The Great Bomb Transfer and Contagion

Through all the talk about the Chinese stock market struggles, a widely held point of faith for analysts is that this will have little to no impact on the real economy or consumers.  The widely cited statistics about the small number of households that own stock is used to support this idea.  Taken in strict isolation, I actually agree that a fall in the stock market will have minimal impact on the real economy.  However, the Chinese stock market absolutely does not exist in a vacuum.

Let me give you a couple of ways the stock market fall is already threatening the broader real economy. First, despite reports that margin financing is declining, the real effect is just a shifting and reclassification to different debt and asset holders.  The large majority of the nearly $800b in stock market support is provided not by high expectations and confidence but by loaned capital and heavily tilted to bank lending.  This will have an enormous impact on the banks capital adequacy ratios as this counts heavily for reserve capital and it merely reallocates the lending from official brokerage/IB margin lending to bank based non-margin lending.  The future losses are transferred from the sellers to the brokers and the CSF.  Whether these are households or firms, the expected losses, accompanying debt and equity, have merely been shifted to brokers and CSF.  From what I am told, the loans to the brokers are no interest no obligation loans meaning  losses are suffered by the public purse rather than the brokers.  Given that China is already projecting a central government budget shortfall of 2.3%, or $250b USD, any significant losses would enormously increase the official projected deficit.  In short, losses and debt aren’t being erased, they are merely being reassigned.  The debt bomb is not being defused.

Second, there is significant evidence that companies are depending on stock profits to maintain profitability or protect against debt calls. Approximately 150 companies shares remain frozen with evidence that they engaged in stock linked debt near the height of the market and would be in technical default or be required to post additional collateral if their stock was trading.  This would require additional selling, potentially concern, or closer examination of their debt obligations.  Easier to just freeze their shares as Beijing tries to come up for a plan.  Nor is this limited to just firms but extends to asset management.  As David Cui notes, brokers have trusts have little capacity to absorb losses before their capital is exhausted.  There are already reports of certain metals investment platforms and products with $6.4 billion frozen seizing up and potentially spreading to banks.  There is incredibly strong evidence that Beijing is attempting to prevent a full scale debt crisis.

Third, though of less direct evidence to Beijing, there is enormous and rapidly accumulating evidence that when China sneezes, other countries catch MERS.  Emerging market currencies are falling rapidly, commodity prices collapsing, increasing the real debt load for a large number of countries heavily exposed to Chinese trade.  Already for instance, there is heightened worries about Australian iron ore miners debt loads and Asian currencies like the ringgit and rupiah are at pre-crisis lows.  Crisis as in 1998 Asian financial crisis not 2008 Global Financial Crisis.  One of the major sub-stories here is that the Chinese RMB has appreciated rapidly against emerging market currencies making it significantly more expensive.  Especially with the rapid outflows some type of engineered weakening or greater flexibility would be welcome, but given SDR aspirations and fear of losing control of the currency, Beijing seems unwilling to choose rational economics over trophy political gains with little substance.

Many analysts have fallen for the tired expression that it must be political.  It can neither be proven true or false but it sounds good for a quote.  While we cannot prove the theory that Beijing is working to prevent a crisis, there is strong and rapidly growing evidence that Beijing is not spending $1.6 trillion USD for political credibility but to ward of much more jarring financial and economic pain.  At the moment, the economic contagion theory is at least as true the theory of political credibility and evidence is mounting much faster and stronger as to its veracity.


