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.

My Last Word on FX Swaps on Chinese Banks Net Foreign Asset Position

Just a few last words on FX swaps and Chinese banks based upon the recent Brad Setser follow up and next time we move on to new material.

First, we cannot say exactly who is taking the other side of this swap position but that in no way negates the point that they are being made and volume according to bank and market financials has risen enormously.  Based upon multiple data points it is clearly happening in large number.

Second, swaps are not “off balance sheet”. They are very much on balance sheet.  However, banks do not record the full cash or “notional” amount of the swap only some type of value at risk or expected gain/lost amount.  For instance, assume I buy a $1 million FX swap that returns the domestic currency at a future exchange rate that imposes a 1% loss plus say 0.5% transaction fee. I would say the “notional” amount is $1 million but I would carry as a liability the 1.5% (1% loss plus 0.5% transaction fee). This distinction will come important later.

Third, there is no explanation to the most fundamental of questions: how are Chinese banks obtaining foreign currency to fund this growth in foreign currency assets?  Again, how does a bank fund asset growth if it cannot access, via deposits or debt, capital to fund asset growth?

Fourth, the preferred explanation of higher foreign currency deposits in Chinese banks does not come remotely close to explaining the growth in foreign assets.  This is explained by noting that foreign currency deposits increased during this time.  However, during a period when net foreign assets increased $300 billion, foreign currency deposits went up by a total of $123 billion. This leaves a significant amount of unexplained foreign currency asset purchases even using those numbers.

What makes this increase in foreign currency deposits even more interesting is that it lines up perfectly with the preferred explanation of a move in to swaps to facilitate outflows.  Let me explain.  Though foreign currency deposits increased by $123b, $54b of this increase comes from overseas foreign currency deposits into Chinese banks. In other words, domestic Chinese foreign currency deposits have only risen by $69 billion since January 2015.  When a Chinese bank sets up an overseas operation, depending on whether they are a legally a branch or a subsidiary office, technically two different entities but typically sharing significant overlap, the financials of a branch are technically credited back to China.  Consequently, China is able to credit foreign currency deposits in overseas offices to its own balance sheet.  It is not uncommon for products to be combined for clients between branch and subsidiary balance sheets.

Here is how this explains the “swap” aspect.  Using the example of a client that has RMB on the mainland but can’t get the money out, when a Chinese bank offers via swaps to move this money, banks virtually always require this money be deposited with them in their overseas entity. For example, let us assume that Company A has a Chinese subsidiary with 700m RMB that they cannot get out of China they want to use for other purposes let us assume in London.  Chinese Bank A will facilitate a swap to “lend” money to Company A in London. However, as part of this transaction, Company A will be required to deposit 700m with Chinese Bank A in China. They will also be required to deposit some portion of the corresponding loan in London with the Chinese offshore entity.  For simplicity sake, assume Company A deposits $25m USD in London and uses the remaining $75m for other purposes, this would show a corresponding rise in the foreign currency overseas deposits of Chinese banks.

Last major point is that the numbers presented match the swaps story very closely.  For instance, if companies with mainland operations want to move capital and the Chinese bank requires them to deposit some percentage of the proceeds in an overseas account, this would match the growth in overseas foreign currency deposits and the growth in assets based upon a “foreign currency” loan being made overseas.

The discrepancies noted between the net asset positions and growth in foreign currency deposits are not just inconveniences or rounding errors but significant problems with the story that this net asset rise.  What is important to note is that everything that has been shown is perfectly consistent with an increase use of swaps to fund the growth of foreign asset purchases.  While it remains perfectly valid to ask who is the counterparty and he right in noting that list is pretty short, that in no way changes any part of the analysis and actually

How Chinese Banks Lowering Foreign Debt & Facilitating Outflows

Brad Setser at the Council of Foreign Relations has a good piece on the Chinese FX position with an interesting point about the state of Chinese bank FX holdings. He makes the very interesting point that Chinese depository corporations foreign assets have continued rising pretty much on trend for quite some time, but after August 11, foreign liabilities of banks have plunged.  He posits that this is a good thing, indicative of financial strength via rapid increase in net FX holdings, and that the PBOC has higher level of implied FX reserves than is understood.

