Reading Between the Financial Tea Leaves

The big news in Chinese financial markets is that the local government bond offerings designed to refinance off-balance sheet high interest short term borrowing into market based low interest long term products have hit a snag.

Chinese banks are refusing to buy local government bonds at the price on offer.  As the Financial Times noted, the trouble with market based financing is that it doesn’t always do what you want it to do.

There are a number of important issues however, that are largely being overlooked.  First, despite all the sooth saying of Chinese and international pundits that the government is not debt burdened, that is really only partially true.  While the Chinese central government has a relatively low debt load, the real burden is held by the provinces.  Seven provinces have debt to GDP ratios above 80% with Beijing coming in at 100%.  According to the FT, Standard and Poors estimated that half of all Chinese provinces would receive a junk rating.  Just because the official national government debt load is low, doesn’t mean government debt is low.

Second, from the banks perspective, the bond program makes no sense.  Let’s take a simple scenario of what the banks are being asked to do.  The bank has a loan that is paying probably 6-10% (as it is an off-balance sheet project with only implicit government support) with a 1-3 year duration.  They are being told to transform that into a bond with a 5 year duration paying 3.6-4%.  This is a losing proposition for the bank.

Third, there is a major information asymmetry involved between China financial analysts and banks.  Chinese banks which are being asked to purchase the bonds from the same underlying borrower with the same underlying asset as existing loans, presumably have much more information than anything a journalist or professor has access to.  Their level of reluctance reveals their concern about the debt quality from largely existing assets.

Fourth, despite some arguing this represents normal financial development, this quite potentially represents something much more ominous.  During the Greece debt crisis that continues to drag on, a key question has been whether a forced duration extension and lower interest on original debt qualifies as a default.  For some the important question here focuses on the level of coercion involved in exchanging liabilities with the same underlying borrower.  The key point here is that there appears to be a fair amount of coercion involved to force banks to renegotiate existing debts from short term high interest into long term and low interest.  The Financial Times sums it up perfectly quoting one analyst saying  “This isn’t really about adding liquidity.  It’s aimed at alleviating debt pressures on local governments and reducing financial risks.”  If we changed the names from Chinese provinces to Greece, we would be discussing whether this constitutes a default.

Fifth, as I have noted, the Chinese response worryingly seems to be to try and sober up a drunk with more Baiju.  The Financial Times writes “China’s central bank is considering extraordinary measures to boost credit flows to heavily indebted local governments…”.  Reuters writes “China’s Ministry of Finance has warned of slowing tax revenue growth and told local authorities to hasten issuance of newly-approved municipal bond debt.”  China’s problem is not lack of credit but firms and provinces with unsustainable debt loads.  This explains the push into long term low interest bonds.

Taken in isolation, this might be seen as standard growing pains.  However, the recapitalization of policy banks, recent defaults, and semi-coerced refinancing paint a grim picture of Chinese finances.

Looking Back at Chinese Finances

The Chinese economy is entering an interesting state.  Producer prices are falling relatively rapidly due to lack of external demand and a supply glut with producer output falling moderately.  A major real estate developer defaulted this past week (though this more likely owes to corruption scandals than financial problems though no one is quite sure) and maybe the biggest news of all a Chinese SOE with a mainland bond defaulted.  Add in the 1% cut in the RRR by the PBOC and while Beijing may not be pushing the panic button but they appear to be making sure it is working properly.

The Chinese economy is under an enormous amount of stress and there are no easy answers.  There are a number of problems.  First, banks and bond markets have tilted heavily to short term lending.  This means that the amount that has to continually be either repaid or rolled over is high.  According to the Asian Development Bank, nearly 60% of corporate bonds are under 5 years with large amounts falling due within the next two years.  Banks have shortened maturity periods with some banks having more than 65% in lending under 1 year.  While it may give some comfort that relatively little external finance exists in China, it should cause high levels of concern over the significantly shortened maturities.

Second, despite the self congratulations be handed out that China has significant scope ease monetarily, this over estimates the economies ability to absorb additional stimulus.  Many industries in China already suffer from surplus capacity,  infrastructure white elephants litter the country, and major firms with access to credit are already over levered (PDF).  Easing monetary conditions is right out of the Macroeconomic I textbook but here it is like trying to sober up a drunk by buying him a beer.

