Brief Follow Up to GDP as Misleading Indicator

I want to do a brief follow up to my piece for Bloomberg Views on why GDP misleading indicator when looking at the Chinese economy.  As usual, start there and come back here for additional detail.

I know that there is a vigorous debate about whether Chinese data is legitimate or not and if you are reading this, you’re probably very well aware of my opinion.  To this day, I do not understand how anyone can look at the headline data and say it is a good faith accurate representation of statistical reality.  Even most people who defend Chinese data anymore set a much lower bar of something like “well the directionality is accurate.”  Talk about an absurdly low threshold.

However, one of the things that has generally escaped notice is that even if GDP is perfectly scientifically accurate, it is a stunningly poor indicator of how we our understanding of the Chinese economy.  In other words, let’s assume for our purposes right here that it is accurate.  If it is accurate, do we understand and frame the Chinese economy well?  The answer is a resounding no.

The fundamental reason is that GDP is a non-existent measurement for quantifying the ability to pay for things.  Whether it is consumer spending or debt coverage, no one can pay for anything in GDPs.  I would encourage you to walk into a bank sometime, apply for a loan, and when they ask you for repayment ability tell them your cash flow is weak but your GDP output is high.  Seriously, try it sometime.

We assume that GDP measures are correlated with measures of economic activity and cash flow but in China for a number of reasons, this assumption, while not necessarily wrong is much much weaker.

For one reason, corporate China, where most of the debt is, has been dealing with long term deflation.  Consequently, while liabilities have been increasing moderately to rapidly their total revenue and revenue per unit have been flat to declining.  In other words, even if GDP is completely accurate, the weak cash flow growth of firms is even worse than the GDP growth making firms ability to service their debt even worse than the GDP numbers make it appear.  This is the problem with deflation but that is what is happening.

We even see this mismatch when looking at per capita GDP which is sued for a variety of individual focused measures not match the cash flow people have to spend.  Household income is on average 45% of per capita GDP and in some major cities like Tianjin, significantly lower than that.  If they pay in GDP’s, then many consumer measures look maybe stretched or excessive but not wildly crazy.  However, if we change to measures of income, the measures look decidedly excessive.

Again, my purpose here is not to revisit whether or not to trust Chinese GDP, but much more fundamental how do we use GDP, even if it is perfectly accurate, to frame issues like risk and consumption.  I would say, not very well.

 

 

Follow Up to Bloomberg Views on Real Estate Asset Price Targeting

I want to write a little follow up to my piece in Bloomberg Views about real estate prices in China.  As usual start there and come here for the follow up and explanation.

It is not just the value of real estate prices that I think is concerning but the framework for what is driving the increase in prices and the theory behind it.  Before I focus on the Chinese situation, let me back up to before the 2008 global financial crisis and what economists were arguing about before the collapse in US housing prices.

Prior to the collapse in real estate asset prices in the United States in 2008 that precipitated the global financial crisis a key, albeit somewhat wonky debate, was whether monetary policy should worry about asset price inflation or just aggregate price inflation. Then Governor Fredric Mishkin argued in a May 2008 speech that “monetary policy should not respond to asset prices per se, but rather changes in the outlook for inflation…impl(ying) that actions, such as attempting to ‘price’ an asset price bubble, should be avoided.” It is questionable in light of the 2008 financial crisis, whether this argument would hold sway today.

On a brief side note, I would love to see a vigorous debate on this topic but there has been little debate on this topic.  I think it is generally accepted that loosened monetary conditions have helped push up asset prices in developed markets, but I have not seen much debate about whether monetary policy should be used to try and restrain asset prices or even drive them down.  Alan Greenspan actually argued before 2008 that monetary policy was better placed to help stimulate after a bubble has popped rather than trying to determine the correct level of asset prices.

Chinese authorities, more for political reasons that from an adherence to economic modelling, have implicitly targeted what they believe to be an acceptable growth rate in real estate prices.  Using a combination of monetary stimulus and regulatory measures, Chinese officials implicitly target real estate asset price growth that they believe represents an acceptable rate of price growth.

