Highway freight traffic in China is down 8% YTD in 2016 registering a moderate YTD gain in 2015 of 5%. This compares with 2012 and 2013 gains of 15% and 11%. Given that freight traffic in 2014 was down 5% while GDP in real terms registered 8.1% growth, this seems like an inconsistent drop in real economic activity.
As the debate about the sustainability about the increase in Chinese credit has grown, a number of points have been raised about why China simply cannot have some type of financial crisis or even needs more debt. Though I believe a near term financial crisis is an extremely low but rising probability event, it is clear that the optimism about Chinese debt levels or growth ranges from misguided to uninformed. Let us elucidate some of these.
Myth #1: China has high savings rates. This is entirely true but does not change the fact that if firms cannot repay their debts, Chinese banks and savers will be harmed. A bank is an intermediary transferring surplus capital from depositors to borrowers and charging a fee for the service and risk incurred. If firms cannot repay their debts, this will place enormous pressure on banks to make depositors whole, and depositors will become decidedly unhappy if they incur losses. Even though China has established a deposit insurance scheme, this only means that bank losses will be imposed on many of the firms who cannot pay initially. Yes, China has a high savings rates, but if firms cannot repay their debts, there will still be large problems.
Myth #2: China does not owe foreign debt. Again, a mitigating factor for sure, but does not fundamentally alter the debt problems. The 1997 Asian financial crisis has programmed most to believe that foreign denominated debt or large foreign inflows is the driver. Financial crises can happen in the absence of a foreign driver. There are many examples of financial crises without major foreign influence. If firms cannot repay their debts, foreign or domestic, that only alters upon who the losses will be imposed and alters the probability for rapid outflows. If firms cannot repay their debts, they cannot repay their debts, and losses need to be imposed.
Myth #3: GDP growth remains strong. Leaving aside questions about the accuracy of official GDP growth, it cannot be stressed strongly enough that firms and governments do not repay debts with imaginary GDP credits but with cash flow. Based upon various measures of cash flow, corporations, the primary debt sector in China, are having enormous struggles with liquidity. From revenue growth that is flat to receivables growth rising double digits annually and an average of more than six months, there are significant cash flow problems in China hampering firms ability to repay debts. Even if GDP growth data is accurate, most of the corporate sector remains mired in a deflationary spiral with debt growth outpacing cash flow and revenue growth.
Myth #4: China can lower its debt servicing cost to international norms to manage debt. Many firms, including a major investment bank recently, pointed out that Chinese debt service costs as a percentage of GDP are high by international comparison. They noted that if debt servicing costs as a percentage of GDP were brought more in line with international standards, China could continue to expand debt levels. However, this analysis makes an elementary mistake: for China to lower its debt servicing costs as a percentage of GDP it must lower interest rates. Lowering PBOC interest rates, especially in an environment when the Fed will likely hike at the next meeting, runs the very real risk of ending the RMB/USD peg. Lowering debt service costs will place enormous pressure on the peg and if lowered much beneath its current level would likely lead to much bigger problems.
Myth #5: China should expand debt as a counter-cyclical tool to boost growth. In the absence of fixed exchange rate regime with capital controls, this would make some sense. However, rapid credit expansion and money growth outpacing nominal GDP by about two to one is a recipe for currency pressure. If China is going to continue to utilize this basket of economic tools, this will lead to the unceremonious end of the RMB/USD peg. You cannot do these things and maintain a currency peg.
Myth #6: China does not need to worry about bad debts as it can print money to buy bad debts. Semi-respectable people have put forth this mistaken notion as proof that the Chinese debt problem really is not a problem. Debt monetization is not a good outcome. This is like hoping for dengue fever rather than malaria. Furthermore, in China’s case would likely require the end of the RMB/USD peg which would present an even bigger list of challenges. Printing the money necessary to buy bad debts would increase the money supply which would place downward pressure on the RMB. Even just the announcement of such a policy would likely rile the currency markets which are already jittery. It is foolish to think China could execute any level of debt monetization without ending the RMB/USD peg which could unleash a whole range of other outcomes.
If you have not already picked up on it, probably the biggest mistake that China debt bulls overlook is that most of their outcomes or policies place pressure on effectively do away with the RMB/USD peg which is already under increasing strain. China has really tightened down capital controls of outward flows and inward flows are dropping rapidly.
While I do not believe a debt crisis is near term imminent for reasons I have already spelled out on numerous occasions, it is flat out wrong to believe the China debt bull story.
There is a strong correlation between the domestic Chinese traded price of commodities and NYMEX prices, even under anti-dumping tariffs.
Rapid growth in bond issuance has caused many to herald potential rise of new sources of funding for Chinese firms. However, the Chinese bond market remains dominated by the state. Out of the 6.4 trillion RMB in bonds issued through April 2016, only 270 billion RMB were classified as corporate.
As a point of reference, the China Import-Export Bank issued almost as much as all corporates with 233 billion RMB issued YTD.
