Follow Up to the Question of Chinese Foreign Exchange Reserves

As usual, I want to do my follow up to the BloombergView piece about whether the $3.3 trillion in FX reserves is adequate.  I normally reserve what I do here on my blog as a more technical exposition on the ideas presented in the BV piece, so as always, start there.

  1. Many people make the assumption that the only thing FX reserves are used to do is defend the currency. That simply is not true.  FX reserves serve numerous other purposes acting like a bank account for the country.  Paying bills that come due in other currencies is the primary issue.  When you have a fixed currency and capital controls, the central bank has to provide the liquidity unlike in a floating regime where participants can just go to the market and buy whatever currency they need.
  2. Many people make the erroneous assumption that FX reserves can be taken down to 0. Again, not remotely close.  Because FX reserves serve multiple functions and are used in different ways, they cannot be taken to zero even if the government wanted to.
  3. China cannot take its FX reserves all the way down to zero. Doing so would essentially bring a halt to any international trade.  One item is international trade.  A comfortable amount is FX reserves equal to about 3-6 months of imports.  China currently imports almost $200 billion USD a month so let’s assume for round number sake, they need $800b-$1 trillion in FX reserves just to grease the wheels of international trade.
  4. Then lets add in the official numbers of what China classifies as “external debt” which they list as $1.5 trillion of which they classify $1 trillion as short term. It is worth noting that the BIS and IMF IIP data list China as having about $1.1 trillion with similar split in maturity.  If we assume that approximately $750b-$1t is coming due in 2016, that gives us another number to add to our list of what the FX reserves need to accomplish.
  5. For 2016, we are already up to say $1.5-2 trillion is needed in 2016 for foreign currency needs. Between just paying bills and having liquidity to engage in international trade, China needs about $1.5-2 trillion in FX reserves.  We could move it a little lower by taking on some more risk, but you can’t move it a lot lower without increasing your risk very very fast.
  6. Now let’s add into the equation that the PBOC has illiquid assets of about $1 trillion USD. These are tied to a variety of different commitments, but the PBOC has about $1 trillion linked to investments and holdings that they cannot easily access to defend the RMB.
  7. We are now at $2.5-3 trillion USD in reserves that are semi-in-use or committed elsewhere.
  8. When people say the PBOC has $3.3 trillion and years of defense left, that simply is inaccurate. They have to have liquidity to engage in international trade and pay the 35% of global EM debt they owe.  They cannot take $3.3 trillion to zero without creating a truly enormous crisis.  There are commitments before then that come with numbers.
  9. Add in, there is a lot more money leaving China than entering right now, and it becomes quickly apparent how serious the situation is.
  10. The PBOC spent a little more than $100b in December and began slow walking FX requests.  While there has been month to month fluctuations, the long term trend of capital outflows is clear and accelerating over time.  There is no obvious trigger that would cause the outflows to stop or reverse.
  11. If we take the numbers presented here that the PBOC has commitments of say $2.5 trillion, that means at current rates, the RMB peg/basket as we know it has less than one year of shelf life left. In other words, the PBOC will have to either impose hard capital controls (70%) or float (30%).
  12. One very important factor here is that the capital outflows out of China are clearly domestically driven. There is not one shred of empirical evidence that this is driven by international investors.  In fact, international investment via FDI and portfolio flows continues to hold up even in a rocky 2015.  The inflows were not as large as in previous years but they do continue to grow.  Pressure on the RMB is completely, entirely, 100% driven by domestic investor capital flight from China.
  13. The reason the composition of funds leaving matters is that this is not a temporary issue. This is been going on for more than a year and picking up speed as it goes.  This is not hot money these are not international investors looking for quick buck these are Chinese citizens and firms moving their money out of China at least semi-permanently.   Definitely more than a simple short term vacation.  That means this is a structural issue that will not be fixed with temporary solution but is structural and long lasting in nature.  Which means….
  14. Get used to this new normal. It isn’t changing anytime soon. Capital will not come flooding back. (Would you send your money back to China?) Deal with the situation and don’t pretend it isn’t happening.

Follow Up on why Capital Controls Isn’t a Good Idea for China

Here is my regular follow up to my work for BloombergView on why capital controls are not a good idea for China.  I write these follow up pieces for my blog only because due to space considerations I may not be able to get deep enough into ideas as I would like.  Very thankful to Bloomberg for giving me the platform and my editor Nisid Hajari makes me sound better than I really am, so always start there before coming here.

Before I launch more specifically into why I do not think capital controls are a good idea, I want to note two further background points.  First, I am a business school professor so I will admit to having strong leanings towards free markets.  However, I think I am also pragmatic and realistic enough to be able to examine situations on their merits.  I am also willing to change my mind if superior arguments are presented or if situations change. I know markets are not perfect or can sometimes be irrational, for instance, you do not need to convince me. I just want to confess my bias but note that as you will see, I think my arguments here are distinctly more pragmatic and empirical than ideological.

Second, this piece was driven by a number of articles I saw in the past week calling for or strongly suggesting capital controls for China.  The Economist, Financial Times, and Bank of Japan have all suggested that China should impose capital controls to prevent a further slide in the RMB.  This is primarily a response to those pieces. Now, let us begin.

In my personal opinion, the arguments I are codswollop which is British for non-sense (I’m currently in London and trying to learn the language).  Let me detail why in no specific order of importance.

  1. Many people have assumed that since the IMF admitted that capital controls had some place in global financial flows, they could and should be used much more widely. However, this betrays a very poor understanding on many levels of what the IMF actually said.  The technical parts of what the IMF actually said are vitally important.  The IMF said that capital controls could be during periods of crisis on a temporary basis focused on slowing or restricting outflows of international money from previous periods of large inflows.  There are many important things there.  The could means that it is not required or necessary but may depending on circumstances be useful.  The IMF does not suggest making capital controls a knee jerk reaction. It also said capital controls should be limited to periods of crisis.  I am pessimistic and concerned about the Chinese economy and finances for empirical reasons but I have to ask: what crisis? An economy not growing at 7% is not a crisis.  A country with downward pressure on its currency is not a crisis. I could write this list all day long but the point is, if you are arguing that China right now should impose capital controls, there is virtually no country on the planet you wouldn’t be able to make the same argument for.  It is an awful precedent to recommend countries impose capital controls because their economy isn’t growing quite as strong or because their currency declines.  (I am going to focus on the other parts of the IMF recommendations later). The important point is that it betrays a very poor understanding of what the IMF actually said and how to apply that to the real world even if you are recommending capital controls.
  2. I have two fundamental objections to the arguments for capital controls that I have heard so far. First, I don’t believe capital controls will address the problems that need to be solved or even the problems raised by those arguing for capital controls. I will get into the specific arguments shortly, but I mean simply if you need to fix your knee you don’t operate on the shoulder.  The arguments all seem to fall back on capital controls with no clear link to whatever problems they see as needing to be solved.  Second, I do not believe that capital controls have any realistic chance of success.  Even if we assume a tenuous link between capital controls being able to solve a specific economic/financial problem, it is important to ask, what are my expected chances of success by using a specific policy?  In virtually every case, for multiple reasons, one would have to believe, the chances of capital controls resulting in a successful outcome is exceedingly low.
  3. Now let me turn to some of the specific arguments. Bank of Japan governor Haruhiko Kuroda called on China at Davos to implement stricter capital controls. I only have access to the FT article on what he said so if there is more nuance or detail not captured, I apologize in advance. The FT writes the following about his comments:

“Mr Kuroda suggested capital controls would allow Beijing not to waste its foreign exchange reserves defending the currency while allowing its domestic monetary policy to stimulate consumption at home. ‘Capital controls could be useful to manage [China’s] exchange rate as well as domestic monetary policy in a constructive way,’ he said.”

