Sounds Like Something Pretty Important Happened This Weekend

I typically refuse to talk publicly about issues like Taiwan but based upon the sheer panic I’ve seen from so many DC journos and think tankers, I feel it is important to put some things down. The saying around here is I can talk about anything as long as it isn’t about the four T’s: Taiwan, Tibet, Tiananmen Square, and The Party. I feel it is important to place what I’m saying in a little context and back ground, that will also help us disentangle some of the issues we are talking about.

  1. I am no fan of Trump and I did not vote for him. His idea to unilaterally raise tariffs on Chinese products to 45% is simply put insane ramblings.
  2. I do however favor stronger foreign policy towards China. The past two administrations have nearly formalized a policy of appeasement across a range of issues.
  3. While I think it is fair to question is this a good policy and how will Trump behave going forward, the hysteria seems to far outpace the reality of what has happened. There are quotes from senior Party member professors wondering aloud about ending China’s relationship with the United States being cited as reasoned positions by the American press.  It is very different to question how this strategy will play out and what Trump hopes to achieve than reverting to doom and gloom vitriol as many have.
  4. This was a planned action by the incoming President elect and was neither ad-hoc or done without deliberation. This is clearly part of some strategy by the incoming Trump administration about how they plan to treat China and Taiwan.  Again, we can debate that riskiness of the strategy and whether it is appropriate given a variety issues, but that again is very different that falling back on a clearly erroneous narrative that attributes this phone call to little more than dialing the wrong number.
  5. The critics of the phone call are making two vitally critical errors in questioning the wisdom of the policy of accepting the phone call. First, that China is operating from a position of relative strength.  China is in reality dealing with a much weaker hand.  An excessively indebted economy kept afloat only with massive credit stimulus. A trade war would be disastrous for both sides but would harm China much more than the United States.  China is already facing push back from most in east and south east Asia so they have real difficulty achieving their foreign policy objectives without massive damage to their international reputation. They have a much weaker hand to play than most realize.
  6. Second, some have argued the United States depends significantly on Chinese cooperation across a range of issues. This is simply bubble headed eternally optimistic gibberish.  The only thing longer lasting than the China crisis caller is the bubble headed optimist who says China will become a market driven democratic country who will become a responsible stake holder in global leadership.  Beijing is actively pushing a global authoritarian regime that seeks to promote illiberal undemocratic values and regimes in every forum.  Even on issues of importance to the US, China has actively sought to combat US interests.  China has been actively aiding Pyongyang to exporting forbidden materials to Iran through Chinese SOE’s.  These are not accidents any more than Trump accidentally calling Taiwan.  Even today, China blocking UN Security Council attempts to address human rights abuses and global conflicts.  Across many issues, China has actively been working against US national interests.  Cries that US needs China cooperation lack understanding about issues where this plays out.  What astounds me most about this line of thinking is how absurdly low people will set the bar for Chinese cooperation to convince themselves China is providing active cooperation.  I saw one comment that China has not invaded Taiwan, therefore they were cooperating with America.  This is like saying a husband who doesn’t beat his wife is a good husband. No, he is just a husband who doesn’t beat his wife, it says nothing about how caring a husband he is.  It just means he isn’t a scum bag abuser, says nothing about his fitness as a husband.  It should be thoroughly disabused that China is somehow some close ally who significantly cooperates with US across a range of forums and issues.  This is simply not true.
  7. While I will be critical of wailing and gnashing of teeth by many people, the risks on the other side need to be clearly understood. This is a bold and potentially risky move by the President elect that clearly shifts policy priorities, However, one of his major policy planks was he was going to stand up to China more than the outgoing administration.  While the Obama administration has pursued a large number of anti-dumping cases against China, they have largely been acquiescent to China across a range of issues.  This is definitely charting a new course for US policy with regards to China and there will be significant risks that need to be handled much more delicately than Twitter rants.  The President elect will not be able to realize objectives and create very real security risks by conducting international negotiations via Twitter.
