The Copper Carry Trade and Monetary Policy in China

As a professor at Peking University at the Shenzhen campus, I am very privileged to work with some of the best and most ambitious students in China.  Every year I work closely with a handful of students on their thesis projects and some years, there are some really interesting and insightful papers that result from this endeavor.

This year I was privileged to work with Michelle Zhang who will become a fixed income analyst for BNP Parisbas next month.  She led the writing of a very interesting paper on how Chinese companies are holding copper to execute the carry trade with Chinese characteristics.  The carry trade is where traders arbitrage interest rate differentials by borrowing in a low interest rate currency and lend in a high interest rate currency typically in a short duration and in liquid high credit quality instruments.  Though hedging future currency risk is typically advised, the research on uncovered carry trades find that uncovered are typically profitable and currency movements do not move in the predicted manner.

In China however, the carry trade due to capital controls is decidedly more complex.  China exists in an asymmetric financial market where FX transactions are largely though not entirely free but capital account FX transactions are tightly controlled.  To move capital but disguise the FX transaction as trade rather than capital movement, firms have found an enterprising way around this.  A firm will enter into a sham transaction to export, for use in our paper copper, a product with a clear market price.  The firm will then secure foreign currency trade financing, typically in a currency fixed against the RMB like the USD or HKD with low borrowing rates and potentially additional leverage, convert back into RMB and bring the currency back into the country under the guise of goods trade.  They will then invest in typically high credit quality short term products and then unwind the trade and the end of the term for the copper holding.

To avoid going into all the technical details both about how this trade is executed and the econometrics, let me just summarize the major findings.  First, there is clear and unambiguous evidence that copper stock holdings are related to the Chinese carry trade.  Given that by our official estimates, China now holds nearly 40% of the global copper stock in warehouses, which excludes ongoing consumption, this is not an insignificant finding.  It is also worth noting that some estimates, have Chinese copper stock responsible for an even higher share of global copper stock holdings.

Second, the carry trade and copper holdings are driven by the approximately 4% interest rate differential between LIBOR and SHIBOR.  Investing in even mildly higher risk instruments can significantly increase this differential.  We estimate that every basis point differential between LIBOR and SHIBOR is responsible for approximately $1.5 million USD in copper stock holdings.

Third, there is little evidence that copper carry traders are entering hedging positions such as FX, interest rate, or credit protections.  For instance, FX volatility or future prices in major currencies appear to have no impact on key variables for expected durations.  While the PBOC maintains tight control over FX, granting traders an implied policy hedge, it appears that traders are insufficiently hedged against FX and interest rate movements.

Though this may seem to have semi-arcane financial market implications, it actually gets directly to one the puzzles of Chinese monetary policy.  That is, if Chinese banks are flush with cash as the PBOC claims and loan demand is low, why does the PBOC continue to release cash into the system via reserve rate cuts rather than cut interest rates when even the best SOE is facing real interest rates of approximately 10%?  This would seem to have a much larger impact on the economy.  Given that debt durations throughout China are typically quite short, this would provide rapid pass through to borrowers and a broader based boost to the economy.

There appears to be a couple of reasons.  First, China is still heavily dependent on capital inflows to finance its continued development.  Given the already porous nature of its capital controls through a variety of means like fake goods trade or over invoicing, any reduction in the attractiveness of RMB assets risks turning the interest in non-Chinese assets into a stampede regardless of official capital controls.  The PBOC appears to be making the tradeoff of trying to continue to attract capital by keeping interest rate high even if that risks choking off businesses with absurdly high real interest rates.  With the decline in the accumulation of FX reserves from the revaluation of the RMB, China needs to find other methods to attract capital.  Despite all the rhetoric from Beijing about rebalancing the economy, this speaks directly to their continued model of attracting capital in order to drive investment, even in a credit saturated economy.

Second, despite all public pronouncements to the contrary, this implies that banks are weaker than is believed.  Though lending rates have been freed, deposit rates have yet to be freed and reducing interest revenue would really compress margins on banks that are experiencing slow loan growth and coming under pressure from rising questionable loans.  Aggressively lowering interest rates in the absence of deposit rate liberalization would squeeze the banks.  Conversely, removing deposit rate guarantees could further exacerbate the move away from major state banks shifting deposits to other financial institutions or prompt capital outflow.  Given the PBOC and government mandate to buy up low yielding government bonds and continue lending to LGFV whether they are paying or have any prospect of paying, banks already appear weaker than public pronouncements.  Slowing the capital inflow or giving reason for capital to flow out could really create problems for China the major banks.