Noting the use of FX reserves, capital controls, and monetary policy is implicitly the widely known trillema.  He is essentially saying to manage that contradiction, China should use more monetary easing and impose tighter capital controls.  By using more monetary easing, Kuroda, and this is the important part if we are asking what will be accomplished by a policy, says this will stimulate “consumption at home”.  Just on the face of it, I believe it is highly unlikely that monetary easing in China will stimulate demand to any significant degree.  Just as a point of economic theory, it is tenuous at best to say that imposing capital controls would boost domestic consumption.  If people are scared by the future due to capital controls and economic concern, they are not going to engage in a consumption spree.  The link between those two things is very weak. If we break this up into consumer and business consumption and introduce empirics, we can see what we mean.  Business demand is very low and being propped up primarily government driven stimulus projects.  Loan demand is low and continuing to fall even as the PBOC has lowered interest rates.  This is due primarily to surplus capacity.  Very hard to see how capital controls will impact this.  Looking at consumer behavior, it might shift existing consumption to domestic producers, however, given the low single digit growth in consumer product output and sales, there is little reason to believe that imposing capital controls and lower interest rates would prompt a consumer rebound.  A weak labor market which continues to deteriorate, simply won’t give people reason to go spend money.  I see very little link between imposing capital controls and boosting consumption and even less chance of success.

  1. The Economist in three separate pieces (here, here, and here) argue in favor of capital controls in China. What I find most puzzling is that they do not make a strong argument as to what problem capital controls would solve.  Honestly, it feels like they are not even convinced capital controls would accomplish much and that they are arguing for capital controls out of laziness rather than conviction.  In one piece they argue that depreciation would “puncture the PBOC’s air of invulnerability.”  First off, what’s wrong with the RMB falling? (more on that later though). Second, the PBOC air of invulnerability is lying in tatters by the side of the road having been run over multiple times.  Probably only the CSRC and NBS have worse reputations in Beijing policy making.  The problem here is simple and will not be easily fixed.  The PBOC has very little credibility and has let the RMB fix out of the bottle.  If they behave like the CSRC in the past 8 months, trying to make small commitments to deal with the problem, the RMB problem will linger on, consume lots of capital to its defense, and most likely still lose in the end. Not a winning strategy.  The Economist elsewhere argues that capital controls would give China “freedom to clean up the country’s bad debts and push through structural reform”.  There are numerous problems with this argument.  First, this is not remotely close to “temporary”.  Banks have recently gone public with bad debts from the lending binge more than a decade ago.  Second, there is absolutely no evidence that Beijing and banks are taking concrete steps to address the bad loan problem.  Credit continues to expand at approximately twice the rate of GDP, companies continue to get bailed out despite a small rise in the number of defaults, and even Chinese bankers admit NPLs are radically understated. To their credit Beijing has now said they want to “deleverage”, there is however, no concrete evidence of steps to address this. Policy needs to be made on evidence and facts, leave hope and faith to theology.  Third, unless there is concern that capital outflows will create a liquidity crisis in banks, something that cannot be ruled but it is not currently happening or the most likely, it is unclear how imposing capital controls would prompt this change.  The causative link between imposing capital controls and prompting better bank management is weak at best.  In fact, lots evidence points to the idea that more financial repression would inhibit restructuring and reform.  The problems Beijing is facing were created by Beijing through financial repression, not international investors or market forces bubbling, but by Beijing financial repression.  Seems unlikely even more Beijing financial repression will solve this problem.  Finally, they argue that imposing capital controls would help Beijing “prepare financial institutions for currency volatility”.  This is a specious argument for third very empirical reasons.  First, Chinese firms already deal with currency volatility they just do it in essentially an n-1 world. By that I mean, they already deal with currency volatility in the trade weighted currency basket for all currencies except the USD.  The Euro, the Yen, the GBP, etc etc are all managed for currency volatility. The USD is the biggest but it is blindness to think Chinese firms do not deal with currency volatility.  Second, Chinese firms owe relatively little in absolute terms of foreign denominated debt and it is shrinking everyday and international firms hold in absolute and relative firms, little in the way of liquid Chinese assets (this excludes FDI assets like plants).  In other words, foreign investors even if they really wanted to, won’t be impacted by capital controls.  Third, if as Beijing is proud to announce and push, international transactions with China are in RMB, this essentially pushes the currency risk to the foreign party rather than the Chinese firm.  The Chinese firm is has both its expenses in RMB and sells in RMB.  This lowers, does not eliminate but lowers the risk to Chinese firms.  In short, the arguments presented by The Economist are weak at best.
  2. Even the Financial Times has decided to toy with the idea of capital controls writing. To be fair, they just toy with the idea and do not seem convinced by the arguments.
  3. There is one last piece that just got sent to me written by former PBOC Monetary Policy Committee member Yu Yongding where he advocates “reinforce(ing) the Chinese governments market oriented reform plans and allow the RMB to float.” To briefly sum up a good piece, the path has been set and since we know the destination, all other options just delay the inevitable with large costs. It would be best to move there deliberately, carefully, but quickly.
  4. There are a number of economic points that are vital, to reincorporate the earlier points from the IMF and one that was also noted by the FT piece. It is important to understand the nature of the outflow.  The IMF is worried about outflows from large destabilizing inflows.  The current capital outflows leaving China are not due to previous rapid/destabilizing capital inflows nor are they due to international investors.  This is a vital and  absolutely fundamental difference to understand.  There was no large international investor capital inflow into China and the money leaving has very little to do with international investors.  Most international investment in China, overwhelmingly so actually, is in the form of FDI.  We do not see that this FDI is being sold off or used up and transferred out.  International investor portfolio asset holdings are tiny in relative terms and have not changed nearly enough to make any appreciable impact.  The capital outflows are driven almost entirely by Chinese citizens and firms voting with their RMB.
  5. This seemingly simple and straightforward conclusion however has a number significant implications. First, do not compare China to Asia 1997.  Stop now. Do not say Malaysia, South Korea, Indonesia, Thailand.  The details of the financial flows are radically different.  There are some similarities due to the rapid expansion of credit/investment, but the prescriptions need to be crafted individually for China.  Second, the capital outflows are most likely not short term outflows but rather a structural shift in capital flow directionality.  The IMF argument about capital controls can be understood if “short term” capital inflows have suddenly reversed causing “short term” capital outflows leading to a disruption.  However, we know that there were essentially no short term inflows that have reversed.  The outflows being driven by Chinese citizens and firms are going to buy real estate and outward foreign direct investment (as simple examples).  Neither of those are remotely close to being considered short term outflows.  Capital leaving China is likely leaving essentially permanently.  Furthermore, this trend is most likely unlikely to see a reversal anytime soon.  In other words, the capital outflows are not going to reverse and turn into capital inflows anytime soon.  This is another reason why the “temporary” moniker seems to make little sense. If the outflows were temporary or purchasing temporary external assets, there is some justification, however, neither holds here.  It is worth noting that China is now the largest exporter of immigrants to the United States and most likely other countries also.  This is not a temporary phenomenon. Third, if the East Asian crisis could potentially be thought of (in very crude, overly simplistic terms) as countries that liberalized their capital accounts too quickly and then gorged on available capital, China is almost the opposite.  The imbalances are caused by a closed capital account gorging on capital because the money supply and credit, due to current account sterilization, grew so rapidly to such enormous volumes.  If restricting capital account openness was the recipe for countries that had opened their capital accounts too much or too rapidly, it would seem to push openness for China that hasn’t opened its capital account.  Fourth, the somewhat amusing cliche coined by Tracey Alloway of Bloomberg that has been coined is the “giant ball of money” that rolls between asset classes pumping up prices until it moves on.  This is due to the closed capital account where capital simply cannot be used effectively.  It pumps up prices until that goes out of style and moves on to other classes.  Loan demand is down because there simply are no good projects because China is so overbuilt.  In the past decade China has expanded money supply at enormous rate even after accounting for official real GDP growth.  We see this in elevated asset prices across China that money supply has rapidly outpaced the real demand.  This furthers this idea that the outflows are very unlikely to be temporary.
  6. There is one final point that is very important and that is how much would a fall in the RMB matter? I am only going to focus on China here as this is an issue you could many very long papers or books about and I am already quite far into this.  I am honestly much more sanguine about the possibility of a lower RMB.  Let me give you a number of reasons.  First, most economies against the USD have fallen in the past 12-24 month pretty substantially and surprisingly, the world continues to spin on its axis, commodity dependent EMs are battered but that is due to falling commodity prices from surplus capacity and weak demand, with the significant problems less related to USD than other problems.  DMs like Japan and Eurozone have fallen against the USD with almost no discernible impact on economic outcomes directly attributable to exchange rates.  Taking Japan as one example, the Yen has fallen significantly against the USD in the past two years and there has been virtually not discernible change in trend economic data.  You would be hard pressed to say any changes are anything other than statistical noise.  Second, if we look empirically at China’s trade, any RMB fall would have a relatively muted impact on imports.  Speaking simplistically, let’s classify Chinese trade as processing for re-export, commodity, and other assuming it is all for consumption (it’s not but work with me).  The re-export and commodity imports will largely be unaffected by any change in the RMB, for different reasons though.  This would likely leave at most let’s say 50% of exports up for grabs in our analysis.  Since China already produces most the mass market products its consumes, whether it is cars to shoes, there is little reason to believe this consumption will be impacted and if anything will cause consumers to shift to domestic producers as imports become more expensive though likely a very small effect.  People or firms on the upper end of the scale will still buy luxury products or specialty goods at a higher prices point as they tend to be less elastic in their purchasing decisions.  In other words, while a fall in the RMB will undoubtedly bring additional pressures and stresses, it seems poorly informed to believe this would create a crisis or anything resembling such dislocations.  Third, as I have already covered for BloombergViews, I believe it is very unlikely that a fall in the RMB would result in any sustained boost to trade or growth in China.  Fourth, if China wants to become a major international currency, which I am still unsure if they understand what that entails, they absolutely must allow capital outflows.  This doesn’t entail profound economic insight to understand: how can the RMB become a major international currency if there is no RMB in the rest of world and no one outside of China can use it?  Fifth, currencies rise and currencies fall.  That’s what they do, are supposed to do and should not be forgotten.  Many people even international economists with regards to China, and really most similar situations, develop a degree of analytic Stockholm syndrome adapting the arguments of their kidnappers regardless of how non-sensical.  As capital has left China and the RMB has declined, with no true crisis in sight, smart people are running around like chicken little calling for capital controls.  It would definitely mark a change if the RMB floated, but that’s it.  Most major currencies have fallen against the USD because of underlying economic issues and the streets of Tokyo remain oddly untouched by pillaging, fire, and villagers storming the castles.  To have this degree of fear you would have to believe that China is an enormously fragile economic state which implies you don’t believe the finances or economic data.  Very real possibilities, but avoid adopting the Chinese mantra of stability above all else.  Sixth, the Chinese are moving capital out of China because they see long term economic problems.