This has resulted in a couple of conclusions or outcomes. First, Beijing appears to have an implicit real estate asset price target.  I say implicit because they have not announced a specific price target as part of the monetary policy framework, but it is clearly near the top of the list of prices they watch and there is a clear monetary and broader regulatory real estate asset price target. They do not want prices sinking nor do they want prices rising too rapidly.  Given what we know about how Beijing manages the prices of all other prices and asset prices, I don’t think it is a stretch at all to believe or watch how they behave and see an implicit asset price growth target framework at play here.  Second, Beijing does not appear that good at price targeting.  Just like the Fed, BOJ, or ECB with their broader inflation targets, the PBOC does not seem that good at asset price targeting though they continually miss on the high side rather than the low side.  Third, there is a clear behavioral response to the implicit real estate asset price target.  There is a reason about 70% of Chinese household wealth is in housing and people buy second and third apartments. There is an expectation that the real estate price target framework of Beijing will be carried out resulting in safe appreciation.

I have become incredibly skeptical of the implicit asset price targeting because you see how clearly investors behave in response to the unofficial asset price growth target.  Asset price growth targeting by central banks inevitably leads to gaming of the system by investors.  Though it may be difficult for investors to profit from generalized 2% price increase, it is much simpler when the government is targeting price increases in such a fundamental asset as housing in China.

I also wonder if there is a difference between asset price targets and specifically about the amount of leverage attached to the asset purchase or amount of wealth it represents as a portion of the national portfolio.  Given the 70% portfolio slice of household wealth, should we differentiate between that major portion and the portfolio holding that represents say 10%.  I would think based just on the wealth effect, there is good reason to treat real estate differently than other assets.  This would seem to imply targeting a lower real estate asset price growth target.

It may also be necessary to think about asset prices differently based upon the debt tied to them.  Use a simple example, you can buy a stock with a 10% return or you can use that same money to buy a house that you also take mortgage to buy that will grow in value 10%.  Now Chinese households are not as leveraged as US households, but I have heard way too many stories of how Chinese skirt the financial system rules to believe it isn’t a lot more widespread than people believe, but given the leverage attached to mortgages, there is higher risk.  Assets attached to rising leverage ratios, as is the case with China, might signal the need for a lower asset price target if one at all.

Finally, it should not be overlooked at housing prices started rising so dramatically as real economic output was really slowing so dramatically.  Previously when real estate prices were rising so dramatically, it was argued it was not a bubble but tied to expectations about future economic growth.  However, with economic growth slowing, and household incomes slowing even more, what is the fundamental rationale now for home price increases?  The real estate asset price target is clearly out of sync with the broader economic reality.

I return to two simple questions: how appropriate is an asset price growth target for China, what are the risks they are running, and how good are they at producing desired results? I would say: not very, high, and not very good.

Some Thoughts on Chinese Financing Growth: Playing Whack a Mole

The focus on the recent strong growth in headline financing growth has raised concerns about underlying demand for credit and continued reliance on investment to drive growth.  However, the headline data fails to capture the important underlying trends that are important grasp the change in Chinese financing.

Beginning with the aggregate YTD changes in financing, in Figure 1, we actually see that most types of financing are up strongly.  Only two categories of financing are down in 2016.  Undiscounted bankers acceptance and foreign currency loans are down YTD in 2016 in absolute terms.

Virtually all of the decline in aggregate financing to the Chinese has come from the decline in bankers acceptance.  All other sources of financing are up robustly to strongly.  What makes this precipitous drop in bankers acceptance notes is the lack of evidence as to where it is going.  Bankers acceptance should be used as a type of receivable’s financing.  Consequently, if the outstanding amount of bankers acceptance is falling so rapidly, we should see a corresponding drop in outstanding receivables, however, there has been no drop in receivables.  In fact, net receivables according to official statistics are up year to date 9.4%.  This makes the supposed drop in bankers acceptance rather puzzling.

If we plot this on to growth in various forms of financing growth, RMB loan figures which grow very closely to the total financing numbers are the smallest number with other forms of financing exploding.

For instance, the combination of trust and entrusted loans have more than doubled through August from the same period in 2015.  Foreign currency loans, as a share of the total new financing in 2016, have dropped by an almost insignificant amount.  While this has a not insignificant impact on FX related flows and pressures on RMB, it is almost irrelevant to the stock of financing in China.  Foreign currency loans dropped by 412 billion RMB against total new financing YTD of 11.75 trillion RMB or only 3.5%.