Third, the PBOC and China have yet to really grasp the enormous change in monetary and financial policy required to become a major international currency.  Evidence indicates that the PBOC is slow to respond to outflows in a fixed exchange rate regime and is not responding to the international demand for RMB outside of China but expecting and even pushing the IMF to make the RMB an international currency.  While it politically may become an international currency, it is struggling to manage the financial transition.  Recently, rather than directly channel RMB to offshore centers, the PBOC moved to begin international repo agreements where foreign branched Chinese banks would enter repo agreements offering foreign assets in exchange for RMB needed for trade liquidity purposes.  It is clear that the PBOC is struggling to grasp the enormity of the shift before them.

The PBOC and China are caught between difficult trade offs with regards to the conduct of monetary policy.  They can either demonstrate resolve to become a major international currency or they can politically push and shrink from managing the financial shift taking place with or without them.  I personally can’t wait to watch what unfolds.

Note: Michelle Zhang while jointly responsible for the academic paper on the copper carry trade is not in anyway responsible my comments on the PBOC and Chinese economic policy.

Responding to Questions on Singaporean Finances

I was sent a couple of emails by people asking me to clarify some issues about various issues.  I have tried to directly address these issues and answer bigger questions from the Singapore government website “Factually”.  If there are other questions, I am more than happy to try and respond as I release information.

  1. What are “operational surpluses”?

Operational surplus are primarily tax and fee revenue minus operational expenditures like paying for civil servants and operational investments like buying computers.  Another way to think of an operational surplus would be revenue made from working at your job minus what you pay on rent and food.  Operational surplus accounts for the year to year operational revenue from economic activity minus the costs of running the government.

  1. Does “operational surpluses” include investment contributions or revenue?

Absolutely not.  There is no investment revenue included in the operational surplus.  Using the analogy of the household again, you may have income from a stock portfolio but that is counted as investment income and not operational income from working at your job.

  1. How do land sales count in operational surpluses?

The International Monetary Fund counts land sales as operational revenue while Singapore counts land sales as reserve/capital revenue.  As a matter of accounting for our purposes, it is better to count land sales revenue as operational revenue.  This is true because it does not come from historical savings but rather acts as additional revenue separate from financial asset investment income.

  1. Are GIC and Temasek counted on the public balance sheet?

GIC and Temasek are both Fifth Schedule corporations legally owned by the government and incorporated on the Singaporean balance sheet.  GIC and Temasek hold the same legal distinction.    This means that GIC and Temasek should be accounted for by Singapore the exact same way.  This means that if one is on the balance sheet, they both should be on the balance sheet.  If Temasek and GIC are not on the official Singaporean balance sheet, this means that there is another investment institution with $800 billion SGD in assets under management making it one of the worlds largest institutional investors.

  1. If there were a problem with Singaporean financial statements, would the IMF would correct this problem?

No.  The IMF collects data from its member countries and provides general guidelines but it does not act as an auditor to verify the data.  In fact, in IMF databases, most data is credited to the domestic statistical agency prepared in accordance with IMF accounting policies.  Consequently, Singaporean operational surpluses with the IMF are different than domestically reported numbers due to differences in accounting policies.  The primary issue being how land sales are credited.  Nor does the IMF review institutions like Temasek and GIC or audit their financial statements and returns.  In short, the IMF does not act as an auditor to correct financial accounting errors or discrepancies.

  1. Are debt servicing costs included in your estimates?

Absolutely.  I have built a database going back to 1974 of the cost of government debt.  Though the government of Singapore may claim otherwise, debt servicing costs are included in my estimates here and in previous estimates.

  1. What return assumptions are you making on the operational surplus and borrowing?

I assume that what the government of Singapore and its related entities are declaring is true.  For instance, GIC claims for all periods we know that it earned a 7% USD rate of return over 20 years.  That is the assumed rate of return on invested capital.  Furthermore, the government of Singapore declares large cash holdings with the Monetary Authority of Singapore.  Even if we match the cash holdings they publically declare with cash holdings earning a 0% rate of return, a conservative estimate, and all other funds were invested by GIC this would still leave a shortfall of $670 billion SGD even after debt servicing and currency losses.  In short, I am not assuming anything that the government of Singapore or its related entities have not already declared.

  1. What about the debt incurred by Singapore?

Most debt owed by Singapore is owed to CPF holders with the approximately other 40% in the public debt security market.  The important question about the debt owed by Singapore is where it has gone.  The government of Singapore outlines the two types of government debt, but more importantly is where this money has gone.  A review of their finances indicates that operational revenue covers operational and development expenditures.   Given this information, where is the cash flow raised from debt sales going?

The PBOC, Interest Rates, the Stock Market, and Nominal GDP

The PBOC cut rates over the weekend and reserve ratios noting the significant amount of available money for lending.  A few brief thoughts.