I apologize for the length of this but I wanted to address some of these issues in a more detailed and technical manner.  Once I got going, I was like Skynyrd on Free Bird.    Balding out.

Follow Up to Bloomberg on Chinese Devaluation

As usual, I want to provide a little follow up to my BloombergView piece on why devaluing the RMB won’t solve Chinese economic problems.

  1. I am not saying that the PBOC and Beijing should defend at all costs the RMB if there is a large sustained outflow of capital. A lower RMB may very well be in the future of China.  The futures market certainly thinks so and based upon the creeping capital controls, it is likely Beijing sees the same events unfolding.
  2. I am saying that it is an enormous mistake to think that a lower RMB will kick start the Chinese economy and restore peace and justice to the universe to grow at 10% annually again. Simply won’t happen.
  3. This is most empirical reasoning much of which I outline in the piece. For instance, though a large trading country in absolute terms, it represents less than a quarter of the entire economy.  Consequently, even if it grew fast, it would represent a small fraction of the overall economy.
  4. Given the large amount of processing trade and reliance on imports to build other exports, a not insignificant amount of the gain to export volume would be eaten up by more expensive imports. Exports might become cheaper, but that means imports are more expensive.  When you need both to trade, you’re not gaining nearly as much as you think.
  5. Given the products China exports, still very reliant on low value products, China needs to compare itself to Indonesia, Vietnam, Thailand and Brazil not its basket of currencies. The basket is comprised primarily of USD, Yen, Euro, etc.  Ask yourself this, though how many Mercedes (or high value cars) does China export? Not many.  The Chinese export basket is still dominated by low value products like garments and electronics assembly.  Changing yes but still dominated by those products.  Consequently, demand for those products is rising but definitely slowly.  This has two enormously important implications.  First, Chinese exports can only increase rapidly by taking market share from other EMs.  This has been happening in recent years but simply not fast enough to push trade.  When global trade was rising rapidly China was a significant beneficiary.  Now with global trade growing slowly, China can only rely on exports by taking market share in large amounts from other EMs.  Second, which flows directly from the first point, is that to drive exports, the RMB would not need to fall against its basket of USD, Yen, EUR, but rather relative to a basket of EM currencies.  That means that to regain competitiveness against its largely EM competitors, it would need a very large devaluation.  Let me give you a simple example.  Let’s assume that all currencies were at an index value of 100, EMs and China in this case.  Over the past year let’s assume that the other EMs have drifted downwards so they are now at 80 (indicating weakening) while China remains at 100 compared to its basket of mostly DM currencies.  For China to regain cost competitiveness against other EMs, it would need to drop to say 70 or 60 before there was a significant benefit. (I want to emphasize, these are just simple numbers to illustrate the point, not intended as a currency forecast).  As other people like Paul Krugman and Bloomberg’s Tom Orlik have pointed out, a mildly weaker RMB will simply have no impact on trade.  Tom Orlik has estimated that the RMB would need to fall to at least 7.7 TMB/$ before there was an appreciable impact on trade.
  6. Given the level of debt, as foreign debt represents a very small percentage of the overall whole, the deflationary spiral is very difficult position for China. Without stimulating some type of inflation, the debt deflation spiral China finds itself will be very difficult to solve.
  7. The problem is that loosening monetary policy only pushes money out of China. The PBOC has recognized this problem and rather than lowering interest rates or RRR, they are trying to push liquidity via reverse repo injections.  I see that as another band-aid over a gunshot that likely solve a short term problem but nothing to solve the real problem.  The more it loosens, the more pressure it places on the RMB.
  8. As I wrote in a previous BloombergViews piece, though it goes entirely against monetary orthodoxy, I would argue that if China wants to stimulate inflation, it should raise interest rates and be prepared to deal with a not insignificant number of firms.
  9. The overall problem is that China is no longer left with good and bad options, but an array of bad options. The policy options are dwindling.  Everything they are doing is really just placing a band aid over a gunshot wound.  The latest is to limit MNCs taking money out of China.   That’s not exactly the way to encourage more investment.
  10. Capital outflows are a Chinese phenomenon, not a foreigner or hedge fund problem.