  8. What has amazed me is both how much China has shifted to goal posts as to what constitutes an actual policy problem and how much of the foreign policy community has bought into the Chinese temper tantrum. As a short list of things we could cite China has built bases in international waters, actively aided North Korea and Iran, hacked most of corporate and government institutions in the US, and supplied arms to most every conflict zone on the planet but the US foreign policy community freaks out over a 10 minute phone call.  This is nearly a text book case of Stockholm syndrome. When exactly would you be willing to risk offending China?  There is an active community of people that study, write about, publish policy papers, and consult about China and as best I can tell after this weekend, most of them don’t actually want to do anything about the problems that so eloquently write or talk about.  They would much rather continue writing about the problems and never actually do anything about them for fear of offending China.
  9. Where so many people go wrong is an assuming that China is a trusted partner to work with to solve problems either on a bilateral or multilateral basis. They issue very nice press releases at the United Nations or after the G-20 but China is firmly and fundamentally in a neo-Cold War mentality viewing the United States as an enemy.  Let me make perfectly clear, I do not mean enemy in the sense of strategic competitor, I mean enemy who threatens the government and country of China.  China is using the strategy of making small incremental gains so as to change to goal posts so people over time don’t even realize how much they have changed.  The ongoing entrenchment of an illiberal order advocated by Chinese apologists outside of China who seem unconcerned by the promotion of a regime and governance order with values they claim to so actively repudiate.  For instance, some have made the argument that this is an unprecedented breach of diplomatic etiquette.  It does concern me however to hear supposed liberal internationalists defend Chinese precedent like lack of democracy, freedom of speech, and human rights. I guess those are Chinese precedents that shouldn’t be touched either for fear of offending Beijing. You cannot simultaneously believe taking a harder line with China is a bad thing and that the values and interests China is promoting are also bad. The Economist today writes that the US should not stand by Taiwan because China is more important. I reiterate my proposal that we propose to China that we give them Taiwan, the Philippines, the south China Sea and half of Malaysia to secure peace in our time.  These types of appeasement strategies of giving away Sudetenland by supposed defenders of liberal values represent the spinelessness of so many.
  10. Given all the talk about the “post-truth” society brought on by the Trump administration, it is worthy to apply this idea to this weekend. Though the Trump phone call is clearly a signal, it is worth noting that the Obama administration just within the past year sold nearly $2 billion worth of military weaponry to Taiwan which would seem to send an even stronger signal about US policy. Though the diplomatic etiquette may suffer a greater breach from the phone call, military weaponry is clearly a much stronger signal and something the Obama administration should be commended for.  The Obama administration clearly knew where Taiwan was and who they were when he sold them this weaponry.  Yet the 10 minute phone call prompts high pitched hysterics.
  11. For the record, I would not have advised taking the call. If the incoming Trump administration wanted to make a point about the direction of policy, I would have done something smaller like issue a press release thanking Taiwan for their warm congratulations on the election, as an example.
  12. I do not like the move because it is too big an early move. This is like receiving the opening kick off and going long on the first play.  You are sending a message for sure but generally not a good opening play.  I would have advised smaller incremental moves to signal the direction of policy rather than this.
  13. For the record, I would strongly advise that Trump give up his Twitter account. Most definitely NOT the way to conduct international negotiations.
  14. For the record, I would strongly advise PEOTUS to back of the China issue for a while. The first move has been made.  Push the envelope is fine, but do not take a hack saw to it.
  15. To everyone talking about, the oncoming nuclear war (yes, I have seen those Tweets), this is way too soon to tell what will happen. All this hysterical kvetching by the chattering class is like day after the NFL draft declaring each team a winner or a loser and which players will be stars.  You have no idea.