Quick Hits on Monday’s Drop

  1. This absolutely did not happen without at least implicit official sanctioning. Government has threatened traders, banned key stakeholders, and endowed CSF with virtually unlimited money to buy the market.  Even the major red chips were limit or near limit down.  This absolutely did not happen without official (in)action.  Maybe CSF regulators were just asleep during the afternoon trading session, who knows right now, but this absolutely did not happen in a vacuum.
  2. I would expect the market to stabilize Tuesday maybe even bounce a little. I would be very surprised to see another drop.  Beijing is fighting enough of an uphill battle with the stock market.  If they let it pick up some momentum, they just might get buried underneath it.  Look for significant resources to enter the market Tuesday.
  3. The market told you what it thinks of the market…..and it isn’t good. Unless Beijing is prepared to dedicate enormous amounts of money or bailout out all stockholders, it is only standing in the way of the correction.
  4. Beijing trying to buoy the stock market is not about political credibility, it is about financial viability. The sheer number of firms still suspended, most of them because they would be in technical default or be required to post new collateral, should tell you something. That would trigger additional selling, defaults, and other nasty stuff.  Further drops are going to push capital to leave the country as foreign capital isn’t even entering anymore.  This has the very real possibility to metastasize into a grade A economic and financial problem.  This is not political.
  5. Beijing always things that they have stopped a problem but are always a few steps behind. Due to the trapped capital, 10% trading limits, suspended trading in firms, and short selling bans, just to name a few, traders have taken to shorting other assets or shifting their capital.  According to one report, nearly $250b left China in the second quarter when the stock market was booming for most of that time.  Imagine how fast capital will flee if the stock market is not booming. Then it appears that China bears are turning to almost anything linked to China they can short, such as copper and yes, that includes Chinese traders.  Beijing: killing one market only creates other markets.  People and firms will find ways to make money and move their capital.  Even you cannot control a modern financial market by fiat.
  6. Chinese economic weakness is showing signs of spilling over into other emerging markets. Malaysian and Indonesian currencies are back to their 1998 crisis levels and imports from a range of other countries, especially lesser developed commodity exporters, is falling fast lowering growth and increasing credit strains.  Though unlikely to impact Japan, Europe, and North America, the Chinese story will have an enormous impact on emerging markets specifically in Africa and Asia.
  7. Ever ask why those remaining firms with suspended trading are still suspended? Though speculation on my part, I’d bet that these firms would be in default or be required to post additional collateral for loans they took to either play the market or used their own stock as collateral. The fact that so many remain suspended narrows the focus to non-general market concerns but why are those specific companies not trading.  Given what we know about their indulgence in stock pledging, it is worth considering these firms are staying suspended for a reason.  If there are serious problems with this many companies, this means enormous problems not just for the market but all of China.
  8. Quote of the day from China: “On Monday, Zhu Baoliang, director of economic forecast department of the State Information Centre, a government research agency, told Reuters the stock market crash was having a deep impact on the real economy and that it was essential for the authorities to cut interest rates and loosen monetary policy further.” First, apparently Mr. Zhu has not talked to his PR and own statistics bureau. China is achieving 7% GDP growth and anyone who says otherwise is mocked and ridiculed by the Global Times and the China Daily. Second, apparently Mr. Zhu needs a basic introduction in macro-economics. Lowering interest rates is going to place enormous stress on the RMB/$ peg and further pushing capital to leave the country. Third, in breaking news, apparently Mr. Zhu has been re-assigned to a county statistics bureau in Inner Mongolia.
  9. Apparently, the Chinese public has a better grasp of economic theory than its leaders. Chatter has been questioning 10% daily limits and whether this prolongs panics and volatility. Empirical academic works has consistently found that limiting price discovering increases volatility.

Why Dodgy GDP Matters

The release of perfect GDP data in China prompted a big enough collective eye roll that Beijing mouth pieces took to the editorial pages to respond to accusations of dubious data.  Most observers outside the National Bureau of Statistics China and the Global Times accept that headline GDP data is questionable (to be extremely polite) but wonder what the implications are.

FT Alphaville puts forward two questions specifically why does the Chinese  government put out the dodgy statistics and do they have better data than we do? They answer these questions well but I would go further asking the fundamental question: why does dodgy GDP data matter?  There are many reasons we should be concerned about the quality of data.

First, it directly impacts our estimates of debt to GDP ratio.  Let’s take a simple example and assume that over the years GDP has been overestimated by 10%.  Now let’s assume that total non-financial debt is three times GDP, not far off in reality.  If GDP is really 90% of official GDP, this increases the debt to GDP ratio from 300% to 333%.  Given the already high estimates of the amount of Chinese GDP needed to service outstanding debt, this would increase GDP dedicated to debt service even higher.