Data Diving on Inflation

So now that we have had some new data releases and I am back from vacation, we get back to what I still consider the meat of this blog, focusing on the data of the Chinese economy.  I have developed a general rule of thumb that if you a read about a Chinese statistic in the headline of a news article, it is most likely heavily manipulated.  To rephrase this slightly, if it is top line data, it is heavily manipulated.   One of the problems for people who have not spent enormous time looking at the data is that, to give credit to Chinese artists, they are very skilled at manipulating the data in a variety of ways that can make it difficult to detect.  Many times, you can only detect the manipulation looking at much more granular data, which in all fairness, simply aren’t available to most people. However, in some cases, even just looking at granular data on the NBS website and comparing it to top line data that should be a summation of lower level data, one can see the discrepancies.

One of the biggest ways that Chinese officials manipulate real GDP growth is by manipulating the pricing indexes.  There has been recent skepticism about the unchanging nature of the PPI flattening at 5.9% over the past few months given the continuing price declines in a range of products.  However, for the moment, I want to focus on the CPI basket weighting.

When building inflation rates, one of the key questions is how to weight each and every product of the basket.  Ideally, you have lots of micro-level data that gives you a very clear idea of how to weight individual products and classes of products.  For instance, food prices should still comprise a major portion of the CPI and budgetary basket as despite Chinese economic development, it still comprises a significant portion of most people’s spending.  The CPI weight should closely resemble people’s spending habits.

There is one other thing that impacts how we want to approach the Chinese CPI basket, there is something called Engel Curve that should provide us a good basis of comparison about how people spend their money.  The idea is really pretty simple in that the more money a household or country makes, the less they will spend on food as a percentage of income.  It is really quite intuitive.  Assume you make $1,000 per year, you will probably spend a pretty high percentage of your income simply keeping yourself nourished.  Now assume you make $100,000 a year, you will probably  spend a higher amount of money in absolute terms, say $500 increased to $2,000, but you will spend a significantly lower percentage on food in absolute terms, going from say 50% to 2%.  As households and countries become wealthier, they will spend less as a percentage of their income on food.

Emi Nakamura and Jon Steinsson of Columbia, currently on leave at MIT, have actually written a paper studying the Engel Curve and Chinese households (PDF).  They write about recent Chinese inflation that “official inflation rose in the 2000’s, but our estimates indicate that true inflation was still higher and consumption growth was overstated over this period.”  If true inflation was higher this would mean that real GDP growth was in reality overstated.  In addition sound empirical and theory based research that inflation is significantly underestimated, we can again look inside the Chinese inflation data calculations.

China began releasing its CPI basket based upon food and non-food items, though in 2011 it released the weightings for the non-food sub items.  In 2011, the CPI food weighting was 31.39%.  This 2011 weighting had fallen from the 2006 number of 33.60% and was expected to keep falling and relatively rapidly.  History, intuition, and wealth of global economic data said that this number should pretty quickly fall beneath 30% of the budget.  Right? Wrong.

In 2012 the food weighting in the CPI basket jumped almost to 32.21% and has risen about 0.5% every year since.  For 2015, the food weighting of the CPI stands higher than the 2006 number at 33.61%.  This stands is such complete contradiction to everything we know about economics that is belies any credibility.

There are a couple of empirical points to look at here.  First, from 2011 to 2014, average urban wages officially grew 34.8%.  From 2006 to 2014, urban wages officially grew 170.2%.  Oddly though, during this period, the amount of money spent on food, according to official statistics, actually increased as a percentage of income.  In reality, this seems distinctly unlikely as it would spell morbid obesity with Chinese characteristics for most of the country.  It isn’t rising that fast.

Second, if we actually believe these numbers, from 2011 to 2014, the Chinese consumer will have seen wages go up 34.8% but food spending go up by 44.4%.  Put into absolute terms, they would have spent about an additional 2,880 RMB or 5.1% of their income on food than if the CPI weighting had dropped by a similar amount instead of going up.  That is not an insignificant amount of income.  I know of no other country that would plausibly claim to triple wages and have people spend the same percentage of income on food as before.

Third, I can’t honestly explain why the food weighting has gone up though I have some guesses.  Given that food inflation in China runs higher than non-food inflation, which given PPI deflation isn’t a surprise, it could be they are trying to obfuscate realized deflation.  Another possibility is that food inflation is actually higher than admitted but by allocating a higher percentage of the CPI weight they can obfuscate the true impact by allocating the same absolute expenditure amount but change the internal percentages.  I will be honest in saying, I’m not really sure why.

Fourth, the inflation basket is riddled with other problems but this is one good example.  For instance, the residence component is only 17.8% of the CPI basket.  Not only is that number incredibly low by really any standard, I think you would be hard pressed to find anyone in China who would say that food has risen as a percentage of their income while housing is only 17.8% of their income.  Until 2011, Chinese residents supposedly only spent 13% of their income on housing, an absurdly low number for any country but definitely one in the midst of one of the most rapid price increases in housing in modern history.  The point however, is that how a CPI basket is weighted internally can have a major impact on the final number depending on what you are trying to accomplish.

Whenever you read of a headline number in China, do NOT, I repeat do NOT just accept it as fact but try and go beneath and figure out what is going on.  There is tremendous and important detail lurking just beneath the surface.