It may be possible, though we have no hard evidence to support this, that the decline in bankers acceptances are being made up for increases else where in the total pool of finance.  The total absolute increase excluding bankers acceptances and loans comes very close to matching the absolute decline in bankers acceptances.  If we sum trust, entrusted, bond, and stock financing change from August YTD 2015, we have a number of 2 trillion RMB compared to the decline in bankers acceptance of 1.8 trillion RMB.  If this is what is happening, this appears to signal that a lot of bank based capital is being shifted into non-bank financial institution lending.

Given that total lending in 2016 to non-bank financial institutions has totaled 1.8 trillion RMB, nearly matching the decline in bankers acceptance, there is some reason to believe that banks are shifting their lending practices  to meet new regulatory requirements about bankers acceptances.  Again, we cannot say this for certain, but there is some evidence that indicates it may be happening.

More Disguised Capital Flight and Fragility in China

Well I am back in Shenzhen and getting back in to the swing of things which means I will be blogging again regularly. I had a great summer with all types of meetings with people providing insight about China and global markets. The more I do this the more I love hearing what other people think because it is stimulating to consider new ideas or have to sharpen existing ideas.

There are a couple of ideas I want to briefly focus on about China today. The first is my sense has been for some time that there are significantly more downside risks to China than upside possibilities. For most of 2016, China between the massive amount of various stimulus pushed by Beijing have kept the economy bobbing along and the global environment was benign enough that some sense of security existed. Let me give you an example of what I mean by benign global environment. Even though outflows in 2016 are already ahead of what they were for all of 2015, PBOC FX reserves remain effectively unchanged for various reasons ranging from a USD not rising, bond valuations, and probable assistance from the Bank of China.

However, many focused on China have begun to realize that even though things are not noticeably getting worse, most if not all underlying indicators continue to worsen. Though credit growth is not exploding at the rate of the beginning of the year, it continues to far exceed real or nominal GDP growth not to mention revenue (the much more important indicator) growth of firms and governments. Public deficit is upwards of 10% and capital continues to flee China. Many realize this continued underlying deterioration of indicators and watching closely.

The term I would use is that what we are seeing is leading to increasing fragility. The $40-50 billion a month in net outflows we are seeing does not represent a signal that a collapse of the RMB is imminent. However, it makes China more fragile to specific shocks. For instance, as the USD has largely languished this year as people wait for more concrete indication of rate hikes, the RMB has not faced significant upward pressure. This has reduced outflow pressures and buoyed PBOC FX reserves in valuation terms also. However, should we see a less benign environment, it is quite possible that the $40-50 billion a month in net outflows and FX reserves could see large and abrupt increases.

Seems like everyday we see a new example of this increased fragility and new data problems. Brad Setser over at the Council on Foreign Relations has pointed out the discrepancy between what China reports paying for “imports” of tourism services and what its counterparty countries report receiving from China. What he has essentially pointed out is similar to what has been pointed out with, for instance, the discrepancy between Hong Kong exports to China and Chinese imports from Hong Kong. When Hong Kong reports exports to China of say $1 billion USD but China reports imports from Hong Kong of $10 billion, that is essentially a capital outflow of $9 billion.

Setser in his post just chalks it up to a discrepancy and claims that it can’t be explained by “hidden capital flows” or actual tourist numbers. There are two important things to note about this which Setser generally either avoids or fails to grasp. First, tourist numbers really are not up only 3%. They are up much more stronger than that and here is why. The historical “tourist” numbers were inflated via day traders shuttling back and forth between Hong Kong and Shenzhen. Consequently, when Hong Kong began cracking down on day trading really beginning in 2014 but limiting actual trips by Mainland day traders in 2015, “tourist” numbers into Hong Kong collapsed. Spending in Hong Kong and land crossings from the Mainland have collapsed. I can tell you first hand standing in passport lines regularly, previously people would test the limits of human strength to carry goods into Shenzhen are now loaded at most with one suitcase. In other words, there was a lot of miscounting of “tourists” who were focused on moving goods from Hong Kong and not moving capital. That has changed.

Because international travel from China basically consists of land crossings from Mainland into Hong Kong and air travel, we can easily compare the two. International air travel this year from China is up 26% while land crossings into Hong Kong, where there are limitations on Mainland crossings into Hong Kong, are down 12%. Given that land crossings into Hong Kong make up approximately one-third of all international travel for China, this is not an insignificant shift. So to say that tourism is up only modestly uses flawed historical data to argue that international tourism from China is up only 3%.
Second, this type of discrepancy Setser has found is a reoccurring theme and is disguised capital flight. We see this type of discrepancy in the previously noted Hong Kong exports to China vs. Chinese imports from Hong Kong but also the difference between Chinese imports from the world recorded at Customs vs. what banks report paying for imports. I have said time and time again that the capital flows from China are structural in nature and are only exacerbated by 25bps from the Fed or carry trade. However, time and time again, people are surprised by large sources of capital flows from China they find from irregularities in the data.