 

 

The Strange World of Chinese Real Estate Liquidity

We are frequently so entranced with the meteoric price increases of Chinese real estate that seem to dwarf anything we’ve seen before that we frequently lose sight of details that really matter.  These details beyond price headlines really matter because many of these are the market dynamics that impact future changes.

One recently caught my eye and I will be honest in saying that I’m still trying to process the impact of what this data means.  The Chinese real estate market has extremely low levels of relative liquidity.

What I mean by that is that relative to the number of housing units in specific metro areas, there are actually a relatively small number of housing transactions.  Many times transactions will be reported for major metro areas in China, but there is frequently little context given that obscures the relative measure of liquidity.

To give you, some idea of what I mean the average home in the United States is sold roughly every 20 years.  This excludes housing units that are apartments, but gives us some idea.  Furthermore, this number does not fluctuate as much as you might think except in extreme periods like during and after the 2008 subprime crisis.

However, in China these numbers are astoundingly different.  As an example, in 2015 Shenzhen housing transactions relative to the number of housing units was under 1.9%. If each unit could only be sold once before being sold again, it would take Shenzhen 54 years before being resold.  What is amazing is that projected 2016 housing transactions in Shenzhen have gone down from 2015.  If current rates hold, unit turnover will fall to about 1.2% or approximately an 86 year turnover cycle.

In other cities, we see similar levels of low relatively real estate market liquidity.  2016 projections, estimate Shanghai unit turnover at under 2.7%, Tianjin at 3.4%, and Xiamen at 2%.  This would equal cyclical turn over rates of 37.6, 29.6, and 50.3 years.  To put these numbers in perspective, China only opened in 1979 so according to these numbers, each unit has yet to even sell a second time with many years to run.

Other cities show similarly low levels of relative unit turnover.  I’ll be honest in saying that giving some the peculiarities of the Chinese real estate market, I’m still trying to think through all the potential implications.  I have a couple of theories.

First, it is quite likely that Chinese real estate hit a tipping point a few years ago where real estate had been transferred on a preferential basis to existing urban residents under various schemes, the large majority of savings had been consumed to purchase housing units, and the only driver of the Chinese real estate market became channeled credit via state owned banks.  As I noted in a previous post, 2015 was the first year where the marginal new housing unit would have equaled a mortgage of greater than 50% LTV.  2016 is likely to be a significant increase from 2015 implying that the real estate driver has changed from a couple of years ago.  It is not longer unit transfer and savings consumption and credit growth of households.

Second, this seems to place a lot of pressure on Beijing to keep real estate prices elevated.  Many in China view this as a form of savings given the lack of other options and household income levels that are both under pressure and slower growing than real estate prices.  While households are little invested in the stock market, they are heavily invested in real estate implying much higher wealth dependence effect on real estate.

Third, it seems to imply much greater fragility in supporting the real estate market than is generally assumed.  Typically when prices go up, we see rapid growth in turnover volume but not only have we not seen this, in some cases we have see a decline in turnover.  The only apparent support of the real estate market is higher credit growth which means to support this, PBOC will need to pump even higher levels of credit to support price increases or stability.  This implies a lot more fragility in the real estate market given the relative lack of volume.

I think there are other implications but I’m still thinking through many of these implications.  However, I think it is pretty clear, there is a lot more going on here that requires thinking about the market microstructure of what is driving these dynamics.

Bloomberg Views Steel and Coal Follow Up

I wanted to do some follow up to my BloombergViews piece on the rapid run up on coal and steel. As usual start with that piece and come here for follow up.

Probably the key point that is so interesting to me, is there is no clear mismatch between supply and demand, or output and consumption in these market in China.

The key thing to look at in these figures is the relative lack of different between supply and demand or output and consumption.  There simply isn’t much of any.  For most of the past year in fact, excluding July and August, the difference between supply and demand in coal was a rounding error and if we go back to the beginning of 2015 was a not insignificant surplus.

We see similar things in the steel market in that output has not boomed but sales have grown even more slowly.  Only in the relatively insignificant cold rolled steel market is sales growth even moderate at 7.6%.  In all other products, sales growth is hovering around zero depending on the specific product while output growth remains in the low single digits.

This appears to be mostly driven by financial speculation and specifically WMP’s playing the policy angle.  In China, you follow the government money and that’s what traders are doing piling in these products.

If there was ever a case of prices moving far beyond what fundamentals would indicate, this is it.

Follow Up To BloombergViews on Chinese Debt Swap

I want to follow up on a couple of points about my BloombergViews piece on the Chinese debt swap.  As usual, start there and come here for additional thoughts.

