imports are up 17% YTD and are ripe for skepticism but in reality probably pretty accurate. However, besides the large increase which raises eyebrows, there is also the fact that payments for imports are up only 7%.  So how can we conclude that the import data is relatively accurate given the large jump in imports and the only moderate growth in payment for imports?

Import growth into China for the past few years has been flat or declining.    Flat in 2014, down 14% in 2015, and down 5% in 2016.  The 2017 growth we have seen for recent history is truly an enormous outlier.

For the past few years, Chinese importers were overpaying for imports by a relatively significant amount.  In 2015, the discrepancy between imports reported at customs and at bank payments amounted to $526 billion USD.  In 2016, this number had dropped to $271 with most of that decline coming in Q2-Q4.

This raises two specific possibilities focusing on customs reported imports. Either physical imports were under reported and payments were accurate or physical imports were accurately reported and payments were over paid.  Absent much more granular data, it is difficult to know for sure, but there is little reason to believe, for many reasons we won’t explore here, physical goods imports were under reported. This means that payments were overpaying for given level of imports.

Now in 2017, if overpayment was still a problem, we would expect to see payments go up by either a similar amount or even more. What we see however is the exact opposite. Payments have gone up by significantly less than imports.  To add to this, not only do we see payments growing much slower than trade, we see that the gap between imports and payments is only $146 billion USD and on track to report $220 billion for all of 2017.

If we believed that Customs reported imports were significantly and structurally under reported prior to 2017, it might be easier to believe that imports are over stated this year, but we have little reason to believe that.

Consequently, the moderate growth in payment actually supports the idea that Chinese import growth has surged significantly. Because import levels are moving much closer to the reported payment level, it indicates that Chinese inspectors are spending more time matching physical imports to what is paid for those imports.

Most importantly, this implies that Chinese crackdown on capital outflows primarily through gray market methods is working. It should be noted that this does no imply there is less desire, only that Chinese inspectors are doing a better job matching different physical and goods flows.  Conversely, it is likely, that Chinese import and payment data is much more accurate.

As I will say, you cannot just assume a given state about Chinese data.

Catching Up on the Chinese Economy

As we start the school year, I want to just throw a bunch of thoughts about the Chinese economy up about what I have been seeing.  We will resume regularly scheduled programming next week.

  1. The Chinese economy is headline robust in 2017. While I may spend more time pointing out the problems that are continuing to grow in China, make no mistake that the 2017 Chinese economy is robust in nominal and real terms.  We see this across a range of indicators and though we can always debate Chinese numbers, I don’t think it is any exaggeration to say that 2017 is a strong year economically for China.  There are however many caveats and important details that need to be remembered.
  2. 2017 is effectively an election year in China. In an authoritarian dictatorship, where one man/Party controls all levers of power, this makes it easy for the government to juice the activity.  This is what has happened.
  3. For all the rhetoric of deleveraging and reigning in credit or leverage, in reality, it has simply accelerated from 2016.
  4. What has happened is that where the credit is flowing has been diverted into different channels or sectors. Non-financial corporate has seen growth slow to more reasonable levels but financial corporate and households have seen credit boom. Even within the specific products, some have slowed growth dramatically but other have grown very rapidly. To me, while this buys time, it does nothing to change the ongoing risk buildup.
  5. What is driving the Chinese economy are all the sectors that they have said for years, that they wanted to move away from. Infrastructure investment, real estate, credit, and exports driven by an engineered currency.  There is no change in the Chinese economic model.
  6. There is NO supply side reform. It simply is not happening.
  7. Be wary of the China is reflating argument. Headline Pthis should be conPI is up pushing up nominal growth even as real growth has been bumped up a couple tenths of percentage points. Many have taken to arguing that the economy is deleveraging.  This in my humble opinion is a very flat reading of the data.  There is no broad based price inflation in China. The vast majority of categories in China have very low borderline deflation level price increases.  However, a small number of key input categories have very large say triple digit year over year price increases.  Coal and steel, though other base inputs have experienced similar price increases, are the major examples. What you have is, to use a statistics term, is a bimodal distribution, where most prices are just above flat and a couple of categories are extreme outliers.  You do not have deleveraging in the Chinese economy, you have deleveraging in base input industries like coal and steel.
  8. This price reflation appears to be driven less by economic fundamentals and more by financial flows that have been encouraged by Chinese authorities. This has entirely turned around the liability growth in base input industries like steel and coal and profitability but we shouldn’t confuse this for a revitalized industrial base.  Unless WMPs continue to boost commodity allocations, we simply will not see this level of price increase again.  The bigger problems are that these industries really are not rationalizing their capacity levels and that net margins are still tiny even after triple digit price growth.  Any fall in the traded price will have an enormous impact on profitability.
  9. I am not personally expecting any type of real slow down in the second half and leading up to Chinese New Year.
  10. I would personally be surprised if there is any type of significant crackdown on things like debt in the next year. While some have now been speculating, just like the first time Xi was crowned, that he would be an economic reformer  and crack down on risky activity, this should be considered purely speculative. Fact of the matter is any real restriction of credit growth, real estate, and infrastructure investment would crater asset prices. Think of it this way: mortgage growth is up 30% and real estate prices are up 10%. What happens if there is any significant slowdown in mortgage growth?