In fact, the per capita tourism spend really began jumping in 2012 and 2013. Why does that matter? That is when China liberalized the current account, began a corruption crackdown, and capital began fleeing through other channels. So in fact, if you put this discrepancy in context in makes sense. For instance, the per capita “spend” by Chinese tourists has actually decreased by about 10% over the past 12-18 months if you account for the decline in day traders from Shenzhen. Furthermore, if you understand the discrepancy will not show up as “hotel” spending but as a new bank account that gets registered in Chinese data as “tourism” services consumed elsewhere, it all makes perfect sense.

Everything that is going on is slowly increasing the fragility of Chinese finances.

Follow Up to Chinese Debt Levels

So I want to write a brief follow up to my piece from BloombergViews on Chinese debt levels.  I am kind of on vacation, this will not be a long piece but will address some key questions and data will be provided at the end which you can check yourself if you want.  As usual, start there and finish here.

I want to start by apologizing for a citation that was brought to my attention by Simon Cox and Bert Hofman that is in an important way inaccurate.  I cited the International Monetary Fund World Economic Outlook dataset as China central government having 46.8% debt to GDP ratio.  This is incorrect as it covers all government debt according to the IMF and for that I apologize as I make every effort to faithfully and accurate present data.

I believe however, it is very important to explain how this mistake was made, how the IMF data is flawed, and more importantly why the basic premise stands in its entirety. When I write and even when I just study various aspects of the Chinese economy, I am combing through a variety of different data.  However, when I write I try to distill what I have learned and cite the most well known data sets or widely accepted data sources.  Prior to having written this piece, I had combed through lots of data, which I will get to shortly, and rather than go through less well known data sources and explain how I arrived at figures, I used the IMF WEO data as a headline number to present the point. The IMF WEO data was the wrong figure to use as it shared, as you will see, some important characteristics with the underlying data.  Let me emphasize there was no intention mislead, as you will see I have no need to, and I was only trying to simplify by using a widely recognized and accepted data source.

Let me now explain how the error was arrived at.  It is possible to access a list of both central government and local government bonds which have been issued in the Chinese market.  These are publicly listed bonds with accompanying data on a large number of important variables like face value and maturity date.  Importantly for our purposes, we can distinguish between bonds issues by the central government and local governments.

The amount of bonds issued by the Chinese Ministry of Finance totals 25,214,898,000,000 or 25.2 trillion RMB.  The amount of bonds issues by local governments totals 23,436,491,110,000 or 23.4 trillion RMB.  Together Chinese government bonds from all levels equal 48,651,389,110,000 or 48.7 trillion RMB.

According to the National Bureau of Statistics in China, nominal GDP at the end of 2015 was 68,550,580,000,000.  If we use that as our base, the total amount of government bonds in China would yield a debt to GDP ratio of 71%.  The level of central government bonds outstanding imply a debt to GDP ratio of 37% or more than twice the official IMF rate central government debt to GDP of 16%.

There are two important points to remember.  First, this is only the publicly listed debt.  Given the bank loan for bond swap program in China right now, this likely omits a large number of local government bank loans.  Second, remember the IMF lists the debt to GDP ratio as 46.8% for “general” government debt.  This is rather different from what we know about the debt to GDP ratio with just bonds much less bank loans and other liabilities like guarantees.  The discrepancy between the IMF debt to GDP ratio and the public debts to GDP of China is large.

To sum up this problem: the underlying data shows gross explicit government liabilities of at least 71% of GDP and given what we known about privately held explicit public liabilities, an outstanding debt to GDP ratio of 90% is by no means excessive given the announced increase in bond debt swaps to reduce bank loans outstanding. It is worth emphasizing, this relies on just official data and does not use any complex statistical techniques beyond what anyone could do in Excel.  To provide some perspective, if we assume official payables aging from Chinese government of the national average, this alone would raise debt to GDP to nearly 90%.  Finally, it is worth noting, that even the IMF and Goldman Sachs have measures, from 10-15%, of implied fiscal deficits that are much higher than the official numbers.

