Economists and Danger: Welcome to Modern China

I do not typically write about individual news articles but I saw an article by the always excellent Lingling Wei (who in case you forgot also broke that the IMF was pushing the PBOC for more information about its derivatives portfolio) about Chinese authorities warning economists.  There are a couple of points worth mentioning and some of them are, warning you in advance are politically incorrect.

  1. Any China bull or anyone who still has any remote belief that Chinese data is anything other than art: you’re just embarrassing yourself. Assume the Chinese economy really is in good shape and economists are just misinterpreting data, why do you need to go around threatening people?  One thing that I get from certain non-Chinese economists (with one senior person at well known institution telling me “we have no reason to believe Chinese data is systematically manipulated”) is that I just don’t understand China or Chinese data.  It is widely accepted in China that Chinese data is heavily manipulated.  This is not some dastardly foreign plot but accepted wisdom in China.  I learned about this, as I have said many times, not from academic work but from my students who thought I was moron for believing it in the first place. If China known to censor the news do you really think they are choir boys on economic data and that the economy is humming along at 6.7%?
  2. Self censoring of economic and financial reporting in business community is wide spread. I was told point blank by a senior executive from a major financial institution that they no longer publish any report that is remotely critical of the Chinese economy or markets.  Of course this is not put in the employee handbook but that is unofficial policy.  We already know this is happening to Chinese reporters but his is increasingly happening to economists. To argue that Chinese doesn’t censor economic data is simply delusional.
  3. Politically incorrect warning (but something that should come as no surprise): I am personally only able to say what I say because I am white and American. Consider the race card played. If you have been following China at all, this should come as absolutely no revelation even if it is maybe somewhat politically incorrect to say straight up. Most all Chinese economists do not want to talk publicly about the economy, even those that are pro-Beijing for fear of saying something that will get them into trouble. In today’s China I cannot tell you how much respect I have for a Chinese economist who says anything publicly and even more so for those who do not perfectly conform to what Beijing says.  I know an economist, decidedly pro-Beijing, who gave an interview to local media but laughed when his comments aired as he mentioned they removed his suggestions and comments about how to reform. Mind you this was not a critical voice. This was in fact a very pro-Beijing voice but even he saw the irony.  I have never been approached to stop writing or saying what I am seeing in the Chinese economy, but if I was Chinese by passport or ethnically, I believe there is no chance I would be allowed to write what I write.
  4. The change in China has honestly given me pause to reconsider my own position for fear I might face retaliation in China. Despite my critiques of the Chinese economy and data on largely technical issues, I can say with hesitation I enjoy what I do, my job at Peking University, and the city of Shenzhen. My family enjoys living in Shenzhen, a very comfortable and pleasant city except for the stifling humidity, and my incredibly white kids speak native quality Chinese which has won me many a bet.  However, the entire environment in China is changing and changing rapidly and not just the economy.
  5. Some absolutely great comments by economists who realize how absurd the system is internally. Some of my favorites:
    1. “You can see they’re not happy when you tried to tell them foreign speculators are not your biggest problem,” said one of the officials who attended the meetings.
    2. “As a Chinese reporter, you can do anything but journalism these days,” said a senior editor at a state-owned media outlet.
    3. “I was told by regulators not to recommend shorting the renminbi,” Ms. Lin told the gathering, “so I’m just going to recommend buying the dollar.”
    4. the city’s propaganda department recently instructed a local think tank to stop researching a planned debt-for-equity swap program aimed at helping big state companies reduce debt, according to economists familiar with the matter. The reason, these economists said, is that officials don’t want the research to turn up unfavorable evidence after Premier Li Keqiang and others have endorsed the swaps.
    5. Despite recent signs of a rebound, Gao Shanwen, chief economist at brokerage Essence Securities Co., told investors that “a lot of the official data aren’t reliable” and the economy still faces “big problems,” according to people who attended the closed-door event. Words of those remarks crackled across social media. Two days later, Mr. Gao issued a clarification on his public account in the popular Chinese messaging app, WeChat, saying those remarks were “made up.” He then released a report on the economy shorn of critical commentary. Mr. Gao and representatives at his firm didn’t return requests for comment.

On Kaiser Kuo’s Thoughts on China

Kaiser Kuo gave an interview about a wide range of topics with regards to China that was stimulating for many topics that I rarely address here.  However, I wanted to veer away from my relatively strict adherence to economic and financial writing to follow up on some of the topics he raised.

  1. We might be through with the past, but the past ain’t through with us.

The Chinese relationship with history is one of the most interesting to witness and something I do not think most people, myself include can fully grasp.  China has left behind its communist past and entered an era of individual dictatorship but what that means for the future remains to be seen with all commentary little more than speculation.  It is inaccurate as many do to argue that China has no understanding of major events or people like Cultural Revolution, the Great Leap Forward, or Mao.  They just understand them very differently than what most of us think of as a understanding them.  My students hear stories from grandparents about the Great Leap Forward or the Cultural Revolution.  They receive little if any and a highly edited version in any class they might take, so their totality of understanding will be like grasping a slice rather throwing their arms around the topic.  However, the know clearly there was great suffering and many died.  Oral history for many years was how history was transmitted, with people giving their perspective, and this is how a lot of modern Chinese history is passed on.  In my office, I have both Warhol portraits of Mao as well as pictures from the Cultural Revolution one among them flogging professors as capitalist pigs.  Students see this and immediately get knocked kneed from seeing a Mao portrait then look at me and their knees start knocking more unsure as to why I have these pictures on my wall and what I am going to do them.  History has a absolute but complex grip on Chinese that is difficult for anyone to understand.  My great-grandmother died when I was young was almost 100 and travelled across America in a covered wagon when she was young but flew in a 747 across it later in life. My mother before she died spent a couple days interviewing on her memories and experiences of such a time in American history.  I have this idea for a book project to collect oral histories from elderly in China about their lives with no other intent to save a record of what people remember and have lived through in truly one of the most amazing times in world history with first hand witnesses.