Third, there is very little appreciation for just how fragile Chinese banks are and how poor their history of lending has been.  I have a forthcoming paper in the Journal of Financial Perspectives which details some of the problems.  From banks that only list a loan as doubtful until after the borrower has declared bankruptcy, ceased operations, and been out of business for at least one year to banks that declare losing loan paperwork as a risk to being repaid, there is little appreciation for their perilous state.  Bad loan numbers are, even while amazingly generous in the definition, spiking rapidly and expected to climb.  China has also started recapitalizing policy banks this past week by converting existing loans into equity.  While the official reason is to boost investment in the Silk Road projects, given the conversion of method of existing loans and in the very unknown projects well off in the future, I remain skeptical towards the official reasons.

There are very real risks to the Chinese economy and financial sector and there should be a lot of attention paid to those risks as repayments come due.

Chinese Foreign Exchange Movements

Concern has been raised over the deterioration of the Chinese economy even though growth is officially only set to slow by a few tenths of a percentage point.  The signals coming from Beijing indicate a greater level of worry than the shift from 7.4% to 7%, officially speaking of course.

As I have noted in other writings, despite its reputation as prudent money manager, China and the PBOC have overseen one of the fastest expansions of the money supply in the world in the past decade. Excluding countries suffering from serious or hyper inflation, even after controlling for real economic growth, China has witnessed one of the highest rates of growth in money supply in the world.

According to State Administration of Foreign Exchange (SAFE) data, net purchases of foreign exchange averaged nearly $300 billion USD annually since 2001.  As recently as 2013, total net purchases of FX in USD terms equaled nearly $400 billion USD.  However, since peaking in late 2013 early 2014, net foreign exchange purchases have deteriorated rapidly on both a monthly and annual basis.

There are a number of interesting conclusions to draw from all this.  First, monthly net foreign exchange purchases as recorded by SAFE have not witnessed such a sustained period of net sales (outflows) since January 2001.  There was a brief period in the middle of 2012 when net monthly purchases turned briefly negative during a couple months.  However, it was smaller, inconsistent, and shorter in duration.  Net monthly purchases are prone to relative volatility, but the overall trend and size are important to note.

Second, if we consider annual purchases on a rolling basis, there is a brief period in late 2012 when the net annual FX purchases by SAFE drop beneath $100 billion.  However, as was noted with the annual purchases, this trend quickly reversed and by February 2013 rolling 12 month purchases were back up above $200 billion USD.

Third, if we consider annual purchases around fixed dates either after Chinese or calendar years, to adjust for potential seasonal issues, we see clearly the magnitude and speed of the change.  2002 was the last calendar year China had net FX purchases under $100 billion USD with a similar result if we adjust the calendar to account for Chinese New Year differences.  From March 2013 through February 2014, China enjoyed net FX purchases of $387 billion USD.  From March 2014 through February 2015, China saw net FX purchases of just $12.6 billion USD a decline of 97%.

Fourth, if we focus on FX purchases since January 2009, the pattern indicates that since about late 2012, gross purchases have grown more slowly while gross sales have continued to grow rapidly.  The net result is that net purchases have declined dramatically.  In July 2010, gross purchases of FX by Chinese banks reached a new monthly high of $114 billion USD.  In February 2015, the latest month with available data, gross purchases totaled $115.6 billion USD.  Conversely, gross sales in the same months grew from $88 billion USD to $126 billion USD.  In other words, while inflows into China have essentially gone flat, outflows have continued on trend.

Fifth, while China is in no danger of a run on the currency or exhausting its FX reserves this does appear to portend a much broader and severe slow down in the Chinese economy.  If gross purchases are essentially flat, this means that both investment in China and Chinese exports are not growing or tepidly.  Given the concern expressed by foreign companies in China over the capricious regulatory environment, anti-foreigner sentiment, and costs, to name just a few worries, this appears to be hitting inflows.

Though too soon to tell if it is a longer term trend, this does appear to be a longer trend than the 2012 phase.  It does however appear to signal much greater weakness in the overall Chinese economy.