One final points.  This empirical discussion omits the slightly more philosophical discussion of what constitutes public debt in China.  Despite what textbook finance teaches you, investors in China believe every state owned enterprise is backed by the state.  Leaving aside whether they are or whether the state should back them, it is clear the Chinese governments at all levels are afraid to let this assumption vanish.  Even leaving aside legal obligations, this essentially transfers the vast majority of Chinese corporate debt onto the public balance sheet. Chinese governments have mastered the art of outsourcing their never ending stimulus programs to coal and construction firms, just to name a few.  Consequently, even leaving aside the elevated explicit liabilities, virtually every major firm in China is treated in China as state backed by investors.

I do apologize for using an inaccurate data citation as it is never my intent to present a complete and accurate data picture.  The data in China is such that I don’t need to embellish as it is problematic enough on its own. However, as I believe one can easily see, Chinese debt levels that we can verify right now, are significantly elevated above the official data closely matching the data citation I presented.  The underlying data supports the general point and numbers I present.  I

It is clear that official outstanding debt numbers much like GDP and a variety of other data simply do not match the headline data.

For interested parties, here is the list of outstanding bonds and GDP data which I present here.

On the Recent RMB Strengthening

There have been questions raised in the past few weeks about the state of the RMB.  Questions have focused on why the market is not reacting more strongly to continued depreciation, whether the PBOC is engaging in active price manipulation, and the direction of the RMB.

These questions at their heart revolve around why the RMB depreciation path seems to have halted and even reversed in the past 1-2 weeks.  In fact, the RMB has strengthened recently which seems to have caught many off guard.  We believe there are clear and straight forward answers for what we are seeing the RMB FX market.

First, according to my esimates, the RMB against the CFETS basked has been relatively stable over the past month with small strengthening over the past 1-2 weeks.  My model shows slight strengthening of the RMB against the CFETS basket whether measured in 1 or 2 week increments even over the last month.  In other words, if the RMB is generally following the CFETS basket, the RMB should have strengthened which is what we see.  This is the spot rate and the Wind estimate of the CFETS but mine and other replications of the CFETS show similar strengthening.

As many have noted previously, there is an asymmetric pattern for when the USD weakens.  The RMB is stable against the basket when the USD strengthens, but when the dollar is weak, the RMB maintains stability against the USD.  Consequently, when the basket is generally strengthening against the USD, the RMB will see mild strengthening which is what we have seen.  The past few weeks therefore, should not come as any type of significant surprise.

Second, the fixed nature of the RMB makes the RMB much more prone to exogenous shocks.  Given a relatively rules based regime, whether moving directly inline with the CFETS basket or with some flexibility to the USD, the RMB tracks other global currency movements rather than building its own internal market that others respond to.  As global currencies have stabilized over the past few weeks and months, it does not come as a surprise that the RMB has stabilized.

Third, there remains overwhelming evidence that the PBOC either directly or via proxies is heavily involved in the market ensuring pricing it wants.  For instance, spreads after factoring in all costs continue to predict a strengthening of the RMB over the next 1-12 months.  Looking at the swaps market, even as the spot price has depreciated, the swaps price post August 11 has tightened considerably.

This is fundamentally counter intuitive.  Before August 11, when there was no expectation of future weakening, the spread was large.  Post August 11, when the market almost uniformly expects depreciation, the swaps price has narrowed so much it actually predicts RMB strengthening.  Spreads on various futures products remain tight even as markets continue to expect longer term depreciation.  Traders continue to report difficulty executing trades at posted prices for various products.  Liquidity appears to remain tight or potentially worse indicating less than normally functioning market.

Fourth, the long term trend remains for continued depreciation.  Capital continues to move out of China at a relatively steady rate over the past 3-6 months and slower than its late 2015 rate.  As previously noted, there is strong evidence that the PBOC is enlisting other parties to prop up FX reserves and slow their depletion, but given the ongoing outflow of capital out of China it seems clear the trend remains to expect further depreciation.  It is worth noting that the RMB outflows have slowed, but still continue.  Foreign inflows are down significantly and net bank payment and receipt surplus is only slightly behind the total for all of 2015. There is pressure within China to allow further depreciation and the continued net outflows necessitate further depreciation.

As the markets have become distracted with Brexit, US elections, and Japanese easing, focus on the RMB has eased as expectations have changed.  However, all factors seem at play to expect ongoing steady depreciation barring some large exogenous shock.  The PBOC has learned how to better manage market expectations and we believe ongoing depreciation should be expected.