Second, if the headline data is questionable, you can bet that official underlying data and significant amounts of corporate data is just as questionable.  For instance, the big four state owned banks are overseen by the China Investment Corporation which is owned by the Ministry of Finance.  Both the Ministry of Finance and the National Bureau of Statistics China report to the State Council.  In other words, the banks and the NBSC have the same boss.  It seems unlikely that the NBSC is some rogue organization within the larger whole.  The banks just like the NBSC know the expected numbers and will do what is necessary to submit the required numbers.

In fact, strong evidence that Chinese banks are submitting similar dodgy data.  While NPL ratios are cited as prime example of solid financials they are in fact a worthless measure for China.  A NPL in China means something completely different than the rest of the world and they even tell you so.  For instance, a one bank classifies a loan as “doubtful” if “the operations of the borrower have been suspended for at least half a year.”  Let me emphasize that loan is not even considered non-performing only doubtful.  The loan classification standards of Chinese banks are surpassed in their novelty only by Inner Mongolian definition of terrorist videos. Another bank listed a ten-year old bad debt that while not technically on its balance sheet, through a complicated swap arrangement, would be repaid for the bad debt after going public.  The loan write offs that have increased recently are only approved by regulators not by the bank implying regulatory coordination over managing the dodgy corporate data.

This behavior is not limited to the banks but true of all companies.  Just last month a governmental auditor released a long list of companies and financial fraud from inflating revenue and profit to make performance appear better than reality to companies that reduced official revenue and profit in order to siphon off funds.  Large amount of firm data is just as dodgy as official economic data.

There is even evidence that the NBSC is increasing its manipulation of underlying numbers.  As in any battle of the wits to the death, a distinct possibility in China, the middling bureaucrat knows knows the Li Keqiang Index and clearly cannot manipulate just GDP anymore.  They know that he knows that so clearly they have manipulate electrical data as well.  Want evidence?  In its second quarter GDP announcement, in the Chinese version of the economic accounts (which will probably be up for another 5 minutes after the blog is posted) the NBSC declares that energy usage per unit of GDP dropped 6%!  To put the magnitude of that change into perspective, if that trend were to continue, in about 12 years China would go from one of the least energy efficient countries in the world per unit of GDP to competing with the Danes and the Germans for the most energy efficient countries per unit of GDP. A 6% drop in energy usage per unit of GDP for a country of 1.3 billion simply does not happen in one year.  Data manipulation is in no way limited to headline GDP.

Inside China, it is taken for granted that the statistics are worthless and has been for many years.  I was first alerted to questionable data not by academic research, a troublesome foreigner, or journalist but by my students.  They were in disbelief that a professor would actually believe official Chinese data as everyone already knows the data is manipulated.

The reason I frequently emphasize looking at what China is telling you simple: if you can’t believe the data, actions act as a type of revealed preference.  For instance, Beijing may publically announce that everything is fine economically, but 10 trillion RMB of market support says other wise. Beijing may declare that the data is perfectly acceptable, but they tell others in private they have to construct their own indexes.  Banks even go so far as to note that official statistics are unreliable in IPO filings.  If you don’t believe me, just look at their actions and their words.

The reason all of this matters is simple: data matters to steer firms and countries away from problems.  Look at any country that suffered a financial or economic crisis and one of the fundamental problems will be inaccurate data.  Greece fudged its numbers to get into the EU and the 2008 global financial crisis was precipitated by bankers and home owners fudging data.  Look at firms that fudge data from Bernie Madoff investments to Enron and quickly the quality of financial data matters.  It is important to note that not all countries or firms that beautify their data stumble into a crisis, but most firms or countries that have a crisis have real data problems.

Finally, the data matters because its directly assists in the pricing of assets.  Whether it is asset quality of banks or the expected revenue, data manipulation allows countries and firms to hide poor asset quality.  Another common thread in financial crises is that that quality of assets is quickly determined to be significantly lower quality than believed by rosy data.  Look at the ongoing battle over Noble Group which is effectively an argument over whether the data is accurate and supports the asset price.  Serious questions have been raised about data quality and the pass through effect on asset price.  Data and asset quality questions linger at least as important in the debate over the Chinese economy.