  1. Liberal democracy is always on a precipice

Another point I think Kaiser points out and profoundly grasps, that most do not, is the semi-capriciousness and delicateness of democracy that we often take for granted.  It is taken for granted by people on the political right and the left how profoundly imbedded into American or European democracy these principles are.  Consequently, I personally see a failure to safe guard the principles of democracy above the interests of a political party or specific political issue.  Democrats in America are all for free speech until it is someone doing unfriendly research on global warming and Republicans are all for individual freedom until it comes to the surveillance state.  My concern for the United States is primarily about how we are accepting an increasingly illiberal democracy on all sides placing individual parties (neither is innocent) or specific issues (many guilty parties here) above the life blood of democracy.  I am not saying there are not difficult issues that need to be addressed but we have taken expedient approaches that consistently place an issue above a principle and then wonder why a law or regulation is being used by the government in unintended ways.  Liberal democracy is sustained by people protecting the principles that aid us all and not just myself at one moment in time.  It would seem a little more humility is in order for people of all political affiliations.

  1. “Baidu exists to expand the information horizon for ordinary Chinese internet users.”

Seriously, who are we kidding with this statement? Baidu is the business side of the Chinese propaganda ministry. Baidu has done some great things like the ones he mentions but to think that Baidu does anything beyond serve the whims of its Beijing masters is fantasy.  I should note that I understand the dilemma faced by companies like Baidu. Baidu is allowed to stay in business because they do what Beijing tells it to do. You can bet that if they announced they were removing internet search constraints, they would be shut down before I finished typing this sentence.  The decisions people and companies make about how much to self censor in China is a uniquely individual one and many will come to different conclusions for different reasons.  Personally, there are three-and-a-half things I will not talk in most any context: a) Taiwan b) Tibet c) Tiananmen d) The Party with the caveat except when it concerns matters directly related to economic and financial policy.  I take this view as a mix of what is my role, what is my area of expertise, and what can I contribute.  Other than that, I have no problem speaking my mind in most any forum.  While I am certain I am on the black list for Chinese journalists, I can say unequivocally I have never had one problem about anything I have written or said that was primarily about China.  My university has never asked me to censor myself about my work on the Chinese economy. My university has never asked me to change anything in my syllabi and I once taught a class on the writings of Milton Friedman. I should note I don’t talk much about my views on China in class only because I believe it is my job to focus on the course material which draws from all kinds of sources rather than use it as a platform to push my views.  Right now everyone has to figure out how far to push that line. Everyone has different risk levels and even points at where that line exists for them. Let me give you two anecdotes. I was recently approached by a major news program and after asking me some questions they asked if I knew someone Chinese in a specific area that could answer some questions for them. I said I thought so but before I passed on their names, I would need to check with them. I reached to a couple of contacts and no one wanted to talk publicly or even off the record about the economy for fear of what would happen.  That is the state of modern China.  Even the economy is increasingly off limits.  Then I was having lunch with someone and we had been talking about Chinese history and they mentioned that the environment has changed so much in China that people are now reporting other people if they hear things in a conversation that are not positive about the government.  I was floored and asked them to clarify wondering if this just referred to President Xi or something.  They shook their head and said no. Our conversation wouldn’t be reported because they were talking to a white guy and most people probably could not understand. However, if they talked in Chinese in a negative way about either the local government, people will now report on each other to authorities.    I will almost never criticize anyone for making an honest decision about what they feel comfortable with but I will criticize someone who is delusional about the decision they have made.  To say that Baidu does anything but provide the information the government wants people to have is simply delusional.

  1. Reporting on China “becomes a place where there’s nothing but political and religious repression, toxic air, venal officials, crass nouveaux riches, and heavy-handed censorship.”

To be fair there is a degree of truth in his complaint but it is buried under an avalanche of illogical delusions atop the apex of hypocrisy.  Let me give you just a couple things to think about. First, for someone from a company whose primary purpose to enforce a censorship regime that ensures only one viewpoint to complain about the lack of diversity of reporting is the sheer apex of hypocrisy.  Your job is to make sure there is only one view point and then complain when those you do not control have another view point.  Yes, news around the world tends to focus on negative events but this is not in any way unique to Chinese coverage.  What is unique is that in most other places there is not the brutal oppression of those who do not toe the party line.  Second, when the Global Times, Xinhua, or People’s Daily provide less xenophobic, nationalistic, sabre rattling, and more balanced contextual coverage of Japan, Hong Kong, Taiwan, its own human rights record, health scandals, stock market, or the United States just to name a few then you might have some argument.  Otherwise this argument is nothing other than propagandistic drivel designed to force everyone around the world to report what Beijing and yes its executioner Baidu want it to report.  To complain as part of the Chinese censorship/media regime that China does not get a fair shake from foreign media when you ensure only one view point gets through and that view points is for some countries virulently anti-foreigner smacks of self-deluding hypocrisy.