I think there is another much more likely explanation that is supported by the data that leads to a different conclusion.

Before we even dive into the data, think about the point that Chinese bank foreign assets have risen effectively on trend (an important point) but foreign liabilities have dropped significantly.  On the face of it, this should strike you as very odd.  The primary input for a bank is either deposits or liabilities that they then use to lend or purchase a fixed income asset.  If a bank has significant drop in its input, how does it maintain trend growth of its output?  Put another way, where are Chinese banks getting the foreign currency (deposits or liabilities) they use to increase foreign assets?

Let me reframe this away from banking.  What if Starbucks reported that coffee drink sales had doubled but they also reported a 50% fall in bulk coffee purchasing?  Would seem on its face a little odd.  Had prices changed significantly? Had they changed their formulas? What was happening to cause sales of coffee and purchases of coffee to go strongly in the opposite directions? That is effectively what is happening here.

So this leads us to dive into the data. How are Chinese banks funding foreign asset purchases while reducing foreign liabilities? Where is the foreign currency coming from?

The rapid drop in foreign liabilities is likely disguising capital outflows and hiding debt. I know of Chinese and major MNCs that are effectively being blocked from engaging in FX transactions but allowed to conduct a variation on this theme.  Here is how this happens.  A company wants to move money out of China but is refused the FX so is forced to keep RMB in China.  A bank, typically a major bank, offers to arrange the transaction for them like this.  The client deposits money at the bank offering the cash as collateral. The bank arranges for a swap with an offshore entity to then lend USD/EUR/JPY whatever the client wants in the jurisdiction, backed by the secured cash.  There is no explicit movement of capital between China and other jurisdictions and there is no foreign currency liability.

It must be noted that while we cannot say with perfect certainty this is what is happening, all evidence supports this hypothesis.  Besides the anecdotal evidence let me give you some supporting data.  Bank of China and ICBC (PDFs) in their 2016 annual reports give evidence of this behavior.  BoC’s and ICBC’s notional amount of FX swaps grew by $125 billion and $69 billion.  In other words, the amount of money that they have worked to provide swaps for, in these two banks alone, is up almost $200 billion in 2016.

Market data supports this move to supporting outflows via the swap market.  In January 2015, turnover in FX swaps was about a third of the spot market.  In between  August and October 2015, the FX swap and spot market equalized (notice the timing) and now the swap market is about one third larger than the spot market.  Since May 2015, FX spot market turnover is up a pedestrian 15%, but FX swap turnover in China is up 73%.

But wait, there’s more! FX spot market transactions between banks and their clients from May 2015 to 2017 is down 6% while interbank FX swap volume is up 82% during this same time.  Now the interbank FX swap market is 271% larger than the FX spot market for bank clients.  Then we see that Chinese banks are significant net buyers from customers of FX in the spot market.  Taken together this implies that Chinese banks are soaking up hard currency into China and arranging for outflows via FX swaps that do not actually facilitate currency flows from China to the rest of the world.

It is worthy to note that while many people believe the RMB has gone global, most central banks hold minimal if any RMB.  What they have are currency swap agreements that allow them to access RMB when needed and the PBOC to access foreign currency when needed.  Given that bankers inside and outside of China treat BoC as effectively a branch of the Chinese Ministry of Finance, it is likely BoC engaging in various types of swaps agreements to give it overseas hard currency funding sources that keep its primarily liabilities in RMB.

There are a few final points of note. First, if Chinese banks moved rapidly out of actual foreign currency liabilities and into swaps to fund overseas asset purchases, this would explain the trend growth in bank foreign assets but the drop in liabilities. Swaps are not accounted for based up the notional liability amount but on a “fair value basis”.  If the banks engage in currency swaps and then use the currency to fund foreign asset purchases, this serves to effectively undercount the liability by carrying it at fair value and double counting the asset at 1+fair carrying value.