The headline numbers are distinctly better in China but the fundamental problems keep growing.

Reconciling Chinese Household Debt Statistics

So after my Bloomberg View piece came out citing a self generated statistic that Chinese household debt to household income was above 100%, I had a number of eagle eyed reader send me a piece from the South China Morning Post from the same day.  In the SCMP piece, they present a graph that shows Chinese household debt to household disposable income at just above 50%. Readers were wondering how could I explain the enormous discrepancy between my self generated number and the number that was cited in the SCMP.

This worry about household debt levels in China and the most common mistake is that people use per capita GDP rather than household income. For numerous reasons, there are enormous differences between per capita GDP and actual household income numbers.  Even this recent SCMP piece about the rapidly rising household GDP number mistakenly uses household debt to GDP rather than household income.

Before I explain the discrepancy, let me stress, I personally am quite accepting of differences in how to interpret the data and whether additional data changes our view. However, especially when focusing on China, presenting the most accurate data and knowing what it does and does not say, is something I take very seriously. So I was also personally intrigued by the discrepancy.

I cannot say with 100% accuracy how the SCMP figure was generated but I can come quite close.  The first data source cited is the Bank for International Settlements which generates a dataset with a figure for market value of household debt as a percentage of GDP. Though it does not specifically say, I would assume that GDP here is nominal.

There are a couple of points worth mentioning about this statistic.  First, the BIS figure on household debt as a percentage of GDP does not perfectly match the figure in the SCMP but it matches within at most 10%.  The BIS lists Chinese household debt as a percentage of GDP at 44.4%. The SCMP figure appears to be just a little bit above 50% and does not have a data label so I cannot say for certain. However, later in the article the writer claims that Chinese “household debt-to-GDP ratio is only 40 per cent” even though the BIS places it at 44.4%. Later the writes claims that Chinese “household debt-to-disposable income is 56 per cent” though again it is not entirely clear how this figure is arrived at.

What makes the authors figures even more suspect is the transformation into “household debt to disposable income by country” that he cites.  If we follow the sources used by the author, we are able to locate within the UN National Accounts data a gross household disposable income number which would appear to represent the number used by the author.

This is where the author appears to get the cited statistic and take amazing statistical liberties. The UN data indicates that in 2013 (the last available year in the UN data set) China had 35.7 trillion RMB of gross disposable household income (more about this specific number later). At the end of 2013, Chinese households had 19.7 trillion RMB of household debt. If we divide 19.7 trillion by 35.7 trillion we get a number of 55.1% which is very very close to the statistic used of 56%.

However, this number is grossly and intentionally misleading. The author never prominently notes that the data used on China, his primary subject, is from 2013. He only notes in the last note of the figure that “the rest are as of 2013”.  The author is writing about second half 2017 discussing current economic situation and never prominently mentions that the data he is basing his argument on is nearly 4 years old?  The authors intention was clearly to mislead readers rather than educate them as to what best available data tell us right now.