Robots and Trade from BloombergViews

I wanted to follow up to my piece from BloombergViews on robots reshaping international trade and development strategies of emerging markets.  As usual, start there and then come here.

  1. I am an international trade professor by specialty though I teach other subjects and the importance of this first hit me when I was reading Tyler Cowens Marginal Revolution a while back about Foxconn threatening to automate its plants. He made the point, why do they need to manufacture in China as a robot costs the same to employ whether in China or the United States. This hit me like a lightning bolt.
  2. Now some have pointed out, and they are correct, that even if a robot costs the same to employ the world over, there are other factors involved in relative costs. This is entirely true but there are a couple of important caveats to this. First, this still equalizes a large portion of the cost differential. In the US labor captures about 2/3 of GDP so that is a pretty large amount.  In many of the low skilled industries like garment manufacturing, labor represents a not insignificant slice of the cost differentials.  I am in complete agreement that it does not equalize all costs and productivity, but it has a large impact.  Second, many of the related productivity inputs are better situated in countries that already have large productivity advantages or can be reshored easily.  Not all industries for sure but it is very difficult to see how this is not the general case.  If we take the iPhone, with components from all over the world, other than building the factory, there do not seem to be a large number of impediments to shifting production someplace else.  Even garments seem to have little fundamental attachment to location as long as the manufacturing cost is similar.  Even many of the related aspects that impact production cost seem to be better placed in developed economies. Whether it is ease of transport, infrastructure, or high skilled labor, developed economies seem better placed to benefit from robotic development.
  3. It also seems much more likely that this will exacerbate inequality. Think about it like this.  Computer scientists and industrial engineers in developed countries will be taking jobs from low skilled peasant migrants in developing countries to make garments.  Even the capital needed to build these plants will come from well paid bankers and other investors.  In other words, this seems very likely to increase both across and within country inequality as the low skilled get displaced by the high skilled.
  4. Rather than trade policy being a driving factor, human and financial capital agreements seem to the new agreements. If you want to leap frog, you need to attract global talent and capital to build these plants.  That is a very different thing than the detailed trade agreements we have today.

Taking it a little bit easy right now in the summer but hope to post some more things soon.

Bloomberg and Left Behind Children

I am enjoying some down time in the States but still bouncing around doing some work so over the summer, I may not update the blog as much.  Baseball games, fireworks, New York City, and middle America are all on the docket for me this summer.

I wanted to write some follow up notes to my BloombergViews piece on left behind children in China.  As usual, start there and come here for follow up.

  1. So often, people that study China, outside observers, and even those of us that live and work there think of China as a developed country. However, and I do not mean this in a critical way, it is not and we too often forget that. Lost amidst the new airports and high speed rail is the fact that nearly half of the population is still only slightly above subsistence farming.  Again, I do not mean that as a critique as China has made enormous strides over the past few decades, but as a recognition of fact.
  2. I’ve gotten a couple of emails asking why I’m picking on China and let’s assume that I am, I don’t think I am but let’s assume that I am, issues like left behind children are a long run inhibitor to Chinese economic development. This cognitive and mental problems impact nearly 1/3 of Chinese children.  The gap between rural and urban children is enormous and will impact the ability of China to meet its long term economic objectives.  I may be critical of China but it needs to solve these problems to become an advanced economy.
  3. What astounds me is that this is essentially driven by a government policy that almost requires splitting up families. I find this a personally abhorrent policy.  What government creates and accepts a policy that encourages families to be divided?
  4. Even beyond the left behind children, the status of rural vs. urban children is amazingly different.   These are major issues for China.

Some Random Thoughts for China:

  1. July data is very weak.
  2. Credit is practically the only driver of the Chinese economy.
  3. GDP data remains incredibly suspect.
  4. FX data is incredibly difficult to reconcile.
  5. Worrying that credit explosion having so little impact on real economic activity.
  6. Decline in exports and imports is not just related to low global demand and anyone who says so is lying.
  7. Corporate revenue in Chinese industry is bad in 2016.
  8. Retail numbers are bogus.

I’m working on a more detailed piece about Q2 GDP which I hope to release next week.  It’s coming.

For now, I’m off to start drinking some good old American craft beer.