  1. I think sometimes we overcomplicate our analysis of issues. I am just as guilty as anyone and not looking at anyone in particular here, but it can be tempting to over complicate an analysis when the reality is much more straight forward and simple.
  2. There has been some good news reporting on the problems and skepticism even with the Chinese financial and economic world about how well these debt for equity swaps will work. The problems have highlighted such issues as the lack of public capital injection. Persuading existing companies to essentially fund the bailout, the absurdity of having a bank create a WMP to fund purchasing a loan off its balance sheet, or how a bank can receive a debt for equity swap with no discounting of the debt price by the bank when the loan is classified as normal among some of the problems.
  3. These are all entirely valid concerns but I see a high probability of failure of the debt for equity swap for a much simpler and fundamental reason as compared to previous iteration in China: the gap between growth and debt. Prior to, let’s say 2008 for a simple dividing line, nominal GDP growth and cash flows were higher than debt growth in China. Since 2008 however, debt growth has been about twice as fast as nominal GDP growth and that ratio continues to worsen.
  4. I do not care how perfect the incentives work, how ideal the financial engineering, or immaculate the restructuring and organization plans: if debt continues to grow at twice the rate of cash flow or nominal GDP growth the debt restructuring will fail and fail spectacularly. We can write a length about a variety of issues about who absorbs the cost of the debt, the difficulty of restructuring, subsidized debt costs, the employment burden, and so many other issues that need to be considered but at the end of the day if debt continues to grow at two times nominal GDP and 3-4 times cash flow growth, there is absolutely no chance solving this debt problem.
  5. It is also important to note that while some may point to developed countries debt growth and their weak economic growth but these are very different levels. Take a simple scenario, not drawn from any specific country. Assume a country has 2% nominal GDP growth and 4% debt growth. After five years their debt level has risen 22% and GDP expanded 10.4%.  Hardly a crippling blow.  However, in China assume that debt goes up 15% and nominal GDP expands 7.5% also for 5 years.  The debt level has more than doubled by 101% while nominal GDP is only up 44%.  Even if a developed country faces the same ratio, debt growth twice as fast as nominal GDP, the scale and speed of the numbers is radically different compared to China.
  6. This debt swap, whether it is perfectly designed and executed or whether it is a disaster, has absolutely no hope of working absent credit restraint.
  7. Let’s project this out slightly. To make the fundamentals of the debt restructuring work, we have to either rapidly accelerate growth in China or we have to rapidly cut lending.  Right now, for many reasons, it is extremely difficult to see any type of catalyst or driver to significantly accelerate nominal GDP growth in China.  Official nominal GDP YTD through Q3 is up 7.4%, leave aside the validity, and I see no obvious indicator of what would push this up above 10% even within the next few years.  Some may disagree with my pessimism here, but I don’t know anyone that believes the contrary and simply strains credibility to posit that as reasonable alternative.
  8. What happens to the Chinese economy if there is any type of significant deceleration of credit growth? Total loans are up 13% and aggregate financing to the real economy is up 12.5%, I have heard some argue that deleveraging is starting and while there may be narrow examples, by firm for instance, there is simply zero evidence of any widespread deleveraging.  If you look beneath headline data, the only thing keeping the Chinese economy from likely entering an actual recession is fiscal and quasi fiscal stimulus.  What happens if this credit growth is restrained going forward by any significant degree? For instance, if nominal growth continues around 7% and debt growth falls to say 4-6%, what happens to Chinese growth?  I don’t think it is unfair to say that absent continued large scale credit growth, the Chinese economy would suffer from a significant slowdown in growth.
  9. Though I am frequently cynical of Chinese “reforms”, I actually believe Beijing wants to delever. However, and this is an enormous caveat, they do not want to make the trade off that comes with deleveraging of lower economic growth and asset prices.  I always tell me students that there is a stunning amount we do not know about economic processes and where reasonable people can have reasonable differences.  However, there are a couple of universal laws. One of them is economics is the study of trade offs.  What trade offs are we willing to make. I believe China wants to delever but that they do not want to make the trade off involved.

Is Chinese Mortgage Data Waaaay To Low? (No, seriously)

So recently a lot of ink has been spilled on the rapid growth in Chinese mortgages.  On the face of it the increase is certainly worrying.  New mortgage lending in 2016 is up 111% and the total stock of mortgages is up 31%.  Even if we take a broader measure of household lending that likely captures a not insignificant amount of real estate related debt, medium and long term loans to households is up 31%.  The numbers on their face appear large with medium and long term loans to household registering 22 trillion RMB and personal mortgages clocking in at 16.5 trillion RMB.