Second, it is important to note that depending on exactly who is holding these swaps and how balanced the book is, this implies that the FX has not fallen at all if there is sudden movement in the RMB.  These are simply implied liabilities.  For instance, BoC is carrying FX swaps equal to a notional value of 5.36 trillion RMB or nearly $800 billion USD but they carry these on their books as liabilities equal to only 87 billion RMB or $13 billion USD.         The accounting value is equal to 1.6% of the notional value.  While on the face of it this appears relatively standard accounting value liabilities, it is important to note this underlying issue.

Third, if the PBOC needed to access Chinese bank assets, their net asset position is being overstated. The foreign currency can fund loans for foreign asset purchases that are recorded on group balance sheets as loans to customers but record only a fraction of the liability used to raise the foreign currency overstating the net asset position. It would also appear to overstate the liquidity of such assets if the PBOC ever needed to coordinate such actions.

I hope this is clear as these are some more technical issues. However, I think it is fair to say that this is much more likely scenario that does not lead to such a rosy outcome.

Here are two good primers on FX swaps from the Bank for International Settlements and Wikipedia.

Some Friday Thoughts

I haven’t had chance to complete a couple of analyses that I have planned but I wanted to bang out a couple of thoughts.  First, a couple of follow up thoughts to my Bloomberg View piece on MSCI including China. Second, some thoughts on the news Chinese regulators asked banks to review loans made to Anbang, HNA, Dalian, and others.

People frequently mistake my writings that I do not want China to join the international market place.  Nothing could be further from the truth. I think opening up Chinese financial markets in both directions is good for Chinese and foreign financial markets.  I think for many reasons the RMB becoming a major international currency is a good thing.  I think, and I will provide stronger evidence of this in upcoming writings, that opening Chinese capital markets specifically in equities and fixed income is a good thing.

What was so problematic about the MSCI piece is that pretty much all of the problems they cited last year still exist and some have even gotten worse.  Their entire announcement focuses on issues that they had never before prioritized and additionally programs that had been in existence before.  Near end they spend a paragraph basically restating all the problems they cited last year and saying they hope these things change in the future.  In other words, little has changed but MSCI decided to admit China anyway.

There are a couple of things, if history such as the IMF is any guide, that MSCI acceptance means.  First, this is the end of capital market reform. Maybe some more on the bond market because MSCI hasn’t included China is MSCI bond indexes but for various reasons which I won’t get into at the moment, that is may not be terribly important.  Whatever impetus for Chinese reform is effectively dead, not that there was much before.

Second, there is no rule(s) that won’t be bent by firms to appease Beijing.  I am a big believer in markets but there is no part of Chinese financial markets that is remotely market oriented.  This is setting up all kinds of problems that will need to be dealt with later.  If there is one thing that we have learned not just in the financial industry, ignoring these risks will frequently catch up with you at some point. However, smashing every rule of what constitutes a market is creating lots of risks.

I’m actually very sympathetic to the dilemmas faced by MSCI. I was talking a fund manager recently who said he was torn recently. As he said, they clearly have such enormous regulatory and structural issues that really haven’t been dealt with but they are also too big to ignore.  However, any real hope that MSCI may hold out for continued reform, if history is any guide, is now dead.

Probably the height of irony that just proves my point is that MSCI says it actually has to implement the inclusion due to continued market restrictions. The day it was announced, China reminded MSCI of market regulations that let us just say create problems.

Briefly on the matter of the Chinese regulators telling banks to review loans made to HNA, Anbang, Dalian, and others. I should note that parts here are speculative and anyone who tells you they really know really does not.

First, we should not be under any illusions that these firms are in anyway ethically or legally saints.  At best they have pushed the boundaries of what even in China was considered legal and would definitely be allowed any place else.

Second, it is important to note that these firms were widely encouraged not just in their overseas acquisitions but their domestic build up.  There is a mountain of evidence and other information that these firms were encouraged to do the behavior that is now being called into question.  I do not mean to say this to necessarily defend them but more to provide context on these events.