How PBOC Making FX Reserves Look Better Than They Really Are

The PBOC has released foreign exchange reserves data and the results are puzzling.  Even major investment banks releasing their notes on post-FX reserve analysis have expressed various degrees of bewilderment at the results.  Fundamentally, it is becoming increasingly difficult to reconcile the stock value of FX reserves and the flow changes we witness every month.

There are numerous pieces of data that form our picture of the whole as to why we say this. Let’s break this down piece by piece show why there is increasingly contradictory evidence.

  1. According to our model, which is similar to other estimates of PBOC reserve composition, and general FX reserve holdings, the PBOC USD value of foreign exchange reserves should have remained essentially unchanged between May and June 2016. The rapid rise in the JPY in June should have largely been offset by the rapid fall in GBP.  While we cannot know the exact weighting of the three primary non-USD currencies, given a range of reasonable parameters would leave this portion of the basket fluctuating around no valuation change. The only plausible method to arrive at a material USD valuation change between May and June in the non-USD portfolio is to assume extreme parameters in EUR, GBP, and JPY assets.
  2. Even if we extend this basic valuation change back to the beginning of the year, there should be a relatively minimal change in the USD value of the non-USD asset portfolio of PBOC FX reserves. We estimate the non-USD portfolio, absent non-USD depletion, to have benefited from an approximately $30 billion valuation increase.  Foreign exchange reserves however through the first six months of 2016 have only declined $26 billion.  Absent other valuation or unrecorded inflows changes, this would imply total net outflows between $55-60 billion.
  3. However, just according to official SAFE data, the YTD bank receipt less bank payment for international transaction reveals a net outflow of $145 billion USD through May. If we add in the expected value for June, this would give us a forecast net outflow from bank transactions of $170-185 billion USD nearly on par with all of 2015.  Given the estimated valuation increase and the official decline in PBOC reserves, this would leave an approximately $115-130 billion USD that we cannot account for in our calculations.
  4. Even if we look at the net flows by currency type, the numbers tell a story of similar outflows. Looking at just the top two currencies, we see that USD net flows were in surplus by $52 billion while RMB net outflows totaled $106 billion in USD terms.  HKD, JPY, EUR, and all other currencies summed to the previously noted $145 billion net outflow.
  5. Breaking it down by currency however actually gives us a clue as to what is likely happening. The $106 billion RMB outflow in USD terms is leaving China for international transactions.  Theoretically, this should result in ever expanding offshore liquidity.  Conversely, we actually see quite the opposite happening in offshore centers with RMB trading and deposits.  Where RMB deposits have been shrinking, specifically in the primary offshore center Hong Kong relatively rapidly.
  6. Bank buying of FX from non-bank customer through May totaled $661 billion USD while sales of FX totaled $541 billion USD for net purchases by banks of $120 billion USD. Given the previously mentioned net outflows from bank payments of $145 billion and the approximately $25 billion in revaluation over the same period, we are able to reconstruct the numbers through May relatively closely.
  7. This conclusion though has a very important implication. This means that commercial SOE banks are essentially acting as a central bank purchasing surplus RMB either on the Mainland or in Hong Kong to prop up the RMB.  It is worth noting that the Bank of China acts as the primary settling bank or cross border RMB and takes a small fee for all offshore RMB remitted to the mainland.  Given that spreads between the bid and ask is less than the fee BoC takes for remitting offshore RMB back to the Mainland, it is likely they are essentially operating a large churning operation propping up the RMB.
  8. We actually see evidence of this in the Bank of China Q1 2016 report. They list a 31% drop in “Net Trading Gains” which they attribute to “decrease in net gains from foreign exchange and foreign exchange products.”  What makes this so interesting is that even though BoC is the primary settlement bank for the PBOC of international RMB transactions, FX market turnover was up 20%.  It seems difficult to understand how with a market up 20% the near monopolist firm see revenue drop 30%.  The most likely explanation is that they are essentially acting as a central banker, soaking up the liquidity at the spread, profiting from the repatriation fee, and churning.  Though much of their purchases are offshore, forcing them to incur a loss, the repatriation fee compensates them harming their margin but upholding the national interest.

We need to keep an eye on this especially as we move forward and BoC trading revenue and matching up the outflows to the SOE/PBOC churn.