There are serious questions throughout China at the macroeconomic level and the firm level on the quality of data and underlying asset quality.  What amazes me is that more hedge funds have not started dissecting Chinese non-Mainland listed firms for data issues looking for short opportunities.  As a variety of asset prices continue to face downward pressure from Chinese economic activity from commodities to non-tier one real estate markets, attention should be paid to the underlying data in those markets.  There are strong indicators that a wide variety of data throughout China is manipulated and that asset prices are subsequently over valued.



Be Careful What You Wish For

The Chinese government has imposed its will on the Shanghai and Shenzhen stock “markets” as both have stabilized since their precipitous late June and early Jul falls.  This stops the bleeding and neutralizes the fear that the market is going to get beaten down like a Chinese lawyer.  However, this presents a whole new set of challenges for Beijing and further restricts its policy options.

FT Alphaville describes the problem using dense, highly complex, and technical analysis from The Simpsons to describe the problem.

Skinner: The Lizards are a godsend.

Lisa: But isn’t that a bit short sighted? What happens when we’re overrun by lizards?

Skinner: No problem. We simply unleash wave after wave of Chinese needle snakes. They’ll wipe out the lizards.

Lisa: But aren’t snakes even worse?

Skinner: Yes, but we are prepared for that. We’ve lined up a fabulous type of gorilla that thrives on snake meat.

Lisa: But then we’re stuck with gorillas!

Skinner: No, that’s the beautiful part. When wintertime rolls around, the gorillas simply freeze to death.

Beijing is enacting a Simpsonian financial policy to contain the stock market fall.  While public purchases stabilize the prices, it creates a potentially even bigger set of problems later and I won’t even address the most obvious moral hazard.

First, given the near complete policy against selling stocks for brokers, insiders, key stakeholders, asset managers, and others which comprise a large portion of recent buying, how can these firms sell without pushing the market down?  This policy is essentially locking up a large amount of stock market and financial liquidity which does push the price higher, but also creates the problem of what happens when firms want or need to sell.  Market volatility in China and the relatively low level of free float implies that large institutional sellers exert enormous downward price pressure.  While the price problem has been stopped in the short term, it has created the problem of unraveling this buying spree by an institution that moved the market.

Second, given the rapid rise in associated debt with the stock market, especially with firms who became dependent on the stock market for profit growth, what happens to this debt given the near criminal prohibition on selling? Given the near perfect correlation between margin debt and the stock market, the debt can only be reduced by selling stock to pay of the debt.  However, selling puts downward pressure on the price.  Additionally, the interest rates on margin loans are relatively high by some accounts approximately 20% for retail investors though likely significantly lower for large companies and SOE’s.  Unless Beijing opts to simply freeze debt and roll it over indefinitely, to avoid having to sell stock pushing the market down which it has done to some degree, that debt is going to remain in a state of suspended animation.

Third, given the policy freeze on sell side liquidity and the encouragement to tie up bank and financial liquidity it stock based lending, how can liquidity be increased without prompting a decline in multiple asset classes?  The entire China economic growth story is built on selective liquidity restrictions to achieve political objectives.  Banks are built upon restricting lending to small and medium size enterprise for the benefit of large SOE’s. A large percentage of the stock market is essentially frozen for fear of collateral calls on debt and jail terms.  Encouraging banks to pump liquidity into the stock market via various loan mechanisms to buy stocks they cannot sell, already an incredibly risky gambit, saps liquidity from the provincial bond market bailout which is supposed to increased to an eye catching 3.6t rmb.  As all current liquidity is coming from the government and government mandates, loosening liquidity requirements run the very real risk of challenging many markets.

Fourth, as the public buying is an attempt to restore market confidence and bring investors back, what happens if hoped for non-public euphoric buying fails to materialize?  Capital is flowing out of China at an unprecedented rate and foreign investors want nothing to do with the Beijing sponsored casino.  This will require enormous public capital to even sustain the market lacking large inflows of private capital much less push it to pre-fall highs. It is questionable whether even Beijing has the willingness to act as the buyer of last resort at specified prices in the stock market.  While Beijing has arrested the decline in the stock market, there is little evidence Beijing has thought through how to extricate itself from this morass.

The China Securities Finance Corp with the eye catching 3 trillion RMB purchasing facility will likely stabilize the market but then what?  There is no evidence that firms or individuals unrelated to the Chinese government are piling back into the market to drive up prices.  All upwards pricing pressure on stocks is coming from public or quasi-public funds.  Even recently, CSF and related entities had to announce they had no exit plan for fear of prompting a market collapse.