  1. This was clearly aimed at the stock market drop of almost 20% in the last two weeks.
  2. Any stock market movement that depends a 25 basis point cut to sustain PE ratios above 100, clearly is driven by mania.
  3. Given the weekends events in Greece and the fear in the Chinese market, I don’t think you can count on a large bounce.
  4. While the stock market was clearly the target, given that real interest rates for even the most credit worthy SOE, any cut in real interest rates for any reason should be welcome.
  5. The PBOC is targeting lending ability but given the drop in loan demand, surplus capacity, and falling aggregate demand, they should be targeting interest rates rather than reserve ratios and loan to deposit ratios. This is simply bad policy.
  6. The more important aspect of all this will be the impact on the real economy and any impact of interest rates on the real economy. Given the very short duration of most Chinese debt any cut in interest rates would seem to impact profitability relatively quickly.  Furthermore, the stock markets impact on the real economy I believe is likely to be minimal.  The only places you saw evidence of the run up was in Beijing, Shanghai, and Shenzhen where real estate prices bounced.  The rest of country, as a comparison, continued to fall.
  7. Given the deterioration of GDP growth with real interest rates upwards of 10%, it seems that the PBOC is maintaining high rates to protect banks and other preferred firms. The carry trade with Chinese characteristics brings in billions of dollars a year for firms with the capabilities to carry it out and major Chinese banks are already under margin pressure due to interest rate liberalization with fixed deposit rates.  Cutting interest rates aggressively would really place enormous pressure on bank profitability.  Though they rank high for capitalization and profitability, given the rapidly rising bad loan, mentioned loans with the already extremely generous classification, and loan rollovers, there is reason to believe these banks are not nearly as healthy as claimed.  With even the state auditor noting that major Chinese SOE’s are falsifying revenue and profitability numbers with banks making questionable loans, you can be sure there are many more problems masked.  The monetary policy of the PBOC however is nothing short of abysmal.

All of this points to a larger problem about trying to grapple with the true state of the Chinese economy.  With HSBC pulling its sponsorship of the PMI index of manufacturing, everyone is trying to figure out how best to assess the state of the Chinese economy given the Beijing dictate that only positive news or data is allowed.  The Financial Times when writing about the Goldman Sachs attempt to measure Chinese GDP, quoted GaveKal with what can only be called the art school approach to economic accounting: “the debate about whether China’s GDP figures are overstated or understated is ultimately a waste of time as there is no way to know what is the ‘correct’ level of China’s GDP.”

If economics is not trying to measure and quantify and make rational decisions on the collected data, then it truly serves no purpose.  Government statisticians and investment bank economists should just get gold stars with smiley faces for their art projects about the state of the Chinese economy where nothing is ever wrong.

While I understand the frustration in trying to measure and understand the Chinese economy there are a number of important points to note.  First, even Chinese officials know and admit that they are being producing low quality data.  While they may not release the high quality data even if they have it, they know that they don’t have the data necessary to manage an economy with 1.3 billion people.  Just this week China announced an effort to better quantify the labor market with 120,000 statisticians equipped with tablets to roam the country conducting ongoing labor market surveys.  This problem is not lost on the highest reaches of Chinese leadership.

Second, we may not be able to quantify the past 30 years of Chinese GDP growth, but we absolutely need to understand the direction of the current economy something many appear unwilling to take a position on.  While I openly believe Chinese GDP growth is significantly lower than official reports, compiling a wide range of metrics, there is little evidence of almost any sector of economic activity in China growing at 7% a year.  While I have previously noted that electricity growth for the first 5 months of 2015 was up only 0.2% YOY, even the Chinese finance minister is grousing about tepid tax revenue growth of 2%.  To provide some perspective, the PBOC just lowered its official growth estimate from 7.1% to 7% and the MOF had estimated tax revenue growth of 7% but so far has only seen 2%.  Assuming the data is accurate this implies that a drop from 7.1% to 7%, or 0.1%, resulted in a drop in tax revenue growth from 7% to 2%.  That is some amazing growth to tax revenue elasticity.  There is no secondary data evidence that China National Bureau of Statistics GDP data is anything other than a pretty art project that deserves a red star.

Third, quantifying the Chinese economy helps us understand the risks. As the Financial Times again points out, official nominal GDP, which you believe at your peril, has fallen from 20% growth in 2011 to under 6% in the first quarter this year.  Given that debts and tax revenue are paid in nominal revenue rather than real revenue, this matters enormously.  This means that nominal GDP has fallen nearly 75% with “average revenue growth for listed companies slump(ing) from nearly 30% expansion in the first quarter of 2011 to just 0.7% in the first quarter.”  This makes the existing debt load that much less bearable.  This means the risks to the stock market, listed companies, banks and China are much higher than understood.  Given that there is strong documented evidence that inflation has been systematically underreported, this negatively impacts our expected risk level.

If you remember nothing else from the attempts understand the Chinese economy, remember two things using official data.  First nominal GDP in China has fallen almost 75% from a few years ago.  Second, 7% is currently only being attained by relying on deflation.  Neither are indicators of a healthy economy so imagine what the real data looks like.

