What China is Doing to Join the IMF

After all the rumblings about China seeking to join the IMF it seems somewhat strange to engage in this discussion as they lack one of the most important factors: a convertible

After all the rumblings about China seeking to join the IMF it seems somewhat strange to engage in this discussion as they lack one of the most important factors: a convertible currency.  While I do think it is important that the rmb ultimately become a reserve currency for the SDR at the IMF, at this point in Chinese development it is really hindering Chinese development more than helping.

China has witnessed rapid growth in outward investment.  As those Chinese companies grow and evolve, so will their supply chains to meet growing demand and building brands outside of China in other developing economies.  Chinese firms looking to expand outside of China need the flexibility to convert RMB for investment purposes when needed rather than when allowed.  According to a study by the Economist, 94% of Chinese firms are planning on expanding their supply chains in other emerging markets.

What China doesn’t realize or is unwilling to admit is that demand for the RMB exceeds its willingness to provide it.  For all the domestic complaining that the RMB is being oppressed for the IMF and the US, freeing the RMB will ease its movement into SDR reserve status but also benefit Chinese firms, the ones that export and those expanding abroad.  As Standard Chartered at the from a series of studies with The Economist Intelligence Unit at their website Growth Crossing points out, RMB usage is competing heavily for invoicing business throughout south-east Asia.  However, this remains primarily offshore RMB usage that will benefit greatly from continued liberalization.

Despite my concerns over Chinese economic and financial risks, the policies and controls are mostly harming Chinese firms and their ability to expand overseas and build brands. Unless these capital controls are relaxed and risks addressed, Chinese firms remain reluctant to expand overseas and manage the risks and position themselves for success.

Why Greenpeace Leads Us to Believe Chinese GDP Growth is Low

One of the great intellectual puzzles for me as an economist living in China is why so many smart people obsess over official Chinese GDP growth data.  Given that there is extensive research demonstrating how Chinese GDP data is managed and even Li Keqiang in his much touted index has warned against reading too much into it, people continue to read every decimal point as an indicator of good times or impending doom.  Chinese GDP data is kind of like the latest Hollywood comic book tent pole, full of special effects that leaves us entertained and wanting more.

The problem, however, lies in finding alternative measures of Chinese GDP growth.  Every alternative measure of Chinese GDP growth that I am aware of, has used some variation of the Li Keqiang Index using electricity and goods traffic as a proxy for economic activity with a few additional measures thrown in for good measure.

These are good attempts to produce better data but run into two significant problems.  First, they are using either fragmented or imperfect data.  This may be from industry groups or other sources that have good data sources but it typically has the very real potential of omitting or missing observations.  Second, if they use more comprehensive data it typically relies on some government or quasi-public data collection agency.  However, this creates a battle of the wits scenario.  If government statisticians are smart enough to manipulate GDP data they are smart enough to manipulate secondary data especially after Li Keqiang made his well known observation.  They know that you know, so clearly they cannot leave this economic variable untouched.  In other words, attempts to estimate GDP data using any public or quasi public data in China suffers from a positive bias.

Greenpeace has released a report (make sure to click through to the underlying links) suggesting that in the first quarter 2015, YOY CO2 emissions and coal consumption have fallen by 5% and 8% respectively.  If true this staggering and incredibly important for our understanding of the Chinese economy.  There is one important caveat.  Greenpeace is utilizing Chinese government data, which as I just noted, is notoriously unreliable.  As one article about the Greenpeace report notes, China has previously reported large drops in coal production only to later adjust the numbers back up enormously due to producers simply not reporting output.

While we need to proceed cautiously in interpreting these numbers, for the reasons noted, I believe we can make reasonable interpretations of this data.  Let us consider a couple of scenarios and the subsequent interpretations.  It seems unlikely that Chinese statistical agencies are purposefully upward biasing the fall in coal and electricity usage.  By that I mean, if Greenpeace is reporting that coal use in China fell 8% based upon official data, that it actually fell 12% but is biased upwards.  Furthermore, the China Electricity Council, electricity growth in the first four months of 2015 grew YOY by a total of (wait for it) 0.2%..  I don’t think even the most concerned about the Chinese economy would be predicting falls in coal and electrical consumption even larger than what is being reported.  Therefore, I consider it less likely that these numbers are manipulated upwards in any meaningful way.