The United States has imposed anti-dumping duties in Chinese steel. Leaving aside both the economic arguments against anti-dumping measures, a key argument of China is whether the the US and Europe are using fair comparison for determining whether China is dumping. Dumping is defined as selling a product abroad for below the cost of production. According to official Chinese NBS data, the Ferrous Metal Smelting and Rolling industry through March 2016 enjoyed a net profit margin of 1.1%. The NBS has not released su-industry data for steel making, iron making, ferrous metal casting, and steel rolling processing since October 2015.
When I wrote in late February that the primary channel for capital outflows from China was overpayment of goods imports, it was initially dismissed by some as an irrelevant statistical oddity while others saw the true magnitude of the problem.
Since as foreign exchange reserves have stabilized, primarily due to EUR and JPY valuation, the story has started circulating that capital outflows have stabilized and China is out of the woods. Net outflows do appear to be stabilizing, but for unrecognized reasons.
Since March 1, the noted discrepancy between bank payment for imports and the Customs reported value of imports has collapsed. This has had a significant pass through effect on the Current Account. From August 2015 to February 2016, the bank payment-customs import discrepancy averaged a net outflow of $50.3 billion. From the beginning of 2015, it averaged $45 billion. Since March 1, 2016 it is averaging $22.9 billion.
To put this size of this shift in perspective, consider this: in April China saw total net bank payment outflows of $9.8 billion. However, if the bank payment-customs import discrepancy merely remains at its August 2015 to February 2016 average, this turns into a $45 billion net outflow.
It should be noted, this is not nearly enough data to call this conclusive. A lot of month to month data is noise, so I am not about to declare this trend but it is interesting to note and something to watch. For instance, during this time, the EUR and JPY were strengthening and the market was pricing in lower probability of a Fed rate hike.
However, sometimes, I do feel like my work really matters.
Despite joining the SDR, the RMB has taken a step backwards as an international currency. RMB deposits in Hong Kong peaked almost in early 2014 and have been declining or almost a year. Taiwanese deposits have barely risen in two years. This is due to reduced interest by foreign investors in RMB denominated assets, onshoring of foreign denominated debt, and active PBOC intervention to reduce offshore RMB liquidity.
Chairman Mao was a brilliant strategic manager. Leaving aside the 30% error rate for the moment, Chairman Mao was one of the most successful cunning, ruthless, managers achieving his objectives at all costs.
There are two specific tactics the Chairman frequently used to get where he wanted to go. First, strategic ambiguity. Reading some of his speeches or directives on a variety of things, one could be forgiven for having no idea what he was saying. Even when the top line direction he was signaling was clear, he would typically leave it very ambiguous.
This was used by the Great Helmsman so that if he wanted to adjust the direction, criticize underlyings, or blame failure on others, he would fall back on the critique that others had either not carried out his wishes or had in some way been deficient. The strategic ambiguity of his words left enormous room for him to lay the blame for the failure of his ideas or policies on others for poor execution or misunderstanding. More than a few ardent believers went to their death or remained imprisoned wondering how they could have let down the Chairman.
Second, Chairman Mao was skilled at creating conflict between different groups to either take focus off of his own problems or create alliances. Many times both sides of a conflict would believe that he was aligned with them in the struggle against another side. For instance, he would whisper to one side the nasty things the other side were doing or saying about them and how he was really with them.
Many this week have written that the Cultural Revolution was something that got “out of control” but the much more unpalatable fact was that it was essentially approved and permitted because of this strategic ambiguity and conflict creation. This was a natural outcome from strategic management practice and not some accident.
We see this pattern, to a lesser degree, being repeated today. Let me give you a couple of examples. The world has been excited at the so called “supply side reforms” and how China has decided to tackle it surplus capacity problems. It could mean that and may mean that, however, there is more than enough strategic ambiguity in those words to mean the exact opposite. In a recent speech President Xi stressed supply side reforms should “improve the quality of supply to meet the needs, the supply capacity to better meet people’s growing material and cultural needs” as well as “reduce ineffective supply, expanding effective supply, improve the supply structure to the demand structure….”. At best that is not a ringing endorsement of significant capacity cuts and potentially even an urge to expand investment and capacity.
In another example, any idea of reform is still as clear as mud. Despite the western belief that China wants to reform SOE’s and make it easier for private enterprise to do business, the Party’s own words from President Xi reveal something different. He says the role of the market is “on the one hand to follow the laws of the market, good at problem solving with the market mechanism, on the other hand the government should take responsibility, all levels of local government departments have the courage to act, dry yourself, dry the matter.” This is not exactly a free market manifesto and could even be read as a call to increase the role of the government.
Let me emphasize that my purpose is not to either extoll the virtues of Mao or to say China will or will not reform. My purpose here is not note that the strategic ambiguity we see in the policy pronouncements, even though some will want to seize on one side, are not accidental. They are willful and purposeful strategic designs to ensure that senior leadership can do whatever it wants and then blame any failure on others. In fact, the recent speech given by President Xi was a speech designed to correct the errors in thinking by cadres in carrying out the supply side reforms.