There is currently no stock market right in China, there is government mandated price level in stocks.  While that may stabilize the price level in stocks, as the only real market participant Beijing got its wish but now needs to figure out how to extricate itself from a mess of its own making, and keep the market buoyant.  Any hint of public selling will incur enormous losses for Beijing and the state owned banks that bailed out the market.  Beijing needs to sell off its purchases but right now it’s the only player in the market forcing it to negotiate with itself.

Beijing stabilized the market.  Now it has to deal with the unwanted lizards, snakes, and gorillas.



Considering the Veracity of Chinese GDP

After China released above consensus GDP numbers showing 7% growth, many asked questions about the accuracy of Chinese GDP growth data.  Articles were written by The Economist and Financial Times, by both publications and journalists I respect, essentially arriving at the conclusion that the numbers are good faith estimates, aren’t perfect, can be considered generally accurate, and have the trend right.  I understand this line of thinking but I think this view point fails to grasp the depth of data manipulation that is being thrust upon the world in the world.  There are so many problems with Chinese GDP data that range from the methodological to the manipulative, I will only be able to cover a few aspects today (and this ended up being much longer than I expected for which I apologize).

I will begin with my own research on the matter.  In August 2013, I released a paper that studied Chinese inflation data and its impact on real GDP specifically focusing on housing CPI. Before turning to the results let me note a two key points.  First, this study did nothing more than build a time series of the underlying National Bureau of Statistics China data.  There is no fancy mathematics.  Second, housing CPI is different than the asset price of a home.  Though there are some rather minor and technical disagreements about how best to estimate housing CPI, as will be seen shortly, the discrepancy within the NBSC data is vastly in excess of anything that might be considered a technical disagreement or rounding error.

According to the NBSC, from 2000 to 2011 private housing CPI rose by 8%.  Let me emphasize very strongly that is not 8% annually but 8% total in twelve years.  In a period when official real GDP growth was averaging around 10% annually, official housing price inflation was a mere 8% total.  To provide some perspective, research covering a similar time period found total real estate asset price inflation of 200-300%.  One recent paper by the same team found “real house price growth has been high, averaging 10% per annum since 2004.”  It defies any reasonable explanation that home prices increased by such enormous amounts while the inflation attributed amount was so small.

Beyond the obvious data manipulation, there were a few interesting and less detectable ways that inflation was masked.  First, even though China was in 2000 and only recently transitioned to a majority urban country, the NBSC gave the data an 80/20 urban/rural weighting.  For instance, total period rural housing CPI was 20% while urban was only 6% in 2011 with the weighted level at 8%.  Over the 2000-2011 time period to arrive at the national average, all years are assigned essentially an 80/20 urban/rural weighting, plus or minus a couple percentage points, to arrive at the national average.  Now we know, and no one disputes, that China only recently became a majority urban country with 2000 having a 64% rural population.  This manipulated weighting overweighted the already low urban housing CPI.

Second, according to the NBSC, only 12% of Chinese households are renters. When including all categories of private housing as defined by the NBSC, and excluding the undefined “Other” category, a total of 85.4% of Chinese households are counted as private housing occupants. This has a very big implication: even though the consumer price of renting increased a total of 53% from 2000 to 2011, this price applied to less than 15% of Chinese households according to the NBSC. The remaining 85% of households are counted as only seeing an 8% increase in their price of housing. This then invites another problem.  Given the explosion in apartment buying, asset price would be much more closely linked to the inflation price.  However, again, this seems not to be a problem for the NBSC.


Third, the NBSC significantly under weights the cost of housing in the total consumer price inflation basket. According to one report, from 2000 through 2010, the NBSC gave only a 13% weighting to housing in the CPI basket.   To put this weighting in perspective, it gave a higher weighting to “education and cultural articles” and only a slightly lower weighting to “clothing”.  Most countries and even Chinese data indicate much higher levels of income dedicated to housing than 13% of 17%.  In 2011, the NBSC reweighted the housing portion to a 17.2% percent weighting to housing despite the fact that it grew significantly slower than all other components of the CPI. In other words, even though housing fell significantly relative to other items in the NBSC basket between 2000 and 2010, it was magically reweighted upward in 2011. The NBSC is implicitly saying its own statistics are unreliable.