Random Thoughts About the Chinese Economy and Research

  1. Fear seems to be gaining a foothold. Whatever your thoughts about economic data, hard vs. soft landing, or prospects heading into 2016, fear trumps all.  If people fear the economic future, it frequently becomes a self fulfilling prophesy.  I am not saying yet fear is pervasive throughout the Chinese economy, but it is gaining a foothold fast.  If Beijing does not get its act together fast, they will lose control of the story.
  2. For many reasons, I cannot publicly relate all the stories I hear from different contacts but I will just gently say that almost every time I hear a story about Beijing policy making, I am going to laugh or cry at the end and not in a good way. Whether Beijing wants to admit it or not, the quality of policy, the objectives, and communication strategy needs to change.
  3. Nobody knows what to believe out of Beijing. I’m not just talking about skeptics, bears, or speculators, I’m saying even the people who want to believe Beijing has a handle on the situation and will be able to come to the rescue.  People I know that I wouldn’t consider distinctly pro or anti-Beijing are now starting conversations about how Beijing messed something up.  When even people who would typically defend you are apologizing on your behalf, it’s bad.  I had been pessimistic for a while but the rate at which China bulls have become bears is startling even to me.  I’m not just talking about people that might be known but friends and contacts.
  4. I am very reluctant to assign a lot of weight to arguments about communication but in this case, there is a lot of truth. As a point of comparison, whatever you think about the Fed decision to raise rates, that 25 bps hike was one of the largest non-events ever.  It happened that way because the Fed and Janet Yellen communicated very clearly with the markets about what to expect, when to expect it, and based upon the criteria.  The Beijing policy apparatus offers conflicting statements a few times a week, changes its mind, and surprises the market as if they are not worth the time.  Beijing: call some press people from London or New York and figure out what you are doing.  Financial markets are not the People’s Daily who do what you tell them.
  5. Doing time series research on Chinese data using public sources is simply pointless. One of the many problems China doesn’t even disclose unless you know, and believe me most people don’t know, is that they have regularly “updated” major data points.  Consequently, as an example (though I don’t remember the exact dates and I’m sure these are wrong), GDP from 1998 is not comparable to GDP from 2004 is not comparable to GDP from 2009, is not comparable to GDP from 2014.  This is true of many key time series even though most people don’t know this.  So whenever someone uses a time series on key pieces of headline data to prove to you they have come prepared, just ignore them, pat them on the head, and move along.
  6. A lot of people looking at China wondering its impact on US and Europe, but the real concern is not whether GM plants located in China will earn less, which is likely, but not earth shattering news. The real concern is over how China will impact other emerging markets.  If we divide those EM’s into commodity and non-commodity countries, it is pretty clear there is some real weakness.  Commodity price declines, in all fairness to China, are at least as much more due to excess supply even if Chinese demand was growing as much as expected.  In fact China in some commodities is experiencing a minimal slow down if any.  In non-commodity EM’s, China continues to take market share in export markets.  The problem, both for China and other EMs, is that international demand isn’t as weak as believed, but the pie is growing very slowly so they are cannibalizing each others sales building deflationary pressures.  If Chinese domestic demand was bigger, which it isn’t sorry rebalancing bulls, that would at least soak up some domestic supply.  In other words, if China spills over, watch the EMs not the DMs.
  7. China watchers are missing the primary story that capital outflows are a domestic vote of confidence not and international portfolio issue. Portfolio investment by foreigners remains very limited, and I apologize I don’t have the number in front of me.  Direct investment in China isn’t rising  but there is no evidence that there is any real selling of operations  to take capital out.  The vast majority of capital outflows and pressures on the RMB come from Chinese voting with their RMB.  Great piece in the WSJ illustrating this point.  If just 1% of the urban population used their quota, that would result in $369b USD in outflows.  Watch the January February numbers as the spike in international travel and people with obvious opportunities to move capital abroad, will tell us something about their thoughts.

Why We Shouldn’t Overestimate the Probability of a Chinese Financial Crisis

As with most everything I write for BloombergViews, I want to write a little follow up especially as I have already gotten a number of messages asking follow up questions.

  1. I am not saying there will never be a financial or economic crisis. I am saying that a financial crisis will only happen as after all other options have been exhausted and no other options are left.  Beijing will employ every tool possible to prevent some type of major dislocation.
  2. As an example, while we can debate the reasons and wisdom of it, the US was willing to let significant financial institutions go bankrupt. Right now, I think it highly unlikely that Beijing would let any financial institution of any real significance collapse.  They won’t let any firms collapse much less the stock market.  I see little to no evidence that Beijing is willing to even seriously address some of their economic and financial problems despite press releases to the contrary.  Their entire strategy appears to be paper things over and deal with it later.
  3. It cannot be stressed enough that this is not because I think China has chalk full of top flight economic policy makers. It is primarily because if you look simply at the economic indicators, yes, the risk is elevated and increasing.  However, this clearly overlooks the political imperative.  Whether it is propping up every bank or firm just so they don’t have mass layoffs or shutting down the internet to prevent communication about economic problems.  The political calculus about how a government will handle any potential economic or financial dislocation is radically different.  The objectives of Beijing policy makers and other policy makers are very different.
  4. The current leadership is acutely aware of its place in history and the comparisons to the USSR. They are absolutely determined to not suffer the same fate.  Despite talk of delveraging, credit growth continues to expand far more rapidly than GDP growth because quite simply, they are not willing to tolerate any type of official real growth slowdown.  Given their concern over this, it isn’t that China will never see a crisis of some type but rather that they will exhaust every means necessary before they yield to something they just cannot stop.

Given everything that is happening in the Chinese markets, I want to hit a couple of major points

  1. One of the things that you cannot quantify, though I am sure you could but I’ve never seen it done, is the enormity of the psychological weight attached within China appreciating and being fixed to the US dollar. Some have tried to point out that against a basket of trade weighted currencies, the RMB is essentially flat.  Psychologically within China, that is completely irrelevant.  Chinese firms and people have been taught for a long time about the stability of the RMB because it is fixed to the USD.  Even if there is good economic logic to the basket argument, you are essentially telling 1.3 billion people there is no Easter Bunny, Santa Claus is a fraud, and they don’t get any candy.  This is going to cause significant worry and concern.  A few weeks after the August devaluation, I talked with a Chinese friend and asked him what he was up to and without missing a beat replied “getting all my money out of China.”  PBOC for a long time had absolute confidence of people, today, they do not anymore.
  2. There is somewhat of a debate about whether the RMB is witnessing a devaluation or a depreciation. Devaluation being an official lowering, depreciation being market driven.  I would personally call it a “devreciation” or “depaluation”.  What we are witnessing is effectively two sides of the same coin.  The market is clearly pushing the RMB lower as capital flees China.  That is completely and entirely true.  However, nor is the RMB value established by the market.  The daily PBOC fix has become much less correlated to the previous days close since December 1.  The PBOC is spending large amounts of USD, more than $100 billion in December, to support the RMB. What country spends almost $4 billion USD a day propping up the price of something if it is strictly a market driven price?  The value of the RMB is clearly not set by the market.  If anyone believe this is a market driven depreciation solely, ask yourself what would the value of the RMB be if it was solely market driven tomorrow and the PBOC stopped spending USD?  In other words, if CCTV announces on the 8 o’clock news the RMB will be freely tradable beginning at 9:30 tomorrow morning, what is the new value? 7.5 or higher would be a good place to start.  What my take would be is this: like with the stock market or other markets, Beijing is happy to allow the market to move when it moves in Beijing’s direction.  The market wants to push the RMB lower and Beijing will release some press releases saying “no, don’t, stop. Everything is awesome.” Then set the fix lower.  They tap the breaks and set the fix flat, regardless of the market prices as HSBC pointed out, just to keep traders on their toes and hopefully prevent what they hope will be a gradual landing from turning into a 25% break.  Clearly isn’t strict market movement, but nor is Beijing letting market do what it wants.  Hence, depaluation.
  3. Inflation data is both PPI and CPI data is bogus. More on the specific later this week.

China Kicks Off 2016 in a Big Way

So while waiting in the airport to fly back to Shenzhen my Twitter feed was going crazy as the RMB and Chinese stock markets decided it had been a while since they had a proper freak out.  So let’s get back into things and tell you what I’m going to do with the blog in 2016.