  1. Egg headed intellectuals critiquing China

This point by Kuo is especially puzzling and it is unclear if he is referring to Chinese or foreign intellectuals or both.  Part of the problem is that Chinese intellectuals who I know first hand have a range of opinions are afraid to speak up.  For someone so ingrained in the censorship regime engendering fear in anyone who does not just repeat the Beijing talking points speaks to the depth of brainwashing that takes place.  I know first hand that Chinese intellectuals have a range of view points from those that are stridently anti-Beijing to those that are stridently pro-Beijing and absolutely every degree of somewhere in between.  However, most all are afraid to say anything publicly that is anything less than exactly what Beijing puts in a press release.  I think it would be great to get a more vigorous public intellectual discussion on (where I am) economic matters in China but the fact that there aren’t Chinese intellectuals willing to run the career risks to do so, gets to the very heart of the problem Mr. Kuo claims to want to combat.  Basic point: you can’t have it both ways.  Speaking now for myself, and only myself, in most everyway I do not think what I do is anything special.  I have had people say some  complementary things about my work which I appreciate but I honestly do not think what I do is all that special.  I am an economics data geek who spends most of my time just poring over data tables.  To show you how perverse the entire intellectual environment in China is, if I was in any other country, my work might be considered interesting but nothing outside the ordinary of what other commentators, public intellectuals, economists, the media, think tanks, or even the central bank might do.  I do work hard and think I have found some interesting things but the fact I am willing to say anything from inside China is maybe the biggest most disturbing thing to Beijing.  On top of this is that the vast majority of what I do is really just data detective work using Beijing’s own data.  To complain about an economist studying the data and saying it doesn’t add up is like a politician complaining that the press is using his own words and actions against him.  If you have a problem with what I am saying, start with the enormously problematic data that provides such rich fodder.  That is the entire point of intellectual debate discussion and free information.  I will not say never, but I try in most of my writings to be restrained and focus on the data and avoid sensationalistic headlines.  Believe me, it would be very easy to be a lot more sensationalist about the Chinese economy.  If you want to complain about critical intellectuals, maybe trying looking at what we are talking and writing about like the glaring data discrepancies in official data.  The fact that a grumpy professor who wears Chucks, jeans, and t-shirts even might register on the radar to Beijing shows just how perverse the intellectual environment in China is.  Either the Chinese economy and political structure is a lot more fragile and insecure than I suspected or I am a lot more influential than I thought which there is no way that is remotely possible.  I am just a guy with a blog writing about data and Beijing or Mr. Kuo feel it necessary to complain about professors like this?  Absurd. The critiques by Mr. Kuo about the lack of balance and intellectual criticism might be well served with a little introspection about why more voices aren’t willing to engage in intellectual discussion rather than the tired whining cliché propagated by his previous paymasters in Beijing.

Chinese GDP and Credit Data with Some BV Follow Up Thoughts

  1. In many ways, I really do love China bulls because they keep me sharp and always honing my arguments and digging for new data. They have such tired and poorly thought out arguments about what is really happening.  The Chinese economy is such a mess that I do not even need to demonstrate how manipulated the data is, I can just show them basic official statistics.  My favorite today is comparing the increase in absolute GDP in 2015 vs. the absolute increase in total social financing or aggregate financing to the real economy.  In 2015, nominal GDP was 4.1 trillion RMB higher than nominal GDP in 2014.  However, new aggregate financing amounted to 15.4 trillion in RMB.  In other words, China invested (spent on projects and rolling over new loans) 15.4 trillion RMB to create 4.1 trillion RMB in new GDP.  That is not a good payoff ratio.
  2. While the idea that commodity trading is driven by trading volumes, one aspect that has received less attention is the fact that there is surprisingly little pick up in real economic activity. Since December, average daily steel output is virtually unchanged.  This gets to one of the driving problems with the Chinese growth, which has not changed, is not consumer driven, and is not rebalancing, is that the boost in investment/credit is having less and less impact on real activity.  New financing to the economy through March is up 43% over 2015 but even just using the official data, nominal economic activity is up 7.2% in the first quarter.  In other words, even as the investment and credit flood gates have been opened, activity is still simply trending downwards.
  3. A couple of follow up points to the BloombergView piece that focused on Venezuela but could have spent significant time on numerous other countries like Sri Lanka and Mozambique. As usual, start there if you haven’t read it and come over here for additional reading. There are a number of interesting things that I want to double back to.  First, maybe the most interesting thing about these episodes is what it reveals about Chinese economic and geo-political strategy.  Oil and copper are some of the most widely traded commodities on the planet with almost anyone willing to sell at the right price.  Not even China or the US can corner the market in these basic materials.  However, China was so insecure that it would be able to obtain the materials necessary to power its economy, it made a long list of bad investments around the planet to lock in these commodities.  This reveals an enormous amount about how Beijing approaches markets, globalization, and relationships with other countries.  Second, the first wave of overseas Chinese investment made in sovereigns and corporates let’s say between 2010 and 2014 was made primarily in commodities, energy, financials, and real estate with a little dabbling in technology.  Whether on a state to state basis or corporate to corporate, there are large amounts of investments that will have to be written down based primarily just on the assets they invested in to secure resources.  This also tells us something about the current wave of outward investment from China.  The prices Chinese companies are paying almost always appear to based upon very rosy assumptions about prices, growth, synergy (sorry never bad mouth synergy), or other excessively positive assumptions about the future.  I think there is a high probability that in a few years a significant portion of the current M&A frenzy will have to be unwound.  Third, it is interesting how China is taking its investment and lending standards global.  China basically applied its own internal lending standards (i.e. throw money around like a drunk rock star and hope you’re still alive the next morning) and is now running into real problems because unlike lending inside China it actually wants to get repaid on its foreign loans.  However, the reasons it made those loans and how it managed the risk are simply not very good.  Given its political clout, there is a good chance its banks will get made whole especially from borrowers like Venezuela, at least in the near term, however the longer term outlook as much murkier.  People linked to the Venezuelan legislature has already said it may simply repudiate any debts negotiated with China under some circumstances.  Making bad loans to friends inside China, where they can be rolled over indefinitely, may work.  However, that doesn’t work when you depend on a specific politician or you expect actual repayment.  Fourth, if this is what we see happening on international loans, image how bad the problems are inside of China given the enormity of the credit bubble.  I believe we haven’t even begun to scratch the surface of lending problems in China.