Third, this begets the questions, so what exactly is going on?  To me there are three basic possibilities (with many variations on these themes). A. Regulators are going through standard management and regulatory processes and these companies just happened to run afoul of the rules.  This is possible but I think less likely.  While these firms may have been the biggest, there are so many firms that could be hauled in for the exact same types of behavior that these firms engaged in.  So why these firms now?

  1. There are political motivations. I think this is more likely than the previous option but not the most likely option. This is what amounts to an election year in China, really only a few months away at this point, so this is not a good look for a regime emphasizing stability and progress.  It is possible they are trying to send a message to other firms but seems like the bigger message is not one they want to be sending right now.  In short, I think it is possible there are political motivations at play here but not the most likely.
  2. I think the most likely explanation is that there are very real financial stresses. I think there is a wealth of evidence of increasing financial stress in Chinese markets.  One thing that has become abundantly clear in Chinese markets is that problems arise unexpectedly and there is always a massive amount of information that should have been revealed before.  I have no secret information but I believe this is the most likely explanation though others are always possible.

Are Chinese Bank Recapitalizations Monetary Neutral?

So a couple of people that I know and some that I don’t know zeroed in, in my last post, on a couple of monetary issues.  They raised some important questions and so I think it is important answer them as best I can based upon what I think we observe in China.

The basic idea that is being objected to is that bank recapitalizations can be monetary neutral.  Before we even discuss the mechanics of bank recapitalizations, it is important that everyone knows what we mean by monetary neutral.  Assume country A has a fixed exchange rate and decides to recapitalize their banks. If they increase the base money supply by a non-trivial amount that could cause pressure and ultimately some form of a devaluation/depreciation.

Now it is very important to note that a bank recapitalization can be monetary neutral but can also violate the concept of monetary neutrality.  So in other words, it is entirely possible that they are right that a bank recapitalization could be monetary neutral, but it could also be false.

Let me give you two very simple examples to illustrate the difference.  Assume a bank needs to increase its capital base, for any number of reasons, and does a secondary rights offering selling shares to the market to meet capital adequacy ratios.  If they offer the shares to the market and the market buys the shares, there has been no increase in the money supply. Investors with existing capital chose between   different investment options. This simple example could be expanded to cover a pre-emptive, hypothetical, type of recapitalization where the Chinese Banking Regulatory Commission (CBRC) orders all banks in China to sell shares to the market to ensure high capital levels. In these instances, there has been no increase in the Chinese money supply. We have not violated the principle of monetary neutrality.

However, it is also very easy to violate the principle of monetary neutrality.  Assume now that a bank has made a bad loan but the government wants to ensure continued lending and investment growth.  The government does not want the market to buy the shares because that would divert capital used for other investment purposes and it would dilute the governments shareholding.  To solve this problem the central bank prints money to buy assets of some kind from the bank to give them capital continue lending. This results in a tangible and could be material increase to the money supply.

To make this example tangible, assume the bank has $1,000 in loans, $900 in deposits, and $100 in capital (I am being very very simple here). If the bank has a shock with NPL’s rising to 10%, assuming depositors lose nothing, the banks capital of $100 is wiped out.  However, the central bank prints money and offers to buy the bad loan at face value of $100. The bank gets $100, returns its NPL ratio to 0%, and can resume lending. The money supply has gone up but the objectives of continuing to lend with functioning banks has been achieved.

Let’s briefly consider similar but very importantly not identical situations.  Both the Bank of Japan and the Federal Reserve have engaged in quantitative easing whereby they print money to buy sovereign debt issued by their respective governments.  The European Central Bank has engaged in a similar strategy buying a variety of sovereign and high credit quality corporate debt.  Absolutely no one disputes these actions are not monetary neutral. They are in fact quantitative easing.  If the PBOC is printing money engaging in balance sheet expansion to fund monetary easing, even if it is purchasing assets from banks or engaging in quasi lending to banks, this will count as monetary easing violating monetary neutrality.

Forecasting into the future is always difficult and it is entirely possible that if there were some type of “event” where these mechanisms would be discussed, it is possible that China could choose a mechanism that did not violate monetary neutrality.  However, if we look at recent Chinese behavior, we have a very good example that clearly violates monetary neutrality.