The Largest Financial Discrepancies Ever?

Singapore public finances contain the largest unexplained financial discrepancies in human history.  That may sound like a grandiose rhetorical bombast, but it is completely and entirely accurate description of existing data.  Using nothing more complex that addition, subtraction, compounding interest, and official Singaporean public financial records, anyone can easily see that enormous discrepancies exist.

The financial irregularities in Singaporean financials are easy to spot when attempting to simply accept all their claims as true and valid.  It is a straightforward mathematical impossibility that all their claims about their finances are true.  Let us present the fundamentals of what Singapore is claiming.

  1. From 1974 to 2014, Singapore enjoyed operational surpluses totaling $369 billion SGD.
  2. From 1974 to 2014, Singapore increased public indebtedness from $5 billion SGD to approximately $388 billion SGD. Singapore claims that this was for investment purposes and given the operational surpluses, it had no need to be consumed via public expenditure.
  3. From 1974 to 2014, Singapore enjoyed total free cash flow from operational surplus and net liability incurrence, totaling $822 billion SGD.
  4. From 1974 to 2014, Temasek Holdings claimed an annualized 16% return beginning with a $374 million SGD portfolio value at inception.
  5. For most of its existence, the Government Investment Corporation of Singapore has claimed a long term annualized return of 7% in USD terms.
  6. The Singapore government lists financial assets of $834 billion SGD on its public balance sheet.

Those are the facts that the Singaporean government claims to be true.  Without knowing anything about finance or conducting in depth analysis everyone should find two claims by Singapore completely contradictory: if Singapore enjoyed such free cash flow of $822 billion SGD for 41 years, how can its claims to produce stellar to world beating investment returns be reconciled with their declaration of only $834 billion in financial assets?

Using conservative estimates that account for debt servicing costs, currency losses from USD returns, and matching existing declared government cash holdings with the assumption that cash earns no return, if we accept Temasek and GIC claims about their returns along with the declared financial assets on the public balance sheet there remains a $670 billion SGD or $499 billion USD discrepancy.  Using a slightly less conservative assumption on cash holdings produces a discrepancy, while still using the claims of the Singaporean government, of $848 billion SGD or $631 billion USD.

It must be strongly emphasized that these estimates are produced using official Singapore financial data and assuming that the claims of the Singapore government, Temasek, and GIC are true and accurate.  If the claims by the Singapore government and its related entities are to be believed, then enormous discrepancies exist what their declared assets are and what they should have.  It belies common sense that $822 billion SGD can be invested over 41 years and produce only $834 bilion SGD even after accounting for debt service and currency losses.

In the days and weeks ahead, I will be writing extensively on Singaporean public finances taking different parts of the data, entities, and key official involved to provide clear evidence of the discrepancy.  This will include a large amount of collected data which will be released for anyone to review.  This will include evidence of how key Singaporeans have benefited enormously from this flow of money, historical examples of financial impropriety, and raise serious questions about ongoing financial transfers.

Based upon all available evidence, while it may seem rhetorical flourish, all existing evidence indicates that Singapore is sitting on the largest unexplained discrepancies ever.

Some Follow Ups and Looking (Ignoring) at Reality

There’s a lot happening in the Chinese economy and financial markets and I am quite busy with the end of the school year, so today I am just going to follow up on a few previous posts which need updating.

I am a strong believer that the RMB becoming a major international currency and becoming a part of the IMF SDR basket is a good thing.  I am also a strong believer in reality.  The IMF and China are trying to suspend the laws of reality of what constitutes a freely tradable currency.  As I have argued, the RMB should not be part of the SDR basket and will never be a major global currency until it is freely tradable.  Spend a minute and ask yourself, how can a currency be a reserve currency if it isn’t freely tradable?  Despite the heady optimism, China and the PBOC have clearly stated their policy about the future role of the RMB and its lack of convertibility.  No less than the PBOC governor told the IMF via the Financial Times that:

“Yet the PBoC has also indicated that its vision of “convertibility” does not involve the kind of unrestricted capital flows that wreaked havoc on emerging markets during the 1998 Asian financial crisis and again during the global financial crisis in 2008. “The capital account convertibility China is seeking to achieve is not based on the traditional concept of being fully or freely convertible,” PBoC governor Zhou Xiaochuan told the IMF in April.”


The IMF for all the Ivy League Phds should return to Economics 101 about what constitutes a freely tradable currency and its importance for being a reserve currency.