Does China Need More or Less Marketization?

I do not normally address other work primarily because a lot of Chinese work is higher quality than it used to be and I will not respond to everyone I disagree with.  However, sometimes there are stimulating pieces that catch my attention and Tom Orlik of Bloomberg wrote a good piece on why China would be well advised to proceed very cautiously on market reforms.

Now before anyone expects a pro or anti-free market rant, as I always stress, these decisions or situations, especially with China, involve a lot more nuance and subtly than simple binary decisions.  While I do have a general free market bias, I recognize the short comings and limitations of the market but consider it like Churchill considered democracy: the worst possible system except for all others.

Let us take a simple starting point. If the PBOC announces before market opening that the RMB is now freely convertible and that people can do whatever they want with the RMB, I think that using a conservative estimate the RMB would fall 20%, creating significant stress in both China and the rest of the world.  (Side note: for everyone who says the RMB is fairly valued, ask them what it would trade at if it was allowed to float: then listen to the equivocation and excuses start.)

The problem is that both free and anti market people forget that economics is, among other things, the study of tradeoffs.  Raising tariffs may protect jobs but what is the tradeoff in both direct financial cost and longer term economic organization and moral hazard costs? Consequently, there is almost no point in time on any analysis that we couldn’t claim that increased marketization will raise risks.  Higher risk with increased marketization will almost always be true.

Even looking at this from a classical risk return payoff framework it will be true: if capitalism has generally proven to have higher growth rates that implies it is also assuming higher levels of risk.  The United States had about 50,000 corporate bankruptcies in 2015 while China had about 1,000, there is on a very basic level a higher risk of overseeing a corporate bankruptcy in the United States than in China.

However, the debate about the role of the market turns on much more subtle issues that something as crude as say whether to allow the RMB to float in the next 24 hours.  The reality of the debate of marketization in China focuses on two questions: whether or not to let have markets have complete dominion but whether markets will have any influence and whether China is moving towards or away from greater market influence.

Right now I think the clear answer is that China continues to move away from allowing greater market influence.  The RMB remains essentially pegged to the USD, financing remains almost entirely political, and the stock market acting as essentially a further way for the government to try and control prices.  Even worse the Chinese government appears to be doubling down on the policies that brought them into the current state of affairs.  For all of the talk about debt levels, China arrived in early 2016 with some of the highest debt levels in the world because of government policy not a market run amok and not only has it chosen not to address them but rather double down on the exact policies that brought it to this point.  It is very difficult to see how in any appreciable way China is even moving in a direction that in anyway increases market influence.

Now before I get emails or comments about the growing number of defaults answer me this: what has ever happened to a company in default besides eventual bailout?  A default in China essentially acts as a time out in sports and not a loss or end of season.  That is not greater marketization if they always get bailed out.

I would actually be willing to be a Keynesian for China or anywhere else for that matter if it would assume its proper place and recede when appropriate.  However, in China, like many places, government stimulus during slack periods becomes a narcotic that can never be pulled with people arguing about the increased risk of pulling it at any time.  Consequently, every wave of the Chinese economy in the past decade has not witnessed any lessening of government influence, but rather a continual growth whether through financing channels or regulatory approval because there is always “risk” in reducing the role of the state.  Whether the economy is weak or whether the economy is strong, well intentioned technocrats or risk averse commentators can always argue that reducing government support raises risks, which it does in some ways as already noted.  However, the story of China in the past decade is not government responding to the needs of the economy but rather permanent domination.