It seems somewhat more likely that the numbers are downward biased.  However, a willful downward manipulation is not completely satisfactory explanation for a few reasons.  First, given the widely recognized existence of the Li Keqiang Index even within China, downward manipulation would seem to needlessly invite speculation about the health of the Chinese economy.  Second, drops in domestic production of energy producing commodities are matched and even exceeded in relative terms by imports.  Given the difficulty in manipulating trade data, which two countries participate in, the general trend of the data seems matched by international data.  Third, this data is broadly matched by domestic Chinese data that is strongly correlated.  For instance, there has been widely reported flat or falling production of coal and electric intensive industries like steel and cement.  This also is matched with similar falls in international commodity trade and prices.  Fourth, given that China has told the world that its CO2 emissions and coal dependency will continue to rise until 2030, there seems little incentive for it to manipulate the data downwards now.  Fifth, nor do the numbers appear to be falling due to a shift in the Chinese portfolio of energy production.  The speed necessary to produce a shift of this magnitude is simply enormous and while hydropower production surged in 2014 due to higher rainfall, new electricity production remains overwhelmingly coal based.  In short, the secondary data fails to support the idea that this data on coal and CO2 emissions is significantly downward biased.

What seems like the most likely scenario is that these numbers are broadly representative and accurate.  I should note that doesn’t mean the data is perfect and unmanipulated, only that appears most likely to be generally representative of coal, CO2 emissions, and electricity production.  In my opinion, Any significant manipulation would require actual electricity growth to come in upwards of at least 2-3%.  In short, much of the data matches close enough that we can feel comfortable that any manipulation is either well coordinated across independent actors or telling a similar story.

If these numbers are generally if not perfectly accurate, this has one very important implications: real GDP growth in China is nowhere near 7%.  In other words, electricity consumption was flat.  Producing GDP growth of 7% with total electricity growth of 0.2% would require electricity efficiency gains never before seen in modern economic history.  If this number is generally accurate, this would imply that Chinese GDP growth is in the low single digits.  A plausible guestimate, based upon electricity growth between January to April 2015, would be GDP in the 1-3% range.  There is simply no way you can have zero electricity growth and manage 7% GDP growth.

The low growth of estimated GDP would further explain many of the strong actions taken by Beijing to support GDP growth such as the “call it anything but stimulus” stimulus to the bailout of indebted provinces.  Maybe Beijing knows something the rest of us don’t?

 

 

Musings on Chinese Debt Concerns

The Financial Times at Alphaville has a great piece on how recent policy changes surrounding the nascent provincial bond market are being interpreted covering a range of thinking, even if I am labeled the resident crank a role I accept with relish.  They do raise some very valid issues which deserve attention.

Anything Deutsche Bank says about China should be read skeptically as it acts as little more than a public relations arm and recruiting ground for the PBOC.  However, more specifically, DB makes two illogical arguments about Chinese debt and the economy.  First, it argues that the slowdown in the Chinese economy is attributable flat government spending.  Considering DB was overestimating Chinese growth by more than 1-2% recently, the fact they even say slowdown is remarkable.  Second, DB believes that even more provincial led investment through additional debt, either by LGFV or bond sales, will continue to drive the Chinese economy.

Even mathematically it is difficult to reconcile the DB claims.  LGFV investment, which is responsible for 20% of the national total according to DB, has contracted so enormously to cause the national slowdown.  With  YOY fiscal spending, again according to DB, essentially flat at -0.2% it is difficult to see how this would cause the national slowdown when it was up only 6% last year.

Additionally, the flat spending conveniently overlooks the fact that local government revenue is falling.  Nationally land revenue to local governments is down 30% and given that on average about 50% of government revenue comes from land sales, this significantly impacts spending ability.  This tracks with something else in the FT piece that estimated growth, by one calculation 5.3%, is significantly lower than official estimates.  Finally, provincial borrowing is only implicitly allowed for LGFV and not operational spending of governments.  Lending guidelines should have minimal impact, according to Chinese law, on general spending.

If Deutsche Bank research economists believe this is such good policy and the financial risks are low, then may I suggest using DB capital to purchase some of the newly issued provincial bonds?

There are two larger points however that are somewhat acknowledged.  First, in China there is an enormous difference between lip service to addressing a problem and enduring the pain (structural reform) required to addressing a problem.   As GaveKal rightly notes about the nascent bond market, “opening the front door and closing the back door”  was intended to introduce transparent financing and market risk to local government debt.  However, what we have witnessed has been the complete opposite of this.  Banks being ordered to continue lending leaves the back door wide open.  The price on the bonds is not commensurate with the risk, which is why the bankers held out so long.  There is no transparency on the financing as it is all private placement offerings.  Then the PBOC is essentially buying any debt the banks decide not to hold.

Economically this means asset prices need to decline and surplus capacity needs to be reduced.  Given Beijing tacit encouragement of the stock and housing market, it appears they have little interest in reigning in asset prices.  The drive to encourage more infrastructure investment and lending to favored companies or SOE’s indicates they have little interest in addressing the capacity issue.  The rising asset prices and declining producer prices, and the policies driving these trends, will only create additional problems later on.  The fundamental take away here is that there remains an enormous gulf between the press releases and the actions.  The policy itself is fundamentally sound but if there is never an adherence to the policy and the restructuring involved, it is worthless.