Fourth, even if we compare Chinese macro data to other countries we are left with odd inconsistencies. For instance, China experienced some of the highest levels of money growth excluding high inflation states; while numerous countries had comparable or higher nominal GDP, China reports inflation levels over the 2000 to 2011 time period less than the United States and among the lowest of even all developed countries.  All of the Chinese real GDP story is dependent on low inflation data.

This matters for a very simple reason: it understates CPI and overstates real GDP.  Using very straight forward assumptions like using the rental price inflation and other straight forward procedures, this would increase annual inflation during this period by approximately 1%.  This subsequently has the impact of reducing 2012 Chinese GDP by approximately $1 trillion.  To anyone who has spent anytime in China in recent history the question is simple: do you believe the price of renting an apartment has risen in urban areas by less than 10% since 2000?

It cannot be emphasized enough that this is not a rounding error or an accident.  An 80/20 urban rural population weighting happens from an organizational decision to manipulate the data to obtain preferred numbers.  The key point is that in addition to straight forward data manipulation, there are multiple examples of more difficult to detect methodological manipulation that skew the results.

However, it would be a mistake to think this type of behavior has disappeared.  Just this past February a major statistical change was made to GDP numbers that was only uncovered by researchers at McKinsey after numerous people, myself included, expressed surprise at the rapid increase in Q4 2014 consumption.  The NBSC went so far as to note that consumption data in 2014 was not comparable to previous years and this change was found only after inquiries were made by people questioning the data.  Without the methodological change to consumption, 2014 GDP would probably have been about 1% lower. Without going into detail here, even the change itself seems incredibly dubious to produce the magnitude of change claimed.  In other words, there are continued examples of statistical manipulation at the NBSC.

Throughout the years, China has been a serial GDP reviser with a non-exhaustive list of changes in 2004, 2008, and 2014 though it is quite possible there are others that are either public or non-public with all revisions making significant upward changes.  Furthermore, the NBSC has admitted that it has not standardized the data so almost any year to year comparison over more than a couple years is worthless.  In fact, even when back to back years are non-comparable due to methodological changes, there is no mention of this anywhere on the NBSC website.

There is also indirect evidence that Chinese data is less than accurate.  Let me give you two examples.  First, Chinese economic data has virtually no variance.  Look at almost any headline number of economic activity from GDP to unemployment or others and you will see essentially a straight line.  Every economy naturally has fluctuations and statistical noise.  Chinese data when compared to almost the entire world, has the lowest measures of economic volatility whether measured yearly or quarterly.  Especially for a fast growing economy, this makes no sense.

Second, China is probably the fastest country in the world to release quarterly and annual GDP.  How many people can even say they have paid their electrical bill for the month of June but China has released national economic statistics for a country of 1.3 billion people as has been the practice for many years.  A mere 15 days after the quarter, China has such efficient statisticians that they have collected a sampling of data and crunched the numbers?  Makes you wonder why companies can’t release quarterly numbers in a few hours.

The problem with deconstructing NBSC data is that it takes lots of work to sort through their math and even now they provide largely only top line data of categories.  One of the only large scale economic industrial census known was leaked (circumstances unclear) of firms in 2007 which became a gold mine for economists starved for data studying the Chinese economy.  However, other than the NBSC essentially saying “trust us”, analysts have little way to verify official data.  By comparison, many other economies such as Japan, the United States, and Europe have significant numbers of large observation datasets with significant granularity which although they may not be the data used by statistical agencies, allow economists to conduct research and replicate official data.

Consequently, many firms have taken to estimating Chinese GDP using some variation of the Li Keqiang Index, the primary drawback to this method is that you are ultimately relying on government data in some manner.  Even when I note that the electricity consumption growth was 1.1% YOY for Jan-May 2015, I am relying on a self-admitted state organization. The challenge becomes how do you estimate change in the Chinese economy for 1.3 billion people.