The real risk is that the failed policies promoted by the never ending government support reach a tipping point that the government can no longer control.  I actually agree that unleashing complete marketization on China right now would probably result in wide spread firm and bank failures as well as a currency crisis.  However, given the state of political and financial oppression, I see little risk of that in the near future. What concerns me is that as China continues to double down on the failed policies that brought it to this point, it will reach a tipping point at which it will be unable to control the outcome.  China is now one of the most indebted countries in the world, even using the narrow official data, with key measures continuing to grow much more rapidly than any other country.  At the rate debt is increasing, there may come a time when it exceeds Beijing’s ability to control the outcome.

The debate about marketization in China is less about whether you should or should not have markets but what direction do you want the country to go and what risks do you prefer to accept.  The answers seem pretty clear: Beijing wants greater control and accept the risk that it can control the outcome.

Just a Little More on Capital Outflows

So just a little more follow up to my most recent piece for Bloomberg Views on disguised capital flows from China.  As usual start there and finish here if you haven’t already.

  1. Here are some slides I prepared for the Foreign Correspondents Club in Beijing this week. You can clear see visually when the outflows really began and the direction they continue to go.  Hint: they are not reversing.
  2. You should not believe any of the official data on inflows or outflows. According to China, they had a pre-net errors and omissions balance of payment surplus of nearly $200 billion.  The NEO figure just brought the BOP into balance.  What country has large BOP surplus is bailing water  from the bowels of the Titanic to keep the RMB from dropping 25%?  This happens because BOP data is built on other faulty data like official trade surplus data.  So whenever someone cites the large trade surplus, they have proven to you that they do not know what they are talking about.
  3. All of the economic issues that people cite as attracting capital from China like the Fed and interest rates are simply compounding factors rather than driving factors. If China were actually enjoying large cash inflows from a $600 billion trade surplus, then the level of foreign debt repayment we are seeing would be completely and entirely irrelevant.  In fact, the PBOC would be forced to push down the RMB rather than prop it up.  However, that is not happening and that is why foreign debt repayment matters at all.  These are compounding factors but definitely not the driving factor.
  4. The Bank for International Settlements report a few months back was a classic piece of weak analysis without proper perspective. They cited foreign debt repayment as a primary factor for outflow but even by their own words, this analysis was extremely limited.  First, it only focused on the third quarter when the original devaluation took place. This omitted any look at a long time horizon.  Why does that matter? Between February 2014 and February 2016, foreign debt declined (drum roll please…..) by a grand total of $7 billion.  Second, by their own words, it only accounted for about a quarter of capital flows.  How does that count as the driving factor?  Given the magnitude of what we know about the gray market flow, foreign debt repayment is nothing more than a compounding factor and not remotely close to what should be considered a driving factor.
  5. I think there are three things that started this whole outflow process. First, China liberalized current account payments in 2012.  Consequently, if you wanted to buy a house in Sydney in 2012, you could either try and legally move it through the capital account, though with lots of difficulty.  You could also just import something from Sydney and enormously overpay so that money ended up in Australia so you could buy the house. Guess what people did? Second, economic activity peaked somewhere between late 2011 and early 2013 and has been on a downward trend ever since.  Given the vast over capacity and declining investment opportunities, this was likely Chinese seeing the declining opportunities taking some of their money off the table for better destinations.  Third, there was a political handover beginning in early 2013 that radically changed the atmosphere and likely well connected were hedging their bets well before it officially happened.  This is absolutely also a contributing factor.
  6. When I say that Chinese are moving their money abroad for additional security, I am using security in a very holistic sense. People are concerned about the cost of real estate, complete lack of the rule of law, the environment, getting caught up even tangentially in a corruption case, or so many other things.  No one in China views China as a secure destination, especially if you have any money.  Whether it is thoughts about where they want to send their children to school or comparing junk local Chinese government bond yields to high credit quality US corporate debt yields, for many reasons that bring greater security.
  7. This is not a short term process. Expect the capital outflows to continue. This is not going to turn around even if the economy does turn around for real.

Noise Vs. Trends or How to Look at the Chinese Economy

China has released a spate of good data which on the surface give a sense that the economy is turning around and everything will be fine.  However, if you look at the data in very straightforward ways, you can quickly see that the data is revealing significant underlying weakness.  Today rather than focusing on China, I am instead going to use China as the case study of how we need to analyze economies.