These sound like big number and in some ways they are, but in reality these numbers are if anything suspiciously too low.  Most get caught up on the size of the numbers but never place these total numbers in any type of context.  In fact, if you place these numbers in context, these numbers are absurdly low.  Let me explain.

For conservatism, data, and simplicity sake, I am going to limit the analysis to urban housing units.  In other words, let us assume that all mortgage and medium to long term household debt is owed only by urban households.  This does not change the outcome in anyway and if anything make it much more conservative than it would be otherwise.

The primary thing we want to do is adjust for the number of households in urban China.  Without going into all the underlying calculations, which come from all official data, there are approximately 272 million urban households in China and according to official data, only a very small number of households do not own their housing.  Again, this is all relying and strictly using official data.

If we then estimate urban residential real estate wealth using the 100 City Index price per square meter as our high value and the Third Tier City Price per square meter as our low value, we have both a high and low value for our estimate of urban residential real estate wealth.  This gives us an estimated upper bound of 330 trillion RMB and a lower range of 189 trillion RMB.

Here is where it gets interesting.  If we translate this into a broad loan to value number, this means that urban China has an estimate loan to value ratio on its real estate holdings of 5-9%.  In other words, almost all of urban Chinese real estate is owned almost entirely free and clear according to official statistics.

If we apply this analysis backwards, the numbers are even more nonsensical.  In 2011, the urban loan to value ratio ranged from 3.3-4.5%.  If we use absolute numbers, the appear even more absurd.  When the average housing unit in 2011 cost 665,000 RMB using the third tier city price and 910,067 using the the 100 City National Index, mortgage debt totaled only 29,675 RMB per urban housing unit.

If we focus just on the new mortgages and new urban units, the numbers look decidedly problematic.  For instance, if we use the 100 City Index housing price, this would give us an implied equity share for new housing units from new mortgages of 71%.  In other words, if we assume that only newly constructed units are purchased with new mortgage debt, owners would be providing a down payment equal to about 71%.

Now while I use the slightly more restrictive mortgage debt, even if we include the broader label of medium and long term this would barely dent the number.  If we use the medium and long term household debt number instead which is only about 4-5 trillion RMB more, again using only urban households, this would still barely move the per unit or value debt number.   To bring Chinese urban housing wealth up to a 20% LTV, would require about a 41 trillion RMB increase in mortgage debt.  Put another way, outstanding mortgage debt would need to go from about 16.5 trillion RMB to 58 trillion RMB. Including the obvious candidates that some have nominated simply does not come close to making these numbers plausible.

We are left with a conundrum: either believe the data at these levels or find a better candidate when no good obvious source of debt under counting exists.  I’ll be honest in saying I’m not sure whether to accept them as vaguely reasonable representation or believe that they are not even close.

If we consider the possibility that these debt numbers are relatively accurate, while there are positives, there are also very real risks.  First, it raises the scope that Beijing could further increase urbanization and home ownership rates by loosening credit.  However, there is evidence that rural households migrating to urban areas are already debt budget constrained and that Beijing is uncomfortable with the level of debt even at these levels.  Additionally, this raises the possibility that real estate prices have a long way further to appreciate which seems implausible given already elevated price to income levels.

Second, this would imply that households have put very high level of savings into their homes and may have less liquidity available than understood.  By some recent estimates, Chinese households had 70% of their wealth in real estate.  Liquidity constraints may exacerbate any real estate or broader economic down turn placing additional pressure on prices.

Third, this would seem to place enormous pressure on public officials to maintain housing prices at elevated levels.  If Chinese households have placed the vast majority of their wealth into their home, though lack of leverage will not magnify the financial returns, it will place enormous pressure on the government to prevent price declines.

There is one possible scenario, though we do not have the data to say for sure this happening that would explain the discrepancies we see.  Given the mismatch of the mortgage data and required down payment this raises the possibility of the leverage upon leverage scenario.  For instance, a home is owned with no mortgage debt.  The owner then pledges the real estate as collateral to borrow money for the equity share and borrows money in the form of a mortgage to purchase additional real estate.  In this instance, only one mortgage appears outstanding where, if we assume the second property is financed with a 50/50 debt/equity split at the same value of the first property, then we have a mortgage per unit value of 25%.  However, in reality the risk level is much higher as both properties have debt against them and depend on stretched cash flow valuations or capital appreciation.