  1. The PMI data releases and concerns about GDP growth might be on people’s mouth but that has nothing to do with what caused the past two days drop in the stock market. Like many recent violent up and downs, I don’t think you can pinpoint one factor.  However, if I would point to one culprit, I would focus instead on the easing of lockup period from summer buying to prop the stock market.  Now let me emphasize, that is just speculation, but that is a much more likely culprit than people all of a sudden waking up and seeing poor PMI data.
  2. Despite so much focus on the decline in margin lending, as I have repeatedly noted, most of the buying over the summer to prop up the market was done with debt financed capital. Remember, the actual amount of equity capital used to buy equities was pretty small.  Most of the capital came from commercial banks, which I still haven’t heard how they are accounting for this in their risk capital weighting, or from the PBOC lending directly to firms.  One contact actually told me at the time that the “loans” were no obligation loans.  Meaning, the public was essentially bearing all the risk.  There are a couple reasons this matter.  First, not that there are lots of great investment projects in China but this is tying up liquidity.  Should come as no surprise that the PBOC began pumping back in liquidity earlier this week.  Second, leverage is being created upon leverage.  As Michael Pettis notes, this is like a thousand central banks creating money.  Third, this increases the correlation between assets and risky assets at that.  The more this goes on, the more the debt markets become correlated with the equity markets increasing the risks of a disorderly unwinding.  Fourth, China finds itself in a difficult position in that it needs equity capital to buy equities but international investors won’t touch the stuff and the only people propping up the market are the public institutions with debt capital.  China can NOT deleverage and keep the stock market up. Period.
  3. The PBOC is in a difficult position of trying to let the RMB depreciate either by steering it that way or letting the market move it that way but without letting the drift become a route. Patrick McGee of the FT who is as smart as they come has a great short piece about how the PBOC is managing the RMB. Now I actually have some minor disagreement with his interpretation, but I want to emphasize, this is a case where reasonable people can have reasonable disagreements.  Noting that the market price of RMB actually increased yesterday and why the PBOC lowered the RMB fix0.2%, he cautions not to read too much into a one day data point.  Completely fair point.  I actually interpret this slightly differently.  For the past few weeks, the PBOC has been setting the RMB fix 0.2% lower daily, following the market which would end the previous day even lower the 0.2%.  The PBOC would then set the fix 0.2% lower, until today when it was still set 0.2% lower even though the market was higher.  Here is how I would interpret this, though I want to emphasize this, I see and understand where he is coming from.  The PBOC was the RMB to glide lower very softly but they also likely have some type of target they want to get to.  As with virtually all Beijing economic and financial policy, they are content to let the market play the dominant role if, and this is a big if, if the market does what Beijing wants it to do.  When the stock market goes up, Beijing is happy to let the market play a dominant role. When the market goes down, Beijing wants to step in and stop the market.  Consequently, when the market increased the price of the RMB that went against Beijing policy designs, they decided to keep the relative downward trend in the RMB price.  A major belief of mine is that you cannot believe the Beijing press releases but have to watch what they do.  The PBOC may say they want the market to play a greater role and I believe that with the caveat that it is true when the result is one Beijing wants.  However, anytime Beijing sees a result in the market they do not like, they will swiftly, adjust it.
  4. One of the things that amazes me is just how dependent on Beijing even smart people become to direct the state of the economy. China is in the middle of truly epic and historical asset price bubbles across essentially every asset class.  Real estate, stocks, and bonds are all wildly over priced.  Why I mention this is that so many people both Chinese and foreign essentially buy into the concept that that the laws of economics and finance do not apply to Beijing and as long as Beijing says it won’t be, it will never come to pass.  The price of assets and imbalances are essentially ignored because well, Beijing will handle it.  Anyone that points out the emperor has no clothes or that assets are over valued is called a doomsayer and not a true believer.  Now I personally think the risk of a Chinese financial crisis is low, for very technical reasons, but I have no doubt that assets are wildly overvalued and will correct at some point.  I have no doubt that the economy is in incredibly poor shape.  I have no doubt that finances throughout China are highly stressed.  There are very few things I think in economics and finance qualify as absolute laws.  One of them is this: if something cannot go on forever, it will eventually stop.
  5. After a break over the holidays with some time to refresh, I have come up with some new ideas to keep the blog fresh and interesting and more than anything, keep my interest. I still plan to do some granular detailed data work, but I also want to expand into writing about some bigger picture issues.  By that I mean this: I originally started writing this blog about China to try and educate because I generally thought the level of knowledge of the Chinese economy was quite poor.  I started it almost to try and educate.  Now I feel some of the big picture data issue battles have been won.  People no longer accept Chinese GDP data, in fact everyone takes it pretty much as art.  What I can’t figure out are who are these people on surveys that still believe Chinese GDP data.  I know most everyone that should be surveyed and no one believes it.  People that know very little about China now know not to trust.  However, there are more big picture issues that people don’t understand about how the Chinese economy works so rather than trying to focus so heavily on data and empirics, I’m going to include some broader issues.  As an example, one issue that I plan to write about soon as the importance of seasonality when looking at Chinese data.  By that I mean, people are talking about the Chinese economy stabilizing in December but that so obviously forget that this mostly likely is nothing more than the pre-Chinese New Year bump as companies stock pile for the one month shut down.  I’ll get into questions like that in more detail.  The basic idea is simply trying to help people understand the Chinese economy better, but if there are questions you might want answered, please feel free to email.  Happy New Year.

Catching up to the Chinese Economy

So I haven’t been writing that much the past two weeks primarily because of a minor wrist surgery two weeks ago.  In addition to some forced time off, forced me to play a lot of catch up to my existing commitments.  Drove me nuts, because there are so many interesting things going on in the Chinese economy right now that I really wanted to write a lot more.  So for the moment, you’ll be stuck with a grab bag of thoughts.