It is also a mistake to assume that potential conflict within Chinese policy making or economic communities is accidental. It is likely organic but do not be surprised also if it is stirred up as part of the overall management strategy to maintain control. Given the clearly mixed signals, this seems a very reasonable assumption. The “authoritative” person interview was not a clear policy signal over rising debt concerns any more than the December deleveraging statement from the preliminary 5 year plan, the interview with PBOC Governor Zhou, or the completed 5 Year Plan statement on lowering debt dependence. All the while, debt across all varieties continues to grow very rapidly. This is most likely not accidental. Even a more nuanced reading of the statements indicates, they are not nearly a dead set on deleveraging as you might think. This however, allows them to complain about bankers to industry and about industry/local government to bankers. Conflict creation from the top is a commonly used historical tactic of senior Chinese leadership.
Too often, complex events in China are read through a dichotomous lens of Beijing can control everything or they control nothing. Reality however is much messier.
Update: When I told my wife of the blog today, she reminded me of a story of a friend. Working directly for the CEO of a good size private company, he finishes up a meeting and summarizes saying “Good. We are clear on what needs to happen.” The Chinese CEO corrects him saying “No. You are clearer. Never clear.” What I have described is a tactic used at all levels.
The Chinese credit explosion has come to dominate discussion with most people drawing a distinction pre and post 2008 global financial crisis. This is however a misleading break point and most importantly obscures very important information about what drives the Chinese economy.
Since 2008, the Chinese economy has been driven by investment which is driven by the expansion of credit. In 2015, total nominal credit expansion was nearly 4 times greater than total nominal GDP expansion. This a worrying development which most have interpreted as a new found appetite for credit that did not exists prior to the global financial crisis. While this is true, it obscures the story in important ways.
Since 2000, quickly approaching 20 years, the story of the Chinese economy relies on injecting ever larger amounts of capital. Many are drawing a clear dividing line between pre and post 2008, but there is a common thread between the them which is the requirement that money, credit, and investment continue to increase to push economic growth.
Pre-2008 this continual injection of capital required an artificially low exchange rate driving large surpluses sterilized by PBOC money printing. Post 2008, even though absolute trade surpluses remained large it wasn’t large enough in absolute terms to drive growth, so China turned on the credit spigots. The large absolute surpluses could no longer drive the relative growth needed, so China decided to manage this by itself.
The argument has been made that China has a lot lower risk than Asian countries in 1997 because they are not exposed to foreign investors. That is partially true but it exposes them to other risks. Foreign investors cannot pull their money but this requires China to financially oppress their citizens to ensure they provide the liquidity. We see this dynamic playing out very clearly. Bank purchases of non-bank financial institution products have exploded as quasi-deposits have moved into non-bank financial institutions. In other words, the lending follows deposits.
Consequently, this makes Chinese financial institutions vulnerable to either some process where domestic depositors pull liquidity. In fact, we see evidence that this liquidity tightening is already rising to worrying levels. For instance, the PBOC is providing ongoing “seasonal” liquidity injections across a variety of lending platforms. The seasonal liquidity injections at this point seem to never end and banks rely on that liquidity to roll over loans that aren’t being repaid.
This is likely what is the real driver behind RMB policy. If we are talking just the impact on trade and consumption, there should be relatively little impact from letting the RMB move lower. However, the concern over the RMB is not about its relative value or impact on exporters but on what would Chinese do if they were allowed to move large amounts of money out of Chinese banks and non-bank financial institutions.
If the RMB was allowed to float and Chinese move money wherever they want, this would place enormous strain on the banking system. Research consistently finds that crises in emerging markets typically come together to create major crises. For many emerging markets, some form of a debt and currency crisis is the perfect example of a two headed monster that would be beyond Beijing’s ability to control it.
The purpose here is absolutely not to predict doom and gloom. There are four points. First, it is important to note what is and has been the driver of Chinese growth for almost 20 years. The source of capital formation changed after 2008 but the driver of the economy did not. Second, if China is unable to continually drive capital/investment/debt levels continually higher, it is difficult to see where economic growth would come from and please do not get me started on the so called “rebalancing”. For 20 years, the story has been the same. Third, just because China is not exposed to international capital markets like Thailand and Indonesia, do not underestimate liquidity and credit risk. Fourth, understand how credit and liquidity risk interconnectedness are working together to drive many of these decisions. Beijing knows they cannot free the RMB because that would essentially prompt a run on the banks. You simply cannot separate many of these decisions.
China is trying to attract foreign capital to keep economic growth. It rolled out the Hong Kong Shanghai Connect to attract investment in Shanghai listed stocks via Hong Kong. China plans on rolling out the Hong Kong Shenzhen connect later this year and plans on rolling out a Shanghai-London Connect scheme in 2017 or 2018. However, there seems to be little appetite for Chinese stocks and it is isn’t just a result of the July 2016 collapse. Currently, Hong Kong based investors are using only a little more than 50% of the allowable aggregate quota of their potential Shanghai purchases.