Then we have the forced restructuring of local government debt in China mandated by the PBOC.  The PBOC and Beijing dictating credit terms and prices is what passes for a Chinese financial market.  Now that local governments are flooding the market with long term, low interest bond offerings this is causing big problems.  Apparently, banks are not being allowed to sell this debt to the PBOC as previously agreed.  Offerings last month outpaced all of 2014 and yields are spiking due to liquidity tightening resulting from the flood of offerings (demand for money).  There are two specific aspects that are puzzling here.  First, the local governments are doing exactly what they were being encouraged to do.  Is Beijing or the PBOC really surprised that after encouraging this, local governments are following through?  Second, the plan originally was for the PBOC to accept these bonds as collateral to encourage additional lending or monetizing the debt appears to not be happening.  Given the downward pressure on the money supply, even though this policy was merely a delaying tactic designed to prop up GDP growth, it was reasonable.  However, there is little evidence that this is happening placing enormous pressure on banks both on the liquidity side and on pricing.  If the PBOC and Beijing were hoping to jump start the economy, this is not the way to do it.

A puzzle of the Chinese economy is that as the stock market has boomed, there appears to be little pass through impact onto the broader real economy.  Though I have no data to specifically support this, I believe there is a much simpler explanation than the lack of pass through.  I believe that the pass through is unevenly distributed throughout the Chinese economy but heavy in places with high financial market exposure.  There is significant evidence of higher demand and a wealth effect in Beijing, Shanghai, and Guangzhou but weak demand in the rest of the country.  Many pundits were overjoyed at supposed signs of the real estate market firming.  However, a closer look revealed that first tier cities real estate prices grew at just over 2% YOY but all other cities were flat and falling.  A South China Morning Post article noted that real estate was bouncing back so strongly in Shenzhen sellers were trying get out of contracts.  Given the already higher incomes and higher wealth levels, we would expect to see more of a wealth effect in these cities.  That is why it cannot be stressed enough that equating first tier cities with the Chinese real estate market is like flying to New York City with a layover on the way back in San Francisco and declaring the US housing market healthy.  Beijing, Shanghai, and Shenzhen do not equal Chinese housing or financial markets.

Finally, what do you do when very little data supports the official line that the economy is strong? Release policy documents claiming that the strength of the economy isn’t being captured in the data.  The China Beige Book writes “Overall, firms continue to do better than official data-and its legions of sell-side users-might suggest.”  In other words, even though all our manipulation can’t make the data look good and even though lots and lots of businesses are saying otherwise, trust us the economy is really pretty good.  I mean its not like data helps our understanding of the economy.  That sounds like a Chinese bureaucratese if ever I heard it.

The Poor State of Chinese Monetary Policy

The quality of Chinese monetary policy has never been high but it seems determined to plumb new depths of mediocrity.  Throughout most of the past decade when the Chinese economy was growing rapidly thanks in large part to a significantly undervalued exchange rate and a rapid credit expansion, rather than act the adult and take away the punch bowl the PBOC instead pushed additional expansionary policies.  Though they prudently raised reserve requirements, the PBOC was the large expander of the money supply excluding countries with major inflation and they kept interest rates too low for too long.  The PBOC never made any serious attempt to exert its influence and tools of monetary policy to reduce excessively exuberant economic policies (doing my best central banker imitation there).

However, now the situation is reversed in a slowing economy and the PBOC is running an excessively contractionary monetary policy.  There are a number of ways that is this clear and reveals the policy mistakes of the PBOC.  First, real interest rates in for even the largest, most credit worthy firms are approximately 10%.  Producer deflation in China has been pushing about three years, currently stands at 4%, and has been trending downwards.  With even the most credit worthy firms paying at least 5-6% for debt, this implies an approximate real interest rate of 10%.  Especially in an economy with significant downward pressures, this is not just slightly high, this is extremely high.

Second, the tools the PBOC is using to loosen money conditions are poor tools to stimulate the economy.  The tool of choice so far has been reserve rate cuts which free up cash for banks to lend out for investment.  This may provide a short term and targeted boost to GDP but it does nothing to lower capital costs for firms.  Additionally, this is only exacerbating the problem driving deflation to begin with surplus capacity.  The PBOC is trying to boost the economy but pushing credit and investment but there is too much credit and investment to begin with, so additional stimulus here only makes things worse.  Furthermore, this is clearly designed to target specific GDP boosting projects not help the largest number of firms and the price they pay for capital.  In short, the PBOC is clearly choosing to target the wrong problem and therefore uses the wrong instrument.

Third, RMB internationalization implies a structurally higher demand for money in the rest of the world, something the PBOC appears not to have realized yet.  Releasing capital controls in China, which it must undertake if it hopes to join the SDR basket, is tricky business.  If Chinese demand for foreign assets perfectly matches the rest of the world demand to hold RMB, then the PBOC has no worries.  However, more likely is that the rest of the world is more interested in holding a lot more RMB than, even if we just consider central bank demand, expected Chinese demand.  Unless China wants to witness a significant appreciation accompany opening up of capital accounts, it needs to significantly loosen money.  While the focus has been on capital controls, which is perfectly reasonable, there is also the money supply and price issue to consider.  The PBOC seems to be blissfully unaware of the multidimensional world they are entering by internationalizing the RMB and how this is going to impact their money supply and interest rate decisions.