In fact, we have best available data right for the year ending 2016. If we take the PBOC data on Loans to Households we get a total of 33.4 trillion RMB in debt outstanding at the end of 2016 which is for all intents and purposes statistically identical to the BIS figure of 32.95 trillion. Now what we need to do is find recent data on the amount of disposable household income in China.  According to the National Bureau of Statistics China, per capita disposable income in China in 2016 was 23,821 RMB.  With an official 2016 population of 1.38 trillion, this gives us a total disposable income of 32.9 trillion RMB.  Next we take the total PBOC household debt number of 33.4 trillion and divide by the NBS number of total household income to arrive at a household debt to disposable income number of 101%.  If we extrapolate out through the first half based upon the rate of growth in disposable income through H1 and use the June 2017 household debt, this number comes in around 104-105%.

What is interesting is that even if we take the official Chinese data used to calculate household debt to household income ratio back in 2013, we get 79.7% not the 55.1%/56% number used by the author. So where did the SCMP and the author go wrong?

In addition to the misleading date, the author confuses a measure of GDP for household income.  The author uses a measure of household income with GDP measures that is based upon the estimated value of household consumption within GDP.  The reason this matters is that the NBS compiles other data on household income that shows relatively different numbers.  So far, I have been unable to locate the exact “gross disposable income” number in Chinese data that seems to be used within UN data.  This is used primarily in a form of GDP accounting that is not widely recognized from the expenditure approach.  I have however, been able to match the consumption number the UN uses to the NBS consumption expenditure within GDP data.  This

The NBS however, compiles survey data where they actually go out and conduct surveys on rural and household incomes rather than compiling it at a GDP level.  The UN data on gross disposable income collected via GDP overstates household income by roughly 43% according to the NBS survey data.  What is important is that this measure of income actually compiles data on income from all sources such as wages and salaries, transfers, and income from business and property.  Similarly the same data also compiles detailed data on the expenditure side with significant detail by category. This does not match identically but close enough the highly regarded China Household Finance Survey conducted by the Southwester University of Finance and Economics that we can take this survey data as much closer to reality than the 1993 methodology using headline GDP data from 2013.

The fundamental problem is that the author uses headline GDP data for household income rather than that survey data on what households actually make.  It should be noted though that the use of 2013 data is misleading.  In both fundamental data errors, there is significant laziness when significantly better quality and newer data sources exist.  The household debt levels for Chinese households is above 100% of household income.

Is China Deleveraging?

Short answer: no and the trend is not towards deleveraging.

A major focus of China watchers is whether China is deleveraging.  Like many questions, it is not 100% straight forward based upon the available data, but on balance we have to say. Let me explain.

  1. Despite all the talk of “deleveraging” and how China is restraining liquidity, this simply isn’t borne out by the data. In fact, in many area, leverage is actually growing very very rapidly.
  2. What is confusing the issue for many people is what is and isn’t growing. Conceptually, most people without realizing it expect a bell curve to represent growth and then the average of the bell curve moves up or down.  However, in this case, that is not what is happening.  Consequently, deleveraging gets confused.
  3. One of the biggest mistakes, in my opinion, is the most common citations of debt are to “non-financial corporates”. The BIS uses this as their primary measure of debt levels for instance.  In China think manufacturing and real estate firms.  By that measure, there is a degree of deleveraging.  From H1 2016 to H1 2017, total loans to NFCs was up only 8.5%.  While this is not absolute deleveraging, it is nominal deleveraging in that if we take a simple measure say nominal GDP growth which was 11.4%, debt did not grow as fast as nominal GDP. For various, reasons, this would not be my optimal relative metric but for our purposes here it works fine.  This is a small victory but it needs to be considered a small victory.  Chinese corporates remain enormously stressed.  Small victory but keep it in perspective.
  4. It has even been pointed out that total social financing (unadjusted for local government bond swaps a very key non-adjustment) as a percentage of nominal GDP actually fell by 0.2% in the last quarter. Given that bond swap adjustment will add 2-4% to the TSF, this is not an insignificant adjustment.
  5. The biggest problem with the deleveraging argument however is that it is basing upon nominal GDP growth. This is not an insignificant problem but an atypical one.  Nearly the entirety of the surge in Chinese reflation is due to the surge in base inputs like coal, steel oil, and similar metals and commodities. Chinese CPI and retail price index (RPI) are up 1.5% and 0.9% respectively.  Business focused price indexes like corporate goods and producer prices reveal the entirety of the surge in price levels is on mining, coal, steel, and related industries. All others are near flat.  Metallurgy, coal, and petroleum in the PPI are up 17.4%, 35.9%, and 9% respectively. The average GDP deflated from 2014-2016 was 0.64 while in 2017 it is 4.61% and 4.25% through the first two quarters.  The triple digit price gains in traded commodities pushed up nominal GDP growth but is highly unlikely to experience another triple digit surge. Consequently, the price level of these commodities is already falling peaking at some point within the past few months.  We can expect it to keep falling over the remainder of 2017 changing the deleveraging argument fundamentally absent major drops in financing.
  6. Another factor of what we see is the surge in non-corporate and quasi-off balance sheet financing. Loans to households and portfolio investment by banks (read WMP holdings) grew by 23.9% and 17.1% compared to the more pedestrian 8.5% growth to NFCs.  Nor are these numbers small. Household and portfolio investment combined are now  13% larger than loans to NFCs and growing at a combined rate of 20%.  In other words, China maybe slowing NFC growth but other areas are simply exploding and now responsible for a greater share of the debt burden than the part everyone focuses on.  To put the level of household debt in perspective, household debt in China is now equal to 104% of household income and growing 24% annually.