  1. What is the trend? Too many people will focus on a one month number and less about where does that number fall around the trend of previous months.  Economic data is noisy and most of the time simply bounces around a clear trend.  Just because it bounces above the trend in one month, does not mean the trend has reversed.  The trends with regards to China are obvious and need no revisiting but the key issue is that it is only normal that in some months, the data is above the trend line.  Take a simple example, if we believe the “rebalancing” story, which has more holes than a fisherman’s net, this absolute requires a long downward trend in roughly 50% of Chinese industry.  There may be short term data around that trend, but that trend is a long term structural shift and we would be advised not to read too much into month to month or quarter to quarter changes. Most every time people call some type of turnaround, plot the data and you can see that it is really just a bounce to slightly above the trend.
  2. What is the number measuring? Sounds a little simplistic but it is very important to make sure that the number being used is properly understood. As a simple example, joining forces with the previous point, many are rejoicing at the March trade data.  However, as China Beige Book so rightfully notes, the “bounce” was not a bounce at all after accounting for the previous years decline to the base and when considering the year to date numbers.  Year to date for the first quarter, Chinese trade numbers continue to decline.  As another example, the trade surplus measures the declared value of products at customs.  Officially China ran a nearly $600 billion goods trade surplus.  However, that measures the “declared value” not the cash transfer value.
  3. Put numbers in perspective. Many times people get excited over headline numbers and forget to put numbers in perspective.  Let me give you two examples. I think Chinese GDP data is completely unreliable, however, in most ways it doesn’t matter.  GDP is meaningless value to the man on street who pay their bills with cash.  Revenue across corporate China is essentially flat for quickly approaching about two years now while liabilities continue to grow significantly.  So for instance, while people say GDP is healthy, the key number of cash available to repay those debts is actually behaving very differently.  As another example, that thankfully many journalists and specialists picked up on is that Chinese bump in FX reserves was all about EUR strengthening against the USD not a decline in outflows.  Outflows remained right on trend.  Whenever you see a Chinese number, stop and think what is this number really telling me?

Sorry for the short post today been travelling in Beijing, Shanghai, and about to leave for Hangzhou before returning back to Shenzhen.  I’ll have some interesting slides to post in the next couple of days.

Follow Up on Chinese NPLs

I wanted to make some brief follow up points that will be a little more technical than what appears in my BloombergViews piece.  As usual start there and finish up here.

  1. I am decidedly pessimistic about the state of the Chinese economy and finances, but I really do not see a near term risk of what we would think of as a financial crisis. China is saddled with enormous sums of bad debt, people are taking their money out of China, surplus capacity is simply astounding, and cash flow growth through the economy is hovering around zero.  There is very little to be positive about, but I see little risk this year of some type of crisis.
  2. I do not believe we have reached or are even at a near term inflection point, barring some exogenous shock, where financial conditions so escape policy and bankers control that the path is set.
  3. Maybe my biggest concern is the inability of bankers and regulators to face the problem. I actually should just say regulators as they are clearly the driving force at play.  As one simple example, after all the talk about deleveraging in December, debt growth has pretty much exploded.  Not only are they not deleveraging, they are adding fuel to the fire.
  4. The supposed 1 trillion RMB debt for equity swap does not even begin to address the size of the problem. Caixin highlights one steel producer, let me say it again one steel producer, with 192 billion RMB in loans in cannot pay with its largest subsidiary not having paid interest since 2011.  Let’s make a simple assumption that you wanted to keep this steel company in business and complete a 100% debt for equity swap.  You would immediately use up 20% of the 1 trillion in capital on one company.  Even the Xinhua has noted the larger problem of unprofitable steel firms which made only a small profit in 2014 and a large loss in 2015.  Accounting for the debt and overstatement of financial health, 1 trillion in capital will not even begin to address the problems in one industry.
  5. There are so many problems associated with some of proposals I have heard floated but one of them what happens to the firms and industries after completing the debt for equity swap. For instance, if all firms stay in business with lower debt burdens the only thing that will happen is an even more heated round of cost cutting.  That is not a real solution.
  6. Furthermore, many are counting on shutting down a firm and selling the assets at the price they are booked for on the company’s balance sheets. History tells us in these situations corporate assets on sale in a bankruptcy type situation even when bought free and clear simply are not worth anywhere near their booked valued.  Then add in the massive surplus capacity and there would likely be little secondary market for these assets.  Anecdotally, from people I have talked to the going recovery rate seems to be about 20-25 cents on the dollar.  This would imply sales, to use a round number, at 10-15 cents on the dollar to investors.  The steel company in the Caixin article supposedly has 290 billion in assets.  Let’s suppose these are all real assets, which as the story notes does have some very real questions, this would imply a sales rate of 30-40 billion RMB, an enormous haircut.
  7. The basic strategy I think of Chinese policy makers is to try and replicate their 2003 strategy of growing their way out of the problem. As I wrote in a paper, there were banks going public in December 2014 with long term bad debt obligations that they used IPO proceeds to payoff.  Economic growth post 2000 was such an ahistorical event that I think it is a highly risky expectation to grow your way out of a mountain of bad loans two times in a row.  Even just think of the strategy of accomplishing this.  Will these bad loans on steel companies be paid off in 5-10 years just putting them off to the side? Unlikely.
  8. The ones that get mentioned the most are coal, steel, and real estate but this same concept holds for virtually any industry in China. Shopping malls, chemicals, and energy suffer from high debt and over capacity.  Even assuming asset prices underpinning assets remains high, which is highly unlikely if there is a significant push to reduce over capacity or reign in lending, large amounts of the Chinese economy need to address the NPL problem.
  9. One of the biggest issues that no one has addressed is what do Chinese banks do with the equity? What secondary market would they sell the equity into?  If they are swapping debt for equity at par, will they be required to mark to market?  What requirements will there be on lending as the equity owner?  This seems like a bad alternative as much of the equity will be near worthless and require haircuts of 90%.  Why then go through the debt to equity swap process if the likely outcome for either the loans or business is large write downs?  This implies that the intention is to try and salvage the value of these assets which would depend on large amounts of new lending.