In what I believe is one of the most overlooked events in recent Chinese history and will likely in time occupy a more central focus of analysis, Beijing conducted a full fledged bailout of local governments and the bad debts Chinese banks held.  The banks who held vast sums of debt, with even much of it now unlikely to be repaid, were ordered to convert short term high interest loans into 10 year low interest bonds.  As a simple example, a 1 year 7% loan became a 10 year 3% bond. If these debts blew up, this would have had an enormous negative impact on bank capital levels and restricted their ability to lend but also the bailout plan would have restricted their ability to lend.

Beijing came up with a solution when the bankers resisted. Local government bonds could be sold to the PBOC for money that would then be used to make new loans.  This solution effectively wiped out local government debts and “recapitalized” banks by relieving them of bad debts allowing them to speed up new lending.  It should come as absolutely no surprise that lending in China really surged roughly 6-9 months after this plan was first announced.

However, and very important to return to our earlier discussion, it completely violated the principle of monetary neutrality.  The PBOC was printing money to buy assets from the banks.  How do we know this? Chinese data tells us this is exactly what is happening.

In January 2015, prior to any discussion of a local government bailout, PBOC claims on other depository corporations stood at 2.6 trillion RMB but by April 2017 that stood at 8.45 trillion. That is an increase of 5.9 trillion RMB or $852 billion.  In other words, the PBOC has spent the last two years buying large amounts of assets from Chinese banks and importantly exactly as it said it would. This was announced and agreed to by Chinese banks to sell the PBOC bad debts. This is not a shock.

Let me put this number in a little perspective for you in a variety of ways. This 5.9 trillion RMB is equal to 21% of the growth in total loans during this time frame.  This is equal to 38% of net capital for the entire commercial banking industry in China.  This is equal to 1,098% of the growth in M0 over this time frame.  As a slight tangent here, I use M0 here rather than M2, or other potential measures, as the PBOC controls the printing presses to print RMB but they do not directly control for our purposes here broader money measures such as deposits which are also related to history and asset prices. These broader measures are outside the immediate and direct control of the PBOC.  In short, as we can see the purchases of the PBOC are significant by any related financial measure.

Probably the biggest impact of this shadow “recapitalization” is that the banks did not have to declare bad loans reducing their capital base and lending growth. By selling via some form of a repurchase agreement, the banks were able to maintain that loan on their books as a standard loan.  Just as other forms of asset purchases by central banks keep capital costs low and stimulate investment/public spending, so the PBOC purchases here are designed to do this using the banks as conduits.

Now I can already hear an understandable objection. This is not a recapitalization because the PBOC is just holding assets as a collateral they are not recapitalizing the banks.  Possible (which I will return to in a moment) but in the short term, irrelevant for what we are discussing here.  In the short run, the PBOC is clearly violating the principle of monetary neutrality.  Just think of how big the drop in lending would have been, not even assuming second order/dynamic effects, from just backing out the PBOC purchases.  Assuming a not insignificant numbers of these pledged assets are bad assets, think of what that does to bank capital.  Banks are making loans with money that did not previously exist printed by the PBOC to further stimulate lending. We have violated monetary neutrality.

The question I briefly circle back to is whether the PBOC is actually recapitalizing.  I would humbly submit a couple of points of importance here that violate the presumption of standard central bank lending that lead us to the conclusion this is a type of recapitalization.  For starters, we cannot consider 228% growth in just over two years as standard and normal growth.  This is clearly far outside the bounds of normal financial growth even by Chinese standards.  Then, and though we cannot say for certain, given that the most likely scenario is that the PBOC is buying distressed, bad, or low quality loans, this absolutely has to count as non-normal lending practice.

However, probably the most important question is what is the nature of the capital here? By that I mean, does the PBOC seem likely to pull credit and the what happens when the underlying loan is either repaid or is defaulted on? On the first part, I believe it is extremely unlikely that the PBOC will pull the credit facility because this was the whole point of the local government bailout.  Banks would only go along if they had a place to effectively dump these low yield junk/NPL bonds. More importantly is whether this is a “recapitalization” or just standard asset lending by central banks. Given that the PBOC is accepting, most likely, very low quality debt, this is not standard central bank lending.