While the deleveraging story in China is not uniformly and entirely bad, there remains no fundamental focus on deleveraging.  Furthermore, the trends are such that even the glimmer of hope due to nominal deleveraging from surging commodity prices and slowdown in non-financial corporate debt seem likely to fade as other sectors build up debt levels rapidly and prices fall back due to the base effect.  It seems we need to wait a bit longer for real deleveraging.

Is the PBOC Fudging FX Reserve Numbers?

There has been a quiet growing discussion about the accuracy of official PBOC FX reserve numbers.  The internal data discrepancies are becoming simply too large to ignore.  Let’s break this down.

Between November 2016 and the June 2017, official PBOC FX assets are effectively flat. $3.052 trillion in November, they stand currently at $3.056 trillion for an official increase of $5.2 billion.  This has largely been greeted with a sigh of relief in international financial markets but there are good reasons to look closer at these numbers.

Let’s start with the change in bond yields.  On October 31, 2016, 10 year Treasury yields stood at 1.84% but had jumped to 2.37% on November 30, 2016.  From October to November, FX reserves fell by $69 billion. Given that the increase in interest rates would have resulted in an estimated mark to market loss on band value of $100 billion if we estimate that roughly two thirds of the PBOC FX reserves are in USD fixed income primary government securities, this does not match up perfectly but at least we are in the neighborhood.  Since the end of November, 10 year Treasury yields have traded in pretty tight range, so for our purposes, let us posit that there is no USD bond valuation discrepancy but hold on to that $31 billion difference for later.

Now let us assume that the remaining $1 trillion in PBOC FX reserves is in EUR denominated government debt.  From October 31, 2016 to November 30, 2016, German and French 10 year government rates went from 0.13% to 0.47% to 0.2% and 0.76% respectively.  If we split that difference, that results in a roughly $20 billion bond valuation loss. Additionally during November, the EUR lost roughly 4% against the USD, as did the other primary reserve currencies.  This should have imposed, using our albeit rough estimate, of $1 trillion in EUR denominated holdings, additional losses of roughly $40 billion.

There is one additional point to make about the month of November. The PBOC reports being net seller of FX to the tune of roughly $33 billion in November.  Taken together we have bond, currency, and net sales (we will return to the net sales issue in a moment), of $193 billion while the PBOC registered a decline of officially declared FX reserves of only $69 billion.  This is only for one month.

If we carry this general framework forward, what is notable is how stable the FX reserve portfolio should be. On November 30, 2016, 10 year Treasury yields were 2.37% and on June 30, 2017 they were 2.31% touching 2.37% just a few days later.  In short US Treasuries at intermediate durations have traded within a pretty tight range.  For our purposes, let us assume that there has been no valuation change to the US bond portfolio.