Official estimates are dropping and state media is talking about the coming economic rebound so there is clear recognition that economic activity is weak and well below public results.  Unfortunately, the PBOC is well behind the curve on addressing the economic weakness in China.  Private firms and SOE’s are pleading for lower debt costs.  What seems puzzling is that the PBOC recognizes the importance of lower interest costs, hence their forced restructuring of provincial government debt, but they have clearly chosen a different path to the larger economy.  There is no good explanation for the continued credit and investment push when that isn’t the problem that needs help and actually only worsens the existing issues.

Are We Witnessing a Giant Debt for Equity Swap?

A working theory by Chinese and foreign observers of the Chinese stock market run up has posited that listed companies are using this time to issue new equity buying out old debt and reducing leverage.  While this is an attractive theory, the data does not support the idea that this is taking place.

If we begin with broad market data on IPO and SEO offerings, we see that many firms are rushing to markets with IPOs.  In the past years, IPO’s have averaged about 25 per month in China but these have typically been relatively small IPOs with an average of 547 million RMB raised per IPO.  By Chinese standards, this is virtually irrelevant from a macro-financial perspective.

If we focus on SEO offerings, there has been an increase the number of firms with secondary offerings and an increase in the amount of total capital raised, but has been nothing like the flood being discussed.  For instance, the number of firms having SEO offerings appears structurally higher but only moderately higher, with lots of month to month fluctuations, and total capital raised reflecting similar patterns.  Total monthly capital raised in the first 5 months of this year averaged 69 billion rmb which a higher than the average 51 billion rmb raised during the same time frame in 2014, but not exactly what one would call a flood.  Furthermore, the average value of capital raised per firm declined from 1.65 billion rmb to 1.46 billion rmb.  While these are not completely insignificant sums of money, 69 billion rmb in equity raised monthly  in a capital market the size of China is virtually irrelevant and does not represent a flood of companies seeking to swap debt for equity.

If we break it down further to look at individual offerings and location, we see a similar pattern.  For instance, since the beginning of 2014, approximately 60% of new stock offerings have been offered by Shenzhen listed firms rather than Shanghai listed firms (180 to 115 to be precise).  Given the differences in types of firms, this results in significant differences in offering size.  The average secondary offering  size since the beginning of 2014 has been  364 million rmb in Shenzhen and 814 million rmb in Shanghai.  As noted in the previous post, given that most firms in Shenzhen are not what would be considered key firms and that most of them are many magnitudes smaller than their state owned competitors, this tells us that while smaller and private firms may be trying to raise new capital, there is scant evidence to support the idea that a macro-financial debt for equity swap is taking place.

There is one final points that makes the behavior of firms and regulators interesting in China.  While firms are typically motivated to obtain the highest price possible for the equity and investors typically see new share issuance as a negative sign, the complete opposite appears to happen in China, at least in the past 18 months.  For instance, the average stock price gain 5, 10, and 20 days after issuance on new stock was 117%, 184%, and 207%.  In one famous case, a post-IPO Shenzhen tech firm gained the maximum 10% every day after debuting for a number of months.  Three, six, and 12 month gains witnessed a flattening and then large declines based upon the original offer price with gains of 232%, 220%, and then 109% from original offer price respectively.  This implies that investors, initially caught up in the euphoria of a new stock offering bid it up rapidly until it peaks approximately 3-6 months after the original issuance, at which point reality sets in and a long term decline begins which still leave original investors better off than the original offer price but having lost a lot from the peak.  Given high average turnover rates however, it is unlikely that original investors remain invested in the stock.

Whereas firms and IBs in most developed markets are free to set equity offering prices pretty much at whatever they deem fair, Chinese regulators assume a much stronger role in initial price determination.  The average PE of newly issued stock is 22.6 with a standard deviation of 5.3.  In Shenzhen those numbers are 23.2 and 5.9 respectively while they are 21.7 and 4.1 in Shanghai.  On a broad market basis, regulators seem to be under pricing new share offerings in Shenzhen but overpricing them in Shanghai.  In fact of equity issued since the beginning of 2014, which is somewhat biased due to the recent stock increase, 6 months after issuance, Shanghai offerings are up 288% compared to 1,407% compared to Shenzhen.  There is no known clear reason why firms are essentially required to forgo lots of capital in order to under price their share offerings.  Furthermore, if the regulator was pushing firms to delever by swapping it for equity, this is a very expensive way to pursue this strategy by significantly under pricing the shares on offer.