When studying the Chinese economy, it isn’t enough to say we believe GDP or other data is wrong as we need to have comparable data that allows us to say with confidence what a better figure is.  Actually, in the fall, I plan to begin a major research project to better estimate Chinese GDP and inflation.  However, for the moment if we attempt to break free from relying on government data, common sense should tell us that Chinese GDP growth is much weaker than advertised. Let me give you some examples.

Let’s accept for a moment, the China Electricity Council number of 1.1% YOY growth in electricity consumption. This number seems to diverge widely from YOY GDP growth of 7%.  Put another way, producing 7% more as a country and consuming only 1% more electricity would require a monumental shift in production techniques or industrial restructuring for a country of 1.3 billion people in one year.  Imports of fuels like coal used for electricity production have collapsed furthering the story that significant problems exist.

Luckily, there is completely independent data that indicates the Chinese economy is much weaker than official data.  For instance, look at trade partners where exports to China have absolutely collapsed across a range of products from consumer to industrial inputs and commodities.  Official trade data with imports declining 15.5%, which given import over invoicing implies a larger drop probably closer to 20%, is not indicative of robust economy growing at 7%.  Not only are prices collapsing due to lack of demand from China but volumes are dropping.  Countries that grow at 7% do not reduce imports by 20%.

Then look at a wealth of corporate data whether domestic Chinese companies or foreign MNC’s.  Almost universally, they are reporting flat to declining revenue and profits in China.  In fact, corporate profits in China rose 0.6% and 96% of that growth came from investing in the stock market.  In other words, absent the stock market boom, Chinese firms saw no profit growth.

Then consider the official industrial production growth of nearly 12% for Q2 2015.  During the second quarter, the HSBC PMI showed constant contraction but somehow official data not only grew but grew well above estimates.  Now the data is not directly comparable but to have such stark differences does invite questions.

Finally, I am always puzzled when I hear people talk about the “weak” Chinese economy when they turn around and talk about 7% growth.  The official growth estimate for 2015 has declined from only 7.1% to 7.0% but somehow this 0.1% has sent commodity prices plummeting, close trading partners like Singapore into recession, cause electricity consumption to flatten, and cars sales to evaporate.  There seems to be an inability to reconcile facts and logic surrounding the Chinese growth story with official GDP numbers.

There is no doubt that the Chinese economy has grown rapidly in recent history.  However, there are enormous discrepancies both within NBSC data and then when comparing it to outside data.  These discrepancies come from both poor quality statistical management but also unquestionably data manipulation.  In other words, the trend is generally accurate but in some cases is also off by such a magnitude as to be considered manipulated.

Li Keqiang made his now famous remarks about GDP growth in the context that the data he received as a provincial leader was unreliable so he focused on measures that were more difficult to manipulate.  The risk here is that Chinese leaders and other interested parties are receiving manipulated data.  While I believe Chinese leadership does have access to better data, I also believe they face enormous gaps in the quality of data they are receiving in order to make informed decisions about the economy.  Only last month, an initiative was announced to improve labor market data as the official unemployment rate has been nearly unchanged for more than a decade.  If Chinese leaders are telling the world how poor the statistical agencies in China are, imagine the reality.

Brief Note on Chinese Trade Data and GDP Accounting

After yesterdays release of Chinese trade data, I think it is important to note the structural discrepancy that exists within Chinese international trade data.  The mathematical impact on GDP is clear but the real impact is less clear.

In China, foreign exchange transactions for international trade in goods and services purposes are largely free.  Foreign exchange transactions for capital movement purposes are tightly controlled and largely prohibited.  However, smart businesses knowing this simply disguise capital movement as goods transactions.  I have written about one form of this known as the copper carry trade.

Import and export over or under invoicing is another means of disguising flow in the restricted sector to look like flow in the unrestricted sector to move capital between countries.  A sample transaction turns a $5m export into $10m to move $5m in capital into China. First, the exporting company issues a $10m invoice, declares $10 export to customs, and ship goods to importing company in another country. Second, the importing company declare $5 of import to customs, pays $5 for the good which is the real value of the goods trade. Third, the capital inflow of $5m will be remitted together with the payment for goods received of $5m, and be accepted by the Chinese company as $10m.  In many cases, the receiving company wants to invest in the company it is buying product from or there is an agreement where to move the money after it is received or there is a third company providing the capital for remission.  Fourth, the exporting company convert the $10 into RMB with invoice of $10 as supporting documents with a bank onshore.  This entire process can work in reverse known as import over invoicing to move capital out of China.