Second, there remains no plan to address these problems.  The entire plan, and the only reason the banks are not in outright revolt, is that the PBOC is allowing the banks to use the bonds as collateral to prompt further lending to favored industries and firms.  This isn’t addressing the problem, this is doubling down on the strategy that created the problems in the first place.  Citi, in the FT piece, addresses the issue quite delicately writing that “…if there is no efficiency gain in coming years, some local governments may become insolvent….”.  GaveKal notes the lack of a strategy writing “Beijing will not admit there is a big solvency problem and cut lending to entities who have trouble.  Instead Beijing wants banks to keep lending in the hope that one day the borrowers may get better.”

As I have noted, Chinese banks were able to outgrow some of the bad debt problems a decade ago, however, hoping for the same a second time is an incredibly risky proposition.  As of yet, there has been no plan even floated to reduce the debt burden or impose the type of discipline required to delever.  In fact, it has been just the opposite.  The plan so far has been to increase lending and investment even more and hope that things work themselves out.

In closing, I want to make two final points.  First, I should note that the PBOC and CBRC by forcing the debt restructure have used standard strategies with distressed borrowers whether they be firms or governments.  They are to be commended for taking decisive action.  However, the very real concern is that they won’t take the necessary follow up steps.  Think of a patient that undergoes heart surgery to prevent a heart attack but returns to  a diet of sweets and red meat with no exercise.  The surgery prevented a heart attack but only put off the reckoning without real changes.

Second, I think a financial crisis scenario is much less likely than a zombie scenario.  I have heard from some that I am predicting a financial crisis and I want to make clear that is not what I am predicting for many reasons.  From the political risks Beijing sees in a financial crisis to the willingness to bailout everyone by Chinese policy makers, I believe a financial crisis is not the most likely scenario.  High debt levels with ongoing problems for many parts of the economy is the bigger problem.

The Chinese Bailout is Starting to Bail Fast

After the PBOC and CBRC announced a unilateral change in debt policy that allowed indebted Chinese provinces to swap their high interest short term debt for long term low interest bonds which banks would then present to the PBOC as collateral for cash to use for additional lending, it seemed like the forced restructuring would ease the pressure on local governments for a while.

However, Friday night the Chinese central government through the Ministry of Finance, along with the PBOC and CBRC, jointly announced a policy intended to further aid local governments.  In the words of the Financial Times, the regulation:

“…told financial institutions to keep lending to local government projects even if borrowers are unable to make principal or interest payments on existing loans….(the regulation) explicitly banned financial institutions from cutting off or delaying funding to any local government projects started before the end of last year and said that any projects that are unable to repay existing loans should have their debt renegotiated and extended.”

Let me say that again just so it sinks in: banks were told to keep lending money even if the borrowers are unable to make principal or interest payments on existing loans and banks are forbidden from cutting, denying, or delaying loans.  While country policy makers around the world have unofficially encouraged excessively loose credit policies and lenders may take such policies in individual cases, I have never heard of a similar countrywide or bank wide policy anywhere.  (If anyone knows of a comparable case please let me know).

Though they are mostly speculative, there are many inferences that can be drawn from this latest announcement.

  1. The local government debt problems surrounding the $3.5 trillion USD are much more widespread and profound than is currently recognized by people outside the Chinese government, the banks, PBOC and CBRC. For comparison sake, imagine Barack Obama and Janet Yellen announcing a similar policy for all local governments and banks in the United States.  If the bad debt was limited to even a handful of provinces or loan types, we would not be seeing these types of policies.
  2. The bankers must really be resisting the new policies. For the last month as news began to trickle out about this policy shift,  we saw how the bankers didn’t want to buy the new bonds, didn’t like the pricing, the duration, and now the regulation tells them to keep lending even current borrowers are unable to service existing debt.  This can only be interpreted as a public and strict ordering of bankers to walk the line set by government.
  3. If debt problems were more limited and bankers were complying this policy would never have been made public in China.
  4. If the bankers are telling you what they think of the debt problems in China by resisting even the early forced restructuring, what is the government telling you by announcing ability to service debt is not a requirement for more lending and forcing banks to lend?  Given the information asymmetries in Chinese financial markets, it helps to judge how those that should know behave.  This policy appears extremely desperate by the government indicating their level of concern.
  5. 7% GDP growth and 1% non-performing loan ratios are both figments of a CCP statisticians imagination. Even in a world where an NPL is only counted after a firm is bankrupt and non-operational for a year, the GDP and NPL numbers are simply fairy tales.
  6. China through a combination of policy and luck grew its way out of the last bad loan build a little more than a decade ago. There are banks that still carry the bad loans from a decade ago and some very large companies have been started out of these assets.  However, even without a significant growth slowdown much less what even the Chinese government touts as “the new normal”, it will be extremely difficult to replicate the debt swallowing growth of the previous decade.  China cannot count on outgrowing its debts again.
  7. Beijing and Shanghai do not represent China. Declaring the health of the Chinese economy based upon trips to these two cities is like visiting New York City and Washington DC and saying the economy looks great.  It is also worth noting that Beijing and Shanghai are two of the most indebted subnational provinces in all of China.
  8. Expect to see a significant portion of the bad debt end up at the PBOC with no recourse back to the bank if the debt goes bad. The PBOC printed enormous amounts of money to keep the exchange rate low and the money supply rising in the past decade.  Their new strategy seems to be to print money to lend out via low credit quality collateral.
  9. The private sector is being forced to bail out the government.
  10. I wonder what bank shareholders will think about their capital being forced to be lent without an obvious path to repayment. No wonder the market was pricing in bad news during the recent stock market runup.
  11. China remains an economy completely dominated by the state. As one economist who argued that the true state share of the Chinese economy was closer to 80% of GDP, just because it is a listed company does not mean it is a private company.  With the exception of Alibaba, there is virtually no major Chinese company where the state does not have, frequently through Cayman shell corps in true capitalist fashion, a major holding in most every company.  Banks as extensions of the state are following the orders of their major shareholders.
  12. While I would definitely be categorized as someone who has significant concern about the risks in the Chinese economy, and I respect many economists who are more sanguine about these risks, at this point I struggle to understand how anyone can see these signals from the Chinese government and not be very concerned about the buildup of financial risk.