  1. China released its 2016 economic plan yesterday and while I’ve only read the news reports at this point, it quite frankly sounds pretty well reasoned, like they read this blog (definitely joking but also probably somewhat true), but very unlikely to actually occur. One thing I always tell people trying to understand the Chinese economy is that you absolutely should not take press releases as fact.  If they announce a GDP figure of X, only believe it after you have verified it.  Same thing goes for the economic plan.  From everything I have read, it actually looks rather sensible.  However, I believe the likelihood of it happening is quite low.
  2. I don’t say this for pure skeptic reasons but a variety of reasons, not least of which is just pure mathematics. Let me give you one example.  The plan notes the importance of deleveraging. However, they simply cannot deleverage and maintain GDP growth of anywhere close to 6.5%.  Let me give you a slightly oversimplified model that will explain why.  (I should re-emphasize this model is using easy ratios in an oversimplified model but it will clearly convey the idea).  Let’s assume that that GDP growth is 6% and credit is growing at 12%.  If they only want to slow leverage build up, not even delever, and cut credit growth to 8%, in our simplified scenario that would cut GDP growth to 4%.  Now let’s add in another wrinkle, one recent report had (again using a nice round number) 50% of credit being used to pay of old debts.  Let’s now assume that 6% of credit growth goes to GDP growth and 6% to paying off old debts.  If they cut credit growth to 8% (leaving 4% to fall on the 6%/6% division), if the entire 4% reduction fell on credit growth to pay off old debts, that could easily trigger a wave of defaults.  Conversely, if the brunt of that credit cut fell on GDP expansion and new capacity expansion (already problematic), that could easily torpedo any growth targets for 2016.  Remember, this still assumes total leverage is rising, just slower than before.
  3. This is the key point: I see absolutely no evidence that the Chinese government is prepared to either accept or even recognize that those types of trade offs are necessary. Beijing wants to believe that markets move in one direction and do exactly what you want them to do and that just isn’t reality.  One of the most fundamental laws of economics is that man has unlimited wants and limited means.  There is a very small number of people, firms, or governments to whom this does not apply in the course of human events.  Tradeoffs have to be made and at this point, I see no evidence that Beijing is prepared to recognize that tradeoffs need to be made and then make difficult decisions to make them.
  4. I have a profound belief that when the government of China wants something to happen, they will make it happen. This is not universally true but mostly true.  If they really aren’t interested, they will nod and agree and ignore.  As the saying in China goes: in China there are a thousand ways to say no, including many where people say yes.  Don’t watch the press releases but look at the results.  That is the only way to judge what is going on.
  5. Beijing is going to face some battles on implementing these plans like deleveraging for a few reasons. First, I truly believe they don’t really know what is going on throughout the country.  Even banks don’t know what is going on in their branches throughout the country sitting at the home office in Beijing.  News reports of major GDP fraud in the north east is the tip of the iceberg.  Imagine how bad the data is at lower levels that receive less public or major official attention.  Second, Beijing has not fundamentally changed the promotion incentives so officials have an incentive to focus on the old line metrics.  Before I get a bunch of nasty emails saying otherwise, ask yourself if a city official would get credit for improving environmental welfare by shutting down a polluting low capacity coal plant and putting people out of work and restructuring the assets and recognizing some bad loans? Are you kidding?  Consequently, even if Beijing really wanted this (which I don’t think they do), they would face real problems pushing this plan.
  6. I don’t like to say told you so but this is one time I will say it: I told you so. A week or two ago, Beijing released details of how badly inflated north east Chinese provincial GDP. There are a couple of things to note about this situation.  First, if you believe this is limited to the north east provinces, please get stronger meds.  Second, China who has been a serial adjuster of GDP upwards, hasn’t made any indication they plan to revise the problematic GDP downwards.  That would be unharmonious.  Third, faced with overwhelming even self admitted evidence the new defense of Chinese cherry red kool-aid  GDP drinkers is that, “this was at the provincial level not at the national level. National level data is still good.”  There are two separate and enormous problems with this argument.  A) This assumes that government statisticians in Beijing are pure as the driven snow, as ethical and honest as Mother Theresa, and have the conscious of St. Augustine worrying over the proverbial pear tree.  I just have to ask: who are you kidding?  A friend of mine who used to teach in China, told me a story about a Chinese class he taught where Chinese high school students believed the same thing about government officials (stop and ponder smart people holding the same opinion as indoctrinated Chinese high schoolers for a minute). When he pointed out that central government officials came from provincial appointments, the students would argue that they were promoted because they were so pure and untainted, at which point he would stop arguing.  Again, if you believe that central government statisticians are pure as the driven snow….get help.  B) Potentially more problematic, this assumes that even if central government statisticians are pure as the driven snow they can calculate what the true level of GDP or other statistic should be.  In other words, if you are an honest Beijing statistician, how to do you adjust data you believe to be faulty to what it’s true number is?  This is harder than it sounds for many reasons.  A Chinese auditing report earlier this year found state owned (at the central and provincial level) falsified financial records, no surprise so far.  What was surprising was that some falsified them to look more positive and some to make them look worse.  They did this depending on whether they were trying to hide money or get money.  In short, just assigning a 3-5% downward adjustment, as a simple example, wouldn’t work.  Furthermore, if Beijing suspects that the data they are receiving is false but then the submitter would know that Beijing would know that, so they clearly wouldn’t submit false data.  In short, there is a lot more randomness and one would have to assume super natural power of clairvoyance if official data is accurately corrected.  That also for many more reasons, is an enormous stretch.

If I can’t write again before Christmas….Merry Christmas to everyone.

Thoughts on the RMB

  1. I am a frequent critic of Beijing policy ineptitude but it simply cannot be underestimated the magnitude of what they are trying to accomplish with regards to the RMB. If you look back on the history of transitions of not insignificant countries transitions from fixed to floating or near floating currency regimes, the shift is rarely smooth.
  2. If we make a simple assumption that the RMB is going to behave more like an EM currency against the USD, or even vaguely similar to the EUR/JPY, it is probable that over the past 12-18 months, the RMB would have lost 20-40% of its value. Consequently, even if you take the low end of that range, that would imply that the RMB needs to decline 15%+ to reach a more appropriate value.  There are other ways to look at this but they all imply the RMB is overvalued by a not insignificant amount.
  3. One of the numerous worrying aspects here is the apparent lack of understanding Beijing demonstrates with regards to markets. For instance, Beijing is a fan of markets on the Mainland when they go up, but not when they don’t do what the Party wants.  Price setting is one of the Beijing’s most treasured privileges in every market.  However, the international currency market will not obey Beijing dictats.
  4. You can see this battle being fought in the regular PBOC announcements and in the markets. PBOC announcements are filled with announcements how strong the economy is, the strong fundamentals of the RMB, and no reason for depreciation or outflows.  While they understandably have an interest in not triggering panic, these releases give them an image that they have no idea what is going on in their own economy they are so detatched from reality.  Then in the offshore market, there is this repeated intervention game going on where the CNH moves sharply away from the CNY and it stays diverged for a few days continues to diverge then the PBOC comes in and typically in the span of a few minutes moves the CNH back to near parity with the CNY.  Most worryingly for the PBOC, these currency guerillas keep coming back for more.  They keep coming back because they know fundamentally the RMB is overvalued by at least 15%.
  5. The biggest risk is pretty simple: the PBOC is trying to gently steer the RMB lower. This is going to be difficult for a variety of reasons.  First, the market knows the RMB is going in one direction and they like those odds.  Even if a hedge fund just shorts the CNY/CNH overnight with a not insignificant leverage and sells at trading open, recently, they would be making solid money.  Second, external factors which played into Chinese policy objectives are going against them.  Probably the last thing China or the RMB needs is a Fed rate hike but that is likely what’s coming.    Third, the domestic economic environment is such that capital wants to leave.  It is no coincidence that the giant ball of money rolls between asset classes in China, one seemingly crazier than the previous fad.  Chinese investors, retail and institutional, know that quality investment options in China are limited and are very interested in moving money elsewhere.
  6. I don’t see the slow slide in the CNY having much of an impact on FX depletion. The decline will likely come in counterfactually slightly better but the difference is enough to have a significant impact.  In fact, there is a strong possibility that the lower CNY rate while lowering the direct need for FX intervention is actually going to worsen it indirectly.  If investors believe that the RMB is going lower, they will move more money out of China.  To counteract this pressure, the PBOC is required to intervene even more just to keep it from plunging even more.  There is some evidence of this phenomenon of this, even though I’m not ready to pronounce it as definite.
  7. The PBOC and RMB are benefiting in one clear way from its link to the USD. The current account surplus has ballooned, primarily due to falling import prices and steady global demand. This has helped ease the need for intervention to hold the RMB steady, even if this was not their design.  Consequently, capital outflows are unintentionally being softened due to a favorable environment.  Should there be any reversal, due to a variety of factors in this favorable current account surplus situation, the RMB could face enormous and rapid pressure.
  8. I differ philosophically from many of the IB’s and traders in RMB predictions. With everyone releasing 2016 predictions, every prognostication eventually tells the same story with slight degrees of difference.  The RMB will be 5% or 8% lower in 2016, a very linear process.  I see the RMB, and many financial assets, moving in decidedly a non-linear and choppier manner.  For instance, I think that say 5% RMB decline is a relatively reasonable prediction.  However, I would say something more like: there is a 90% probability of a 5% decline with a 10% probability of a 40% decline. Let me emphasize: this is not my prediction, I am only trying to give an example of how I view this process and the movement processes at play.  Furthermore, the more the PBOC moves the RMB down, I see the pressure build on the RMB for additional weakening and additional pressure for rapid and violent movement.  I see the incremental downward movement as adding incrementally to the probability of a sudden dislocation.
  9. I had someone email me about how a trader might profit from this and part of the strategy, to me depends on what type of strategies you like. However, let me give two examples.  First, I think there is a very low probability the RMB will start appreciating.  Consequently, as a low risk strategy, one strategy might be shorting the RMB with leverage near the end of the day, especially if the trading day has seen a downward drift, and closing out after next morning fix.  Second, buy long dated out of the money options on the RMB say at 7 RMB/$ playing the less likely probability of a large RMB movement at some point in the next 6-12 months.
  10. Pressure continues to build.