The question then focuses on the capital supplied by the PBOC.  If the underlying debt is repaid, then the PBOC is repaid and no “recapitalization” has taken place.  So then what about the scenario if the underlying debtor defaults?  In most every system I am aware of and I would assume the same for China, though I cannot say for sure, during a repo, which is likely the type of transaction taking place or a similar transaction when a lender pledges a fixed income security as collateral to borrow if the debtor of the fixed income security defaults while the security is used as collateral for borrowing, the original lender can be held liable for the bad debt. Put another way, if ICBC holds a bond of province X, ICBC takes that bond to the PBOC and sells that bond agreeing to repurchase it in say 5 years, if the province defaults during those 5 years, the PBOC can pursue ICBC to make good the bad debt portion.  Here is what I think is important: assume province X defaults on the bond ICBC sold to the PBOC, I think the probability PBOC would pursue ICBC for damages to recoup losses as above zero but very very low.  In this scenario, the PBOC has effectively recapitalized a bank absorbing the loss they should have suffered.

Circling back to our original questions, while I think it is possible that recapitalizations can be monetary neutral, in China this is clearly not the historical case and would I believe be unlikely in the future. Furthermore, while not all of the new money supply will be “recapital” into banks as some of the securities held by the PBOC sold to them by banks will be repaid, I would deem it highly unlikely that the PBOC would pursue bad debt claims against Chinese banks in the event of default. Banks would in this case receive a backdoor recapitalization by not suffering losses they should have suffered.  It is quite likely, the PBOC is the new Superbad asset management company for China.

Can China Address Bank Problems without Having Currency Problems?

A while back I was asked by Brad Setser during a Twitter exchange involving many people spell out why I think China if it has banking system problems will also likely suffer a currency problems.  This is a very good question.  Let me try and answer that in detail and provide many reasons.