China FX Reserves for March 2016

Tomorrow marks one of the big days in Chinese data releases: FX reserves.  Like with all data releases in general but definitely for China, need to be careful in interpreting what the numbers means exactly.

Let me explain why.  SocGen released a note earlier this week where they predicted, very boldly, and I will publicly admit they are right if the final numbers bear them out that Chinese FX reserves would rise almost $50 billion USD.  This would be an astonishing reversal if true.  The reality both from what the data tells us and how they arrived at that number.

Before turning to the SocGen piece, let me address recent conventional wisdom on outflows. There was some relief in when February data was released showing much smaller drop of I believe $26 billion.  The bull thinking was that this was due to increased capital controls and improved economy.  However, looking closer this clearly is not the case.  In February 2016, China only had 10 working days with very low levels of economic activity. As an example, how much do people really work between Christmas and New Years even the people that are in the office?  Given the primary channels of capital outflows then, this level of decline should not come as a surprise.

In fact, if we do nothing more than recalculate the observed FX decline in February to a full working month, we actually have a $58 billion decline in FX reserves.  If we then increase economic activity only slightly from very low levels, it is very easy to see how this would represents a $75b+ decline in February without the season factors.  In short, there has been absolutely no easing of outflow pressures.

The reason that it is important to provide the seasonal context is that SocGen and others have bought into the idea that outflow pressures are easing.  In fact, YOY from February 2015 vs February 2016, the outflow pressures and ratios are significantly worse. Then compared to the recent trend, February is not just in line with previous months ratios and direction, but continues the worsening.  Do not believe the hype that outflow pressures are easing. That simply is not the case and as I have noted this is a long term outflow driven by Chinese citizens and firms trying to move money out of China and does not change with daily or weekly events that so many focus on.

With that said, I do believe SocGen is right about one thing and that is Chinese FX reserves will not see a large drop.  This however is due exclusively to valuation changes between the USD and EUR.  As the EUR has strengthened pretty significantly against the USD in one month this will cause the USD value of the FX reserves to increase.  Take a simple guesstimate that one-third of FX reserves, I know some have very complex estimates and as I’m not revealing all my secrets and this is a free blog the guesstimate will do, that would imply about a $50 billion USD value gain to FX reserves.  If China held roughly two-thirds of their reserves in EUR that would in a round number be up to $100 billion valuation gain in FX reserves

To reach their forecasted $50 billion USD gain in FX reserves, SocGen is essentially forecasting zero net capital outflows from China in March.  I do not believe this is remotely close to a realistic expectation.

Given what I mentioned previously about seasonal factors and the basis of comparison, I believe that you can still expect cash outflow from China in March of at least $45-70 billion.  This would be in the range of outflows that we witnessed in November through January and we saw larger FX declines.

The reason this matters is simple: when FX reserve numbers are announced and the decline is much smaller to maybe a small increase, do not be surprised.  However, remember that the dynamics between the USD and EUR is what drove this and has very little to do with the health of the Chinese economy.  Focus instead on numbers released later about cash outflows.  I would be floored if cash outflows did not return to the large outflow trend that we saw pre-February.

Receiving a valuation change is like winning the lottery: a good boost but you cannot count on that. The cash outflows should be the focus instead.

Little Treat Before Tomorrow’s Chinese PMI’s

So I do some ongoing side work for investment clients interested in getting more technical information on the Chinese economy.  I don’t post much of it here for numbers of reasons but definitely draw inspiration from some of that work and do use some of what I do as blog posts.  From time to time, when the mood strikes me, I may drop some of this research on to the blog for the more data interested reader.  I should emphasize, I won’t be doing this on a regular basis.

I have developed some data indicators that will come from more high frequency and granular points than the more opinion like poll like nature of the PMIs.  This report uses actual operating data from actual Chinese industries that is as current as a couple days ago.

Based upon the data I’m seeing, I think there is a high probability we will see at least a stabilization in PMI’s and most likely an uptick in PMI’s.  There has been a pretty clear increase in operating rates and capacity utilization across Chinese industry from basic PTA straight through to heavy sectors like steel and coal.  Whether or not this will be sustained or whether this is more of a post-Chinese New Year bump, remains to be seen but the evidence is pretty clear that we should expect to see positive PMI numbers tomorrow.

Couple quick notes, this data is compiled at a variety of intervals and in some cases daily but is quite recent.  Furthermore, it is compiled by industry groups or companies and shows much greater variance (read: it isn’t a straight line like official data) so even if it is not perfectly accurate it should give us a much better idea about the direction of industry even if the levels may not be perfectly accurate.

Most Chinese industry remains at very low rates of operation.  If most industrial investments require operating rates upwards of 80% to be profitable due to the large capital costs, there is almost no specific industry that would be considered profitable.  There is simply massive over capacity all throughout Chinese industry.

This uptick in activity seems to correlate with other evidence of a quiet stimulus and growth in credit.  That is not a long term positive but this seems to be what is likely driving this uptick in operations.

I am skeptical this will be a sustained increase and is more likely due to season factors of returning to work and the stimulus but as my kids remind me: I have been wrong before.

You can find the file here.

Some Stories and Things to Read on the Chinese Economy

Having lived in China for almost seven years, I started blogging about China I believe about 4-5 years ago because what I was reading in the popular press was just not representative of what I was seeing on the ground.  There were too many important details that were left out.