Separating Out Regional Differences in the Chinese Economy

I was recently asked by someone to help on a project they are doing about China, which you will learn more of in the future, and look at some data.  Always willing to help interested parties and always willing to look at new data that might give me some new perspective on what is going on I said yes, and boy am I glad I did as it gave me a new appreciation for just what is going on in different parts of China.

I put together some data on specific provinces, industries, and much narrower slices of data so I want to stress at the outset standard caveats about reading too much into this for the entire country and economy.  Maybe I will extend this analysis at some point, but for now this was intended to focus on specific regions.  The division is really pretty simple: I gathered data on the Chinese rust belt comprising the provinces of Hebei, Jilin, Heilongjiang, Shanxi, Inner Mongolia, and Liaoning to compare against the coastal provinces of Guangdong, Fujian, and Zhejiang.  For anyone unfamiliar with China, the divisions here are rather stark.  Rust belt provinces are in the north and north-east area of China and dominated by heavy industry like mining and steel.  The coastal provinces are much more manufacturing and trade focused.  Guangdong for instance is known as the workshop of the world with Fujian and Zhejiang having major export industries.

As coincidence would have it, our simple breakdown of provinces also have roughly equal populations with the rust belt and coastal provinces each having around 200 million people.  Between the two of them, this means that our small sample has a total of about 400 million people or about one-third the population of China.

Let me highlight some of the stark data we see coming through.  Government finances are starkly different between the rust belt and coastal provinces.  In the rust belt, government revenue through September has fallen 9% compared to the same period in 2014 while expenditure has grown 7%.  Hebei and Inner Mongolia actually witnessed moderate revenue gains of 6% while Liaoning has seen government revenue absolutely collapse by 27%.  What is even more amazing is the size of public deficit.  Provincial expenditures are 105% larger than revenue in these provinces with Heilongjiang recording expenditure 212% of more than three times higher than revenue.  In other words, in Heilongjiang for every 1 RMB of government revenue, they spend 3.12 RMB.  Conversely, coastal provinces are almost pedestrian and boring with revenue and expenditure growth of 15% and 16% respectively.  Additionally, the public deficit is quite restrained with expenditure only 2% higher than revenue.

This data has a couple of important implications. First, it seems incredibly difficult to believe that in rust belt provinces, economic growth is positive with government revenue falling by almost 10%.  Second, despite talk that local government finances are being tightened, it is quite clear that certain provinces are running very large deficits.  Third, there is an enormous difference between province economic health.  Fourth, it is difficult to see based upon other data, some of which I will get to, what is causing coastal province government revenue to increase by 15%.  Maybe governments are simply pursuing revenue they are rightfully entitled to but while economic activity in the coastal areas is not nearly as bad the rust belt, there is nothing to indicate strength that would precipitate a 15% increase in government revenue.

Let me turn now to specific provincial data on business revenue broken down by industrial sector.  Let me note one important things about this data.  It does not include service industry data, like financial services, but does account for the manufacture of many consumption products like garments, electronics, and appliances.  In other words, while it does not provide us with a complete picture of the Chinese economy, it would be an enormous mistake to intellectually limit this data to heavy industry.

The difference between provinces is again stark.  Rust belt provinces registered an industrial firm revenue decline of 10.6% from January through October 2015 compared to the same time 2014.  Every province registered declines with Inner Mongolia witnessing the smallest decline at 2.8% and Liaoning registering the largest decline at 19.9%.  Conversely, Coastal provinces clocked in with a small but positive 2.1% revenue gain.  Fujian saw the strongest at 7.8% with Zhejiang registering a small decline of 1.3%.  The economic divergence between provinces has been stark for many years and continues.

There are a couple of follow up points worth mentioning.  First, given Chinese nominal GDP accounting proclivity to closely track revenue growth, it is very difficult to see how Rust Belt provinces, and at least specific provinces, aren’t in outright recession.  For instance, in service sectors like financial services where financial firm revenue is closely correlated with financial service GDP sector growth, if this were to translate to areas like secondary industry, this would require significant nominal falls with the GDP deflator and productivity among other factors to make up the difference. For instance, Liaoning registers GDP growth of 2.7% but industrial revenue collapse of 20%.  Those two things are very difficult to reconcile.  In other words, very real questions about GDP accounting persist.

Second, it seems highly unlikely that service sector growth is so strongly negatively correlated with industrial revenue growth.  Let’s take a simple example where every RMB of revenue is equal to a unit of GDP and there are only two sectors industrial and service with each comprising 50% of the economy (again, overly simplified but definitely not grossly distortionary).  If Liaoning industrial revenue falls by 19.9% and they register GDP growth of 2.7% this means that the service sector needs to register revenue growth of 28.3%.  Now I don’t mean to be skeptical but I’m going to call bull dung.

Third, there is no evidence that the difference can be explained by either output remaining slow to moderately positive with large falls in prices keeping real GDP constant.  All evidence on output on a variety of industries indicate low single digit growth or declining output growth across most sub-industries. There simply is very little evidence that GDP growth in these provinces or nationally can be explained by the measured economic activity.  The real GDP gains announced by official departments would require enormous deflation and productivity gains that are unlikely in a declining environment.

Fourth, even if through some magically economic accounting trick GDP is at 7%, it simply does not matter.  As I have repeatedly stressed, to some degree any debate over GDP is irrelevant as firms and people do not earn money in GDP or repay debts with fictional GDP credits but with cash.  On a cash flow basis, firms in China are hurting and in large areas.  No province in northeastern China saw industrial and manufacturing firms as a whole see declining revenue, for the entire area by 11%.  Even the more prosperous and stable coastal provinces saw total revenue growth of only 2%.  Let’s use the national figure that debt growth is still 10-12% for these provinces and real interest rates are let’s say 10%.  It does not take a Phd to figure out that double digit revenue declines for business in a region with 200 million people as debts go up by 10% at some point will come to an end and typically unpleasantly.  Even with cash flow growth of 2%, debts simply cannot continue to see 10% growth, and pay a 10% real interest rate.

Fifth, Chinese public finance deleveraging or restraint is a myth.  Firms in the northeast are making drunken sailors on leave before a kamikaze mission seem like bastions of restraint.  The average rust belt province is spending more than twice as much as they take in with some spending three times what they take in.  Outside of the divergent underlying economies, it isn’t clear when public finance policy is so different between provinces, but is clear they are vastly different with weaker provinces in serious fiscal imbalances.