  1. I do believe it is possible China can deal with significant banking problems without having currency problems, but I believe it is much more likely that if there are systemic banking issues that currency problems will also arise. In other words, I am not ruling out his argument that it is possible but I think it is much more probable, one will precipitate the other.
  2. Let’s begin by assuming there is some type of “event” that requires Beijing to step in and provide capital in a systematic way to prevent larger problems. If we have learned nothing from watching Chinese financial markets over the past few years, we should know that market sentiment is incredibly fragile.  Given the ongoing outflow pressures, it seems highly likely if there was an event that required or pushed Beijing to step in (I use “event” here to cover events ranging from pre-emptive large scale recapitalization to significant financial institution collapse) this would likely have a major negative impact on sentiment.  This would likely require significant steps on the currency side ranging from full draconian measures to prevent problems with the RMB. Individuals are not taking currency out of China as a vote of confidence so any type of large scale bank or financial institution event would likely only redouble their drive to take currency out of China.
  3. I believe, as I have believed for some time, that the currency and financial system in China are intricately linked. Beijing is obsessed with preventing a fall in the RMB due to financial system concerns.  Here is what I mean by that. Let’s assume right now the RMB drops 10% against the USD. What would happen to the real Chinese economy?  Adjustments would happen but for many reasons, which I have covered elsewhere, I do not believe until you get to extreme numbers that a decline of the RMB would have a major negative impact on the real Chinese economy. So then why is Beijing working so hard to keep the RMB up and stop capital outflows? While some have argued it is US political pressure under Trump, China has been working to keep the RMB elevated for a number of years. Furthermore, they have never had any trouble ignoring US political pressure on economic and financial matters, so this seems a strange place to start. The much more likely explanation is that Beijing fears the domestic financial problems if it did not prevent large scale capital flight that either precipitated a fall in the RMB or followed.  Even with steep drops in outflows, the Chinese financial system is facing significant liquidity problems even as the PBOC remains net provider of liquidity and its balance sheet continues to expand.  If there was any move, not just of currency out of China, but out of the Chinese financial system, it seems unlikely that the Chinese financial system would be able to survive even a small move out of its walled off system.
  4. One argument that is made is that the government has a lot more space to bail out Chinese banks and so can avoid any entanglement with currency problems. However, even here, I believe it is less likely that currency problems can be avoided. Let’s take a couple of simple scenarios.
    1. Assume that China opts to issue bonds to recapitalize its banks. It cannot sell the bonds to banks, who by definition lack the capital, so it sells the bonds to the PBOC who increases the money supply above an already strong growth pace. Even stronger money growth would place significantly stronger pressure on the RMB. It seems inconceivable that China could materially grow the money supply above current trends and would not face some type of major currency adjustment. Consequently, even if the government can (has the fiscal capacity), which is another discussion all to itself, bailout/recapitalize the Chinese banking system, they cannot do it without lowering the value of the RMB.
    2. Despite many people believing the PBOC can bail out the Chinese banking system, there are numerous problems with this hypothesis. For instance, at this point the PBOC simply does not have enough money. Depository corporations in China have total assets of 236 trillion RMB. $3 trillion converted into RMB is only 20.7 trillion RMB or only 8.8% of assets. Any significant loss or recapitalization is going to require more than the amount of FX reserves held by the PBOC.  Needless to say, if the PBOC depleted its FX reserves to convert into RMB and pay for the recapitalization, this would have a negative impact on confidence in the RMB.
    3. Another proposal has been to let quasi-public distressed asset management firms buy up bad loans as they did roughly 15 years ago. However, this fails to fundamentally address the problem also.  Mechanically, this would work similarly to a straight bank recapitalization with bonds issued by the government and cash provided by the PBOC. In this instance, if the AMC’s bought loans from the banks at full face value to keep the banks solvent, this would solve the banks problems but merely move the losses elsewhere.  If we assume that the AMC’s are buying at full face value to keep the banks solvent and recovering at 30 cents on the RMB, that still requires them to receive enormous capital injections for any significant loss level. The AMCs then must either receive some type of direct public capital or issue bonds to the PBOC or private investors. While the AMC’s have the expertise and guanxi, they do not have the capital.  China has been ramping up these companies but so far, even though the numbers are not entirely insignificant, they are operating under the framework of the official 1.74% NPL rate cover roughly 91 trillion RMB in commercial bank loans. If we just increase the expected NPL rate or expand it to cover off balance sheet items owned by banks or include non-bank financial institutions, the expected numbers are simply blown out of the water. Ultimately, we return to the problem that any significant increase in capital to bailout the Chinese banking system will require an enormous increase in the money supply on top of the already robust rates. A large increase in money is going to place enormous downward pressure on the RMB