It is incredibly tempting to try and read rational motives into the behavior of regulators, investors, and firms.  One theory on offer is that the stock market run up is allowing heavily indebted firms to delever by selling equity to buy out debt.  However, there is little evidence of this happening and definitely not in amounts necessary to reduce corporate debt levels or by the major companies in China.  While Chinese stocks may not be as overvalued as a whole as some believe, firms definitely are not using this time to delever by any significant degree.

Note:  Here is the data used in this analysis from WIND

Even I Can’t Avoid Writing About the Chinese Stock Market

If economic forecasts only exist to make astrologers seem respectable, the stock market forecasts only exist to make economic predictions seem respectable.  As Chinese stock markets have spent the past year or so on a rampage that would make any Party chiefs child proud, I have done my absolute best to avoid writing about it.  I only decided to write about it, with a few follow up posts, because I think there are numerous poor stories and interpretations about what is happening.  My focus here will be on providing data and detail that I don’t think is being recognized.

The first question is whether or not there is a bubble in the Chinese stock market.  Most people, and very understandably, argue there is clearly a bubble.  While I generally agree with this view point, the reality is much more nuanced than that.

One of the most enduring lessons I have ever learned about China is from the Yasheng Huang book Capitalism with Chinese Characteristics that probably more than anywhere else, details matter if you want to understand what is happening.  In our case, people who argue there is a bubble point to astronomical PE ratios while those who have bravely argued there isn’t a bubble point to while somewhat high much more reasonable PE ratios.

Here is the misunderstanding: the Chinese stock market is bifurcated.  In geek speak, we would say that there is a bimodal distribution with one part of the market doing one thing and the other part of the market doing something completely different.  Since 2010, the average Shanghai PE has been 15.4 while the Shenzhen board has clocked a significantly higher 30.7.  More recently, while Shenzhen has been on a tear with the average PE topping 60, the Shanghai market only in May topped 20.  In fact, it wasn’t even until March that the Shanghai board topped 18.

While I believe the 20 PE is overvalued for other reasons, I think you would have a difficult time making a solid argument that the Shanghai market is radically over valued in a bubble driven mania.  In fact, if you believe that official growth numbers, even with slowing growth, let’s assume 7% GDP growth, a PE of 20 probably is not entirely unreasonable speaking in generalities for major red chips. Conversely since 2010, the Shenzhen board has averaged a PE of 31 and broke that barrier in November last year.  Even as late as February it was trading at a PE of 39.  In the past few months however, this number has exploded and recently hit 61 with a median PE much higher.

When you look beneath the headlines at individual stocks, you see very similar patterns of firms and how the market is pricing them.  In Shanghai, such major red chips as Agricultural Bank, Bank of China, and ICBC have PE’s of 7-8.  The bulk of Chinese industry from banks, securities, car companies, steel, real estate, power, and airports all of which are very large and state favorites, all have very reasonable though in my estimation somewhat high valuation.  These valuations are even more reasonable if you believe the expected path of growth and earnings.  The firms with astronomical PE ratios, regardless of whether they are listed in Shanghai or Shenzhen, tilt much more heavily to different industries that I would strongly suspect, though I don’t specifically have data on this topic, to be private or near private firms.  Pharmaceuticals, hi-tech, new energy, and of course my favorite clothing firm Metersbonwe.

Though I have no specific data on this, given the space that many of the firms occupy in Chinese industry with low valuations, I would strongly suspect that the amount of GDP and corporate profits linked to firms with lower PE is a grossly disproportionate share relative to firms with above median PE.

All of this analysis matters for a couple of reasons.  First, the headline grabbing numbers of astronomical PE’s are probably distorting the picture a little of what is really happening.  Second, the headline number run ups are not from firms who are responsible for most of Chinese GDP.  Third, any fall in the stock market in the absence of related economic events, will probably have a more muted impact on the major firms and broader economic activity.  Fourth, given all the additional risk factors, not just basic PE analysis, investors are probably assuming a lot more risk than they believe investing in these types of firms with high valuations.  Fifth, there is probably more muted financial and economic risk from a stock market decline, but significant political risk if investors feel cheated.

I believe major Chinese firms are currently overvalued but more due to earnings quality and future economic risks.  If you believe future growth prospects and earnings quality, there is a strong case to make that the major firms are not overvalued or not enormously overvalued.  There seems to be a much stronger case that smaller and private firms are significantly overvalued though I believe any decline would have a more muted impact on the Chinese economy in the absence of other events.

Here is some PE data on markets and individual firms and I will be presenting some other data refuting other misconceptions about high share prices later this week.

A Few Quick Follow Ups: Bonds and Electricity

Just wanted to post a few quick follow ups to some previous posts to put out information about the decline in Chinese provincial bond prices and electricity production.  If you wanted evidence of just how quickly Jiangsu bond prices dropped, here is a screen shot of the past two weeks (Sorry problems at the moment inserting pictures into the post).  That is the provincial bond version of being a Chinese thin film solar manufacturer.