There are many possibilities but the only thing we can say for sure at the moment, once we break down mortgage data into per housing unit basis, the numbers seem implausibly low.

 

Follow Up to Bloomberg View Piece on China’s New CDS Market

So I wanted to write a few more technical issues on China’s CDS market as a follow up to my Bloomberg View piece.  As usual start there and come here.

  1. I hate to sound so negative, I really do, but this is another incredibly poorly thought through idea that seeks dress up symbolism as some type of real reform. There are so many technical problems that simply have not been thought through.
  2. Though it is not the same type of instrument it is a very close parallel, credit or loan guarantee firms already exist to manage this focusing on SME. Though there is not good data on these firms and their pricing schemes, evidence seems to indicate that there is little price discrimination on credit quality.  This implies that either existing firms do not or are not allowed to change the price based upon the risk of the borrower.  Given the lack of price dispersion in the bank loan market based upon credit quality this seems to indicate that the pricing mechanism is simply not being used in the credit market.
  3. The reason that the lack of price movement in the credit risk market matters is why if it is not moving from the major banks in China in these other major financial institutions do we think that it would move significantly with the introduction of a CDS market? One of the primary purposes of the CDS market is to provide a clear, transparent regular price for the default risk of a specific firm.  However, there is little evidence in any market that China would allow the market to accurately price the risk given the prevalence of intervention in asset price markets to set a price preferred by the government.  If the market cannot set price for default risk, the government is better off leaving this market absent.
  4. There is also the lack of market reform that makes this even more of a concerning move. Assume ICBC has a 100m RMB loan to a coal company and Bank of China has a 100m RMB loan to a different coal company. They both want to hedge their default risk so they buy a CDS that covers their potential losses so ICBC buys a CDS from BoC and vice versa.  Now both are worse off because there has been no net change to the total risk level but both think they are better off and potentially become even riskier after purchasing the CDS.  Unless there are large outside investors selling to people wishing to hedge potential losses nothing has changed and people believe they have hedged their risk potentially allowing them to absorb more risk believing they are covered.
  5. There is also an important psychological point here that has been overlooked. When China is controlling the price it is normally through more opaque methods and markets.  For instance, we do not know exactly when the PBOC intervenes in currency markets or how much.  Furthermore, the risk is much more macro oriented or focused.  However, in a CDS market it focuses the attention on a weak firm and has an important psychological impact.  Even if the government intervenes, it will only be calling to attention to the state of a weak firm.  This has the ability to concentrate attention much more on the weakness of a firm or industry that it might other wise be able to obscure.

It seems a lot more like a symbolic reform of sound and fury signifying nothing that has not been thought through.

Some Brief Thoughts on Outflows

So I have been travelling to much and am currently enjoy a strenuous regimen of two a day umbrella drinks and naps on a south-east Asian beach.  The battery is getting recharged and looking forward to writing more.

I wanted to put out something someone sent me about the rapidly shrinking payments gap. As you can see below, the difference between bank payments for imports and the customs reported imports has shrunk rapidly and dramatically.

Since the recent peak discrepancy number, of $58 billion in January and writing about it here in February when the discrepancy dropped slightly to $47 billion, the difference between bank payment for imports and customs reported imports have fallen dramatically.  In August, this discrepancy was just above $10 billion USD.

The fall off in this discrepancy has been nothing short of stunning.  The last time there was a single month this small was in September 2013 with periods of 2012 and 2013 matching some type of moving average.  SAFE is clearly cracking down on moving money out of China this way.

Placed in larger context it gets even more interesting. First, this drop is responsible for essentially all of the supposed slow down in outflows from China.  If this number returns to the pre-crack down average, outflows from China would be approaching $100 billion per month.  Second, there is a game going on here which we can call whack a mole.  Shutting this avenue down will only drive the money out other channels which we already see evidence of as other channels become more prominent.  Third, this movement represents a structural outflow of capital.  As I have noted before, this is not due to 25 bps in New York but rather a structural and likely quasi-permanent shift in the demand for foreign assets by Chinese citizens.

Interesting stuff now back to my pina colada.

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.