Revisiting Chinese Balance of Payments and RMB Pressures

Despite all the attention focused on the credit woes of China, and there are a lot, the state of the RMB remains my biggest concern.  China has chosen a policy that significantly limits its policy movement reducing its flexibility exactly when it needs it most.  Most people continue to focus on the headline FX reserves held by the PBOC, which as I have noted many times, simply are not the best metric here for a variety of reasons.

China has just released additional data from the Balance of Payment and the International Investment Position datasets which give us insight as to what is happening with capital flows and pressure on the RMB.  The story continues largely unchanged as net flows continue to decline but with additional detail to help us better understand what is happening.

  1. Balance of Payment data continues to obscure the state of Chinese financial flows. According to the official BOP data, China enjoyed another bountiful quarter between January and March 2016 with a total net inflow of 256 billion RMB or $39 billion USD at current exchange rates.  In fact, if we lengthen the time horizon, since the beginning of 2013, China has had only two quarters of net negative outflows with the last one coming in March 2014.  These net outflows total only 250 billion RMB or less than the net inflow enjoyed in Q1 of 2016.
  2. If you have been following the Chinese economy at all over the past 12-18 months what strikes you about these numbers is that they do not match the large outflows we are witnessing and yes, depletion of foreign exchange reserves. For instance, the 256 billion BOP net inflow includes a large 256 billion RMB net error and omissions outflow.  It defies any economic common sense that a country could be running such large and ongoing BOP net inflows while at the same time depleting FX reserves and devaluing its currency.  Cumulative in the past four quarters, BOP net inflows have totaled 1.04 trillion RMB or $156 billion.  In the past two years this amount rises to 2.35 trillion or $351 billion.  If we believe the official balance of payment data, there is absolutely no reason for downward currency pressure.  In fact, we would expect this level of net inflow to prompt moderate appreciation pressures.
  3. BOP data is calculated relying primarily on the official trade data from customs. As I have written about previously, this presents an enormously misleading picture of the trade and currency transactions and the subsequent inflows or outflows of capital.  BOP records a 679 billion RMB surplus in goods trade.  SAFE and Customs report a 694 billion and 810 billion trade in goods surplus.  In other words, official BOP data is highly correlated with other official data like Customs and SAFE data.  However, through Q1 in 2016 banks reported a surplus of only 150 billion RMB or only $22 billion RMB in arguably the most important category when considering net inflows.  In other words, banks are reporting a trade in goods surplus of 78-82% lower than what BOP is reporting.  This matters enormously because essentially all of the reported net positive BOP comes from the goods trade surplus.  If you eliminate the goods trade surplus you eliminate the positive BOP position China reports to the world.
  4. In fact, if you focus on the BOP capital account data, it becomes obvious how delicate the situation is and what is driving these imbalances. First, investment inflows into China, as I have mentioned numerous times previously, are simply borderline collapsing.  In Q1 2016, direct investment inflows into China were down 44.4% according to BOP data.  Portfolio inflows into China were not just experiencing slower growth but experienced negative growth meaning there was net international disinvestment in China by $19 billion from a positive inflow of $17 billion in Q1 2015.  Second, despite all the stories about the flood of Chinese outward investment, there is an important caveat to the overall story.  What is happening is that if we incorporate the International Investment Position data, what we see is not a rapid rise in Chinese owned foreign assets but rather a rebalancing of the Chinese portfolio.  By that we mean that total Chinese owned foreign assets have actually declined from Q1 2015 to Q1 2016 by $156 billion.  In fact, Chinese owned foreign assets peaked twice above $6.4 trillion and most recently in Q1 dipped to $6.22 trillion.  However, within this asset basket, we have seen a significant rebalancing.  The entire growth in outward FDI and portfolio investment comes from depletion of official reserves assets.  As total assets were declining from $6.4 trillion in Q4 2014 to $6.22 trillion in Q1 2016, Chinese owned FDI grew from $744 billion to $1.19 trillion and official reserve assets declined from $3.9 trillion to $3.3 trillion.  These offsetting changes explain the entire growth in OFDI and decline to total assets.  Furthermore, there is absolutely no way you can have the amount of supposed net inflows and at the same time witness total declines in Chinese owned foreign assets.  Those are two contradictory data events.
  5. One question I frequently get asked is about reports like the BIS 1 ½ page brief talking about how virtually all of the outflows are debt repayment. These types of studies focus on official data like BOP data that simply does not capture the reality of what is happening with Chinese outflows.  Furthermore, though there is monthly noise, we see a clear long term structural shift in capital outflows that is simply not reversing.