I hope I am wrong about what I see as the financial risks as signaled by the Chinese government are extremely large.

The Giant Debt Restructure

Let’s run a simple thought experiment.  Assume a government is drowning in debt.  They can’t raise the money to pay off the debt coming due.  The interest rates are too high and the maturities too short.  Revenues are falling and the banks are reluctant to continue extending credit to the government.  The situation looks dim.

The government and central bank, however, come up with an idea to solve the problem.  The government imposes a debt swap on the banks where they unilaterally turn short term high interest debt into low interest long term debt.  Though there is no write down in the face value of the debt, there would be a reasonable case given the coercion and change of terms, to ask whether this was a debt default.  There has been no change in asset or borrower quality but rather a unilateral rewriting of the debt contract using coercion.  Not wanting to miss out, the central bank offers to accept this troubled debt as collateral should the banks want cash instead, effectively monetizing the bad debt.

This scenario isn’t about Greece but about the debt swap imposed by the Chinese government in partnership with the PBOC on lenders holding local government debt.  While no one is saying this is a default, if this same scenario played out in Greece, there would be arguments over whether this constituted a default.  Furthermore, less anyone forget the magnitude of debt, the debt swap constituted only about $160 billion of the estimated $3 trillion.  To put this in comparison, this is a similar absolute number as is being discussed in Greece and still only about 5% of publicly acknowledged local government debt.

There are a number of important points to note about the overall debt swap.  First, the bankers are going along with this not because they think it’s a good deal but because Beijing is threatening them and the PBOC is buying them off.  As with most countries, if the central government tells you to do something you do it.  If the central bank essentially offers to take some risky debt off your hands at face value, you accept and don’t look back.

Second, the bankers are telling you a lot about what they think of the state of local government finances in China.  They wanted nothing to do with refinancing the debt and definitely not at the prices being offered.  Given their knowledge of debt repayment capacity of their clients, this tells us a lot about the state of local government finances.  Especially with land revenue falling by more than 30% annually when it typically constitutes more than 50% of government revenue, the provinces ability to repay is highly suspect.

Third, Beijing did not ask nicely but rather imposed regulations about the interest rate tying it closely to the central government cost of funds.  The interest rate on the debt will drop from typically above 7% to about 3.5% with maturities moved from 1-3 year to at least 5.  The PBOC accepting bonds that the banks can’t wait to unload should also call into question the prudence of accepting such widely acknowledged low credit quality instruments.  It seems unlikely that the PBOC would try to collect capital from banks if the underlying borrower defaults, essentially turning the PBOC into a bad debt asset manager.  This could the Chinese method of tapping the PBOC balance sheet by swallowing bad debts.

Fourth, the banks, after getting cash for the bonds as collateral from the PBOC, are being encouraged to lend out this cash to firms in favored industries.  Given the drop in risk weighted capital from holding government bonds as an additional benefit, this means that banks will have significant new capital to lend.  The rapid rise in Chinese debt, which has even officially surpassed most developed countries, seems bound to rise even more.  I can’t help but think that this seems like trying to sober up an alcoholic by buying him a beer.

While this certainly heads off larger financial problems in the near term, it seems at best designed to put off dealing with the problems and at worst exacerbating the credit bubble.  Most China watchers have been focused on debating whether the PBOC is running QE with Chinese characteristics, but missed the importance of the debt restructuring.

Here is hoping that deposit insurance will never be needed.