I actually believe today that the level of understanding on China among interested people, still has a ways to go, but is actually a lot higher than it is given credit for.  I still see some people go on major outlets and talk about the Chinese economy with little more than an appreciation for General Tso’s chicken as qualifications, but I think the frequency of this type of “expertise” is falling relatively rapidly.

One of the primary dangers in trying to throw your arms around the Chinese economy is becoming too laser focused.  The most obvious example is that most foreigners tend to live in Beijing, Shanghai, and Shenzhen and use that as their window on China.  Those three municipalities have 47 million residents, which is a lot but when placed against the backdrop of a country of 1.3 billion that amounts to only 3.6% of China’s population.  Just as everyone knows that New York City and San Francisco do not make the United States, it is important to understand the Chinese economy outside these cities.  Whenever you see a graph showing housing prices in tier one cities like Beijing, Shanghai, and Shenzhen just remember how small a percentage of the country and even urban areas they really are.

As a professor and data junkie, I also think it is vitally important to add perspective by talking to as many people as possible about what is going on inside the Chinese economy. Both of these points were brought home to me yesterday by a conversation with a businessman friend of mine recently who regularly travels around China.  Travelling even less than an hour outside major cities like Shenzhen, you feel like you can step back in time and China is still a developing economy.

He relayed a story to me about a small town he had recently been to with about 250,000 people that had a not insignificant “international” airport and was preparing for high speed rail station.  However, his final destination was a town of about 75,000 a little further up the road which also had an “international” airport that was actually larger than actual town. He says if you look the town up on Google Maps, the runway is longer than the city itself.

He proceeded to relay the following story after questioning how on earth all this is being paid for or will pay for itself.  One of the local bigwigs in the city of 75,000 in this poor part of China where subsistence farming was still common would drive around town in a new Bentley was also a major construction boss and linked to the government (I didn’t ask details).  After securing money to install concrete lined rain ditches all over town, hence the new Bentley, during his last trip to this town my friend saw workmen jack hammering holes into the drainage ditches.  Puzzled by this, he asked what the problem was with the ditch.  Come to find out, there is no problem at all.  However, by destroying what was just built is the surest way to get money to build it again.  This nearly matches the old adage about increasing GDP simply by digging holes to refill them over and over again.

My friend, a smart guy who has held senior business positions at major firms, looks at me and says two things of note.  First, imagine this problem multiplied by 1.3 billion.  I forget which Chinese leader said it, but any small problem multiplied by 1.3 billion is a big problem.  What is worse is that these are not small problems.  Second, how does this not end in a fireball?  This is someone that has worked in China for a number of years with years of senior business experience.  As he pointed out, cities are building massive airports for a few flights a day with nearby cities getting airports and high speed rail stations everywhere.  He took his family on vacation on a high speed rail to a popular destination for a price that would much too small to cover the costs.  You can only continue to lend so much money out for unprofitable projects before you hit a limit.

Carmen Reinhart has a great piece on China’s Incompatible Goals about the impact of debt.  Too many people have read her previous work has mechanistically predicting either crises or growth slowdowns.  I think this is a serious misreading of what she and others have found about debt.  I would recommend reading this piece about how economic slowdowns with calls for monetary stimulus frequently place central banks in positions to allow greater credit growth precisely at moments when bad loans are rising worsening the eventual outcome.  China will find it difficult to run accommodative monetary policy and maintain a stable exchange rate.  The reason this matters is simple: “banking sector problems have regularly set the stage for currency crashes.”  Though I think a financial crisis in China is a low probability outcome, the scenario that scares me is a credit and currency crisis combining forces.

Eric Burroughs also has a good post on what we know about the bad debt in China making a point that many overlook: “what is private sector vs. public sector debt almost doesn’t matter. The state’s hand is everywhere.”  Too many, primary foreigners and financial analysts, try to make fine distinctions about debt in China.  To onshore investors, there is almost no distinction for most investments.  Holding an SOE bond is considered by investors in China as almost equivalent to holding a Beijing bond.  Think this is a small, irrelevant point?  Junk local government debt is being priced in some cases better than sovereign and many SOE’s enjoy similar pricing as onshore investors believe these companies are equivalent to Beijing.  Why does this matter?  Beijing will have a hard time credibility wise distancing itself from these companies as they go bust.  Before I get messages talking about increasing defaults, note that virtually every default has received some form of a quasi-state led bailout.  As is my belief, Beijing will attempt to keep bailing out companies as long as possible because losing credibility is the bigger risk than financial losses.

Finally, the Financial Times has produced a great video on “The End of the Chinese Miracle”.


This is a great piece that combines on the ground reporting with solid academic references about the big pictures structural drivers at play here.  In addition to the significant temporal headwinds like rising debt and NPL levels, there are major structural issues like an aging population and falling urban migration.

Probably what I find most amazing in many of the pieces I have cited is how much the discussion on China has shifted.  Even among more bullish commentators, the talk is no longer about the poor Chinese economy but rather arguing that China will not face some type of financial crisis or hard landing.  The human cost associated with a hard landing or financial crisis would be enormous, but it is clear even Beijing is increasingly worried about the economy and it is not getting resolved any time soon.