Most Euro denominated government yields continued to climb moderately during this time.  German 10 year bunds rose 0.3% and Italian 10 year yields rose about 0.35%.  This would result in a bond valuation loss of about $25-30 billion USD.  However, during the same time the EUR rose against the USD by about 7.8% which turns that $25-30 billion loss into about a $45 billion gain in USD terms for the Euro denominated portion of the portfolio.

While the asset value of the PBOC FX reserves, registered roughly a $45 billion gain, the PBOC was also net FX sellers to the amount of $120 billion.  In other words, there is an unexplained $75 billion in the PBOC FX reserves.  If we add in November, this really raises the discrepancy.  Since the end of October 2016, the PBOC incurred FX reserve decline of $64 billion, but also spent $153 billion of FX reserves and incurred estimated valuation losses due to interest rates and currency movements of $110 billion.  In short this means, that even though there are verified and estimated PBOC losses totaling approximately $263 billion, FX reserves only declined by roughly one quarter this amount or $64 billion.  This is a discrepancy of approximately $200 billion.

This raises two specific possibilities. Either the PBOC is engaging in some unique accounting or China is drawing on other sources of FX to prop up the RMB.  Based upon available evidence, it seems most likely that China is drawing on unofficial sources to prop up the RMB.

It is worth noting that in December 2015, China stopped publishing data that accounted for bank capital available for FX purchase.  Consequently, we have to draw from other variables that might reveal evidence of propping up the RMB.  Fortunately, they are sources available which give us a solid basis for comparison.

First, we have a data from the PBOC called the Net Foreign Assets from the Overview of Depository Corporations.  What is interesting with this data point, as we can see in Figure 1, is how closely it matches up with the previously ceased data Bank position Available for FX purchase.

Figure 1

The Net Foreign Assets data shows a continual and significant drop.  From October 2016 through May 2017, the total drop in net foreign assets was 1.1 trillion RMB or at current exchange rates $159 billion USD bringing us much closer to this estimated $200 billion discrepancy noted above.

What makes this 1.1 trillion decline in net foreign assets is the primary source of decline.  Another data point we can draw from is something denominated in RMB but which has been published since January 2016, notice break from December 2015, which is drawn from the Sources and Uses of Credit Funds of Financial Institutions dataset and is categorized as “Funds Uses: Foreign Exchange”.  From October 2016 to May 2017, the RMB balance here declined by 993 billion RMB or $146 billion.

While there are numerous other ways we could make this case, I will leave you with one more.  The PBOC maintains another dataset on the External Balance Sheet of the Banking Industry and is reported quarterly.  The data point Net Foreign Currency Assets of the Banking sector from September 2016 (remember reported quarterly not monthly) to March 2017 (June data for this dataset will not be available for a few months) declined by $43 billion.

Consequently, if we average out the Net Foreign Assets number and Funds Available for Foreign exchange number, a reasonable assumption extrapolating backwards, this leaves us $3.47 trillion at current exchange rates in capital to defend the RMB. After removing the PBOC official FX assets, this would imply there is roughly $416 billion in unofficial FX assets available.  This would imply based upon current rates of net sales, which appear to come primarily from banks, that within the next  9-18 months, the RMB will have to start drawing primarily from PBOC reserves rather than bank positions.

Though I have tried to be faithful, let’s assume I have mildly overstated the FX discrepancy and there is some statistical noise here, this would match the decline in foreign assets quite closely.  What is important to note here is this: China appears to be using third parties to prop up the value of the RMB.  What is interesting is that this decline in net foreign assets does not appear to be driven by the usual suspects of the major SOE banks like Bank of China and ICBC.  The net foreign asset position by large commercial has actually grown significantly implying there is some large sector of financial institutions propping up the RMB by depleting their foreign exchange reserves by a very large amount.  It is not entirely clear where this decline in net foreign assets is taking place because it is not taking place at the PBOC or large state owned banks.

What is most important is that the PBOC appears to be shielding itself from the worst of capital outflows by enlisting quasi-public entities to prop up the RMB though at the current rate of decline, this has a limited shelf life before the PBOC will need to be the primary institution.