  5. There are other problems. Despite the belief China addressed its bad debt problems before, the reality is much simpler, it simply outgrew them. What is important is that not only did growth remain high it experienced a sustained acceleration. From 2000-2002, quarterly YTD real GDP growth ranged from 8.3-9.1%. From 2003-2011, the only time Chinese GDP growth was below the 2000-2002 range was right after the global financial crisis. Most of this time was marked by double digit growth topping out at 14.4%. China did not address its bad debt problem as much as outrun it. In one example, a Chinese bank went public in Hong Kong listing a complicated swap agreement where IPO proceeds would be used to pay off a decade old bad loan it had made. This matters because if we project forward, this implies that to manage its debt problem China must experience a significant shift between the rate of growth and debt.  Either debt growth must enormously decelerate or nominal growth must rapidly accelerate.  Taking this out of the macro-financial and into the micro-financial, a large amount of the “cost” of the previous bank bailout via AMC’s simply melted away from a growth acceleration as asset prices rose sharply.  I do not think it is likely that China will enjoy either acceleration of nominal growth from current rates or continued double digit growth in asset prices to absorb the cost of financial system bailout.  This returns us to the question of what will happen if there is a large increase in money to pay for the bailout? If the PBOC prints money in excess of the already robust rate of growth, the most likely outcome if significant pressure on the RMB.
  6. Another reason any significant problems in the financial sector in China will result in currency pressures is the role of lending and asset prices. Assume there is any significant financial event (again ranging from pre-emptive significant recapitalization to institutional collapse), there are two possible responses.  Now assume while managing the financial event, China opts to engage in counter-cyclical lending splurge to keep asset prices and economic activity high.  For instance, at the moment YTD aggregate financing to the real economy in China (total social financing) is growing at 13%. Assume while recapitalizing its bank China tries to boost activity by increasing lending significantly above trend. If we add in the growth of money from PBOC bond purchases, this would cause Chinese money supply and then money flowing through the system via lending to increase enormously.  This would result in significant pressure to move capital out of China in an inflationary environment or with major increases to the money supply. Take the opposite where China opts to recapitalize banks (or some similar event) but in this instance, China opts to constrain lending by some appreciable amount.  This would have a major negative impact on asset values throughout China and by extension the rest of the world. Imagine a Chinese real estate market where mortgage lending isn’t doubling. What will happen to prices? They will fall and when they fall people will most likely look to get their money out of China.  If people are worried about the fall of the RMB and try to get money out, imagine what will happen when real estate prices (responsible for about 75% of household wealth) starts falling. It is very reasonable to believe this will increase real estate price pressures with people looking to move money out of China.
  7. Now I can already hear people complaining, and somewhat understandably so, that in each scenario whether China deleverages or accelerates lending, after a “financial event”, I believe it is likely that currency pressures will increase. That is accurate but I also believe a reasonable position to hold.  Not only are both logical positions they match the empirical data but return to a larger macro-financial theme which gets to asset price levels in China.  Assets in China are simply enormously overvalued and need to fall.  Michael Pettis has referred to this in similar terms as a “balance sheet recession”.  I think of it slightly different, with regards to the currency discussion, in that I believe there is a much larger structural demand for foreign assets by Chinese citizens/firms in virtually any scenario than there is for Chinese assets by foreign firms/citizens. There are many reasons for this but it is simply very difficult to see where this structural demand tilts towards net inflows into China. One of the reasons for the focus on stability by Beijing is that as long as asset prices are stable and moving in the right direction, they will be able to minimize flow pressures.  Even if we think about how to fund the public contribution to the bailout, it has been suggested that China sell off some assets to create a fund to bailout the banks. Who is going to buy these shares at some type of inflated price?  Domestic firms do not have the financial flexibility required for any significant asset purchases having resorted to SOE’s playing circular IPO cornerstone and international firms will be incredibly reluctant to fund large scale asset purchases without a wide range of concessions.  There simply appears a requirement that asset prices fall and part of this is a decline in the RMB.
  8. The last major question is whether this can be financed with a simple expansion of the Chinese government balance sheet. Partially but it is distinctly more complicated than that. For instance, just saying “expand the official level of government debt” to pay for a bank recapitalization does not answer where cash needed now to keep banks solvent comes from.  The most direct way would be via bond sales purchased by the PBOC from printing money but that clearly brings a variety of issues and most importantly for our discussion, pressures on the RMB.  Furthermore, and this is something that is poorly understood by many many people, is the virtually every debt is perceived as being backed by the government by Chinese investors. I want to emphasize this does not mean they have technical or even implicit state backing but from sophisticated institutional investors to small scale retail punters, there is a wide spread belief (which Beijing while officially denying in practice has not given people reason to behave differently) that virtually every debt product has a state guarantee.  The simple reality is that in the event of a financial event that requires public action, large sections of “private” Chinese debt will simply be absorbed by the state.  Now with total depository corporation asset of 316% of GDP at the end of 2016, it wouldn’t take a large bailout as a percentage of total asset to take Chinese central government debt soaring into Grecian territory.  An explosion in government debt financed via some of the various channels here is possible but it is important to note there are greater constraints there than generally realized and the impact it would have on the RMB.

I want to emphasize this is what I view as more probable than no or minimal impact on the RMB given some type of financial sector problem but as I have noted many times, I think it is important to think in probabilities.  Also, this is intended not as any type of personal attack but simply laying out what I see and expect.  Finally, while individual points are important, I am also looking at the range of factors. Even if I am wrong on some of individual speculations, I believe the totality of evidence implies this is the most probable  direction.