Then apparently, I’m not the only one picking up on the weakness in overall Chinese economic data.  Mizuho Securities in Hong Kong makes the unfortunate mistake (if they ever want Chinese business again) of writing:

In1Q15, housing starts growth was -18.4%; the volume of railway freight growth was -9.4%; electricity production grew by only 1.0%; fiscal revenue was 2.4%; and SOE profits growth was -8%. We believe China’s GDP could in fact be lower than the official number, consistent with what the Li Keqiang (LKQ) index suggests. We note that other research houses have made similar estimates. For example, Capital Economics pegged the quarter at 4.9%, the Conference Board’s China Center put it at 4% and Lombard Street Research said it was 3.8%.

Sorry to hear Mizuho is now banned from Chinese IPO work, I guess that is the risk of such tepid honesty when writing that “China’s GDP could in fact be lower than the official number.”


The Great Chinese Debt Restructure: The Saga Continues

The past couple of weeks Chinese financial markets have been driven by the stock market boom, bust, and then boom coupled with the massive government debt restructure/bailout.    Why the two are correlated seems to only speak to the rationale of what investors believes drives the Chinese stock market.  The deal went roughly like this: banks would be forced to trade high interest short term government debt in the form of bank loans for long term low interest bonds that would then hand over to the PBOC as collateral they would then lend back out to favored industries.  The unilateral debt restructuring (provincial bailout) is a bad deal for the banks but it could have been worse.  The PBOC accepting the provincial bonds as collateral, with likely no recourse back to the banks if the debtor defaulted, took a lot of the sting out of the deal.

It just got worse for the banks.  Reuters is reporting that trading in the bonds is thin due to lack of demand and prices are dropping rapidly to entice those willing to shoulder the risk of an excessively indebted Chinese provincial government with no legal ability to enforce a claim as even debt contracts will be unilaterally rewritten.  This is bad news for the banks.

This is quite surprising and has numerous interesting implications if this continues.  If this is true, this is imposing significant capital losses on Chinese banks already struggling with rising (even very generously defined) non-performing loan rates.  While Chinese banks and regulators adhere strictly to the international “mark it at whatever we feel like today even if they haven’t paid us for a year” accounting standard rather than GAP or IAS, even by their own standards bonds available for trade should be marked to market.  Banks may not be trading the newly issued bonds due simply to the fact that this would require them to recognize significant losses that are at the moment not explicit but would become explicit if the bonds are traded or available for trading.  Furthermore, given their funding costs, this essentially gives the banks a near zero margin on government debt straining their resources when they can least manage it.

Another possibility is that there is some short term delay in using the loans as collateral with the PBOC as promised.  Given what was announced about the overall debt restructure and the time lag, it is distinctly possible that final details of the PBOC collateralization have yet to be finalized and debt essentially moved onto the PBOC balance sheet.  Due to the lack of trading and drop in price, it seems likely that banks will hold on to the debt for sometime or wait for the PBOC to open the promised lending facilities required to redeem the provincial bonds.

There is one more worrying and counterintuitive possibility here.  It is possible that after the banks swapped the short term high interest debt for the long term low interest debt, with the promise of redemption at the PBOC, the PBOC has decided to opt out and not accept the bonds as collateral.  I assumed based upon the PBOC accepting the new provincial bonds as collateral that banks would receive the bonds turn right around and give them to the PBOC.  Given the fact that this appears to not be happening raises the very real specter that the PBOC is getting cold feet.

If the PBOC is not having the printing presses running late to monetize the dubious debt on offer, this itself raises a couple of issues.  First, given the history of enormous money creation by the PBOC, this seems like an odd time to turn the printers off.  Both textbook economics and the shrinking money supply in China from a variety of factors like capital outflows indicate this would be a time to pump money into the system which the PBOC is appearing increasingly reluctant to advocate.  Second, the PBOC as prudent bankers seeing what the bankers see may be just as reluctant to act as a bad debt repository.  The PBOC may execute their political orders like good soldiers, but they are also smart economics and finance guys who see the risks they are being told to incur.  It is quite possible they are dragging their feet or refusing to uphold their side of the bargain in accepting this bad debt as collateral.  Third, if the PBOC is dragging their feet or backing out of the deal to accept provincial debt as collateral, this sets a bad precedent for all the debt that Chinese banks are going to be asked to swap.  If the bankers were in near open revolt over the forced debt restructure when they at least could hand it off to the PBOC, think of what will happen when they realize they are getting suckered.  While everyone knows (or should know) that Chinese banks are little more than public slush funds even if they are listed, this simply confirms it.

I am going to hold a verdict in reserve until more information comes out about what the PBOC is going to do.  Neither the thin trading or drop in prices should come as a major surprise as everyone knew the banks were not receiving a yield commensurate with the risk.  However, this was all predicated on the PBOC promise.  Your move PBOC.