The easiest way to know this is happening is to compare official Chinese import and export data to the import and export data of its trade partners.  In other words, if China declares $10m in exports to Australia but Australia only reports $5m in imports from China, we consider that a significant discrepancy.  Differences are to be expected in trade data but they are typically and should be quite small.

In fact if we look at the discrepancies between Chinese reported exports to its five top trading partners in the past three years and their reported amounts of imports from China, the numbers in relative terms are quite small.  From 2012-2014 the total export over invoicing discrepancy between China and its top five trade partners was approximately $40billion USD.  While that may sound like a lot, give the enormous amount of trade with the top five partners over three years, this is little more than a rounding error averaging about $13b a year.  However, import over invoicing, which moves capital out of China, has grown rapidly in the past few years.  From 2012 to 2014, the import over invoiced discrepancy amounted to $525 billion rising every year from a low of $148 billion in 2012.  Import over invoicing for the top five trade partners of China represents approximately 30% of the value of imports.  That is what we call a structural difference.

Now mathematically, the impact on GDP growth is unambiguous.  If real imports are lower, this raises net exports and therefore by definition GDP.  However, I believe the reality is more complex and here is why.  Let’s assume a firm imports $1m of goods and sends $1m to the counterparty in another country.  In this case, there is $1m worth of goods entering the country and $1m in currency leaving the country.  Now let’s assume a firm imports $500k of goods and sends $1m out of the country, potentially to multiple accounts.  Financially, there is no difference between scenario one and two as $1m has left the country in both scenarios.  Economically, the country is actually worse off because the receiving firm has few inputs to make products or few goods to sell in a store.  In other words, the same amount of money leaves the country and the country has fewer goods to sell after receiving the imports.  I’m sure there is some model that would allow us to estimate the impact on GDP but I suspect it would not be the strict increase described in undergraduate economics.

More importantly for our understanding of China, this is proving an enormous channel of capital outflow from China.  Despite the PBOC being well acquainted with it, there has been little effort to stop it.  Given the rising surge of capital out of China and the high interest rates in China needed to sustain capital inflows, this cross current of events puts China in a difficult position.  It needs to lower interest rates but this risks increasing the capital outflow and lowering international investor interest in China.  This is the real importance of international trade data in China.

Cognitive Dissonance Over $933 Billion USD

Analyzing the Chinese economy for many people involves trying to carve out intellectual space that allows them to refute all other deeply held beliefs about how economic exchange and basic mathematics functions.  An astounding number of people, ignore all market data falling back on tired clichés that in some manner pay homage to the Great and Powerful Beijing’s ability to skillfully manipulate a profoundly complex economy of 1.3 billion people.

GoldmanSachs in predicting the coming bull market as the Chinese stock market was collapsing wrote that “China’s government has a lot of tools to support the market.”  Gavekal largely joins GS writing that “it will be clear that the present weakness in the market was actually a buying opportunity. The main reason is that in China, market sentiment is driven as much by government policy as by liquidity – and there are powerful reasons why Beijing wants to see a bull market.”  There is essentially no other reason given to buy than we think Beijing is omnipotent.  Call this the Communist stock market version of “this time is different.”

The Gavekal separation from factual economy analysis continues when writing that “Beijing is pursuing transformative economic reforms, which promise a greater role for market forces and less direct management of the economy by organs of the state.”  Even before the recent suspension of any semblance of a market, I would respectfully ask: what reforms? The entire continued focus of economic policy is to increase fixed asset investment and channel subsidized credit to politically favored firms while restricting private markets.  The only potential tangible reform, the Hong Kong-Shanghai connect was designed to increase capital flows into the stock market which could, as history has shown us, can be trapped.  Economic analysis of the Chinese economy has widely fallen prey to a type of Party conditioned Pavlovian response that ignores data and the basic of economics.

While many read official NBSC press releases about top line economic data and lament that GDP growth slowed from 7.1% to 7.0%, a statistical measurement error in an economy of 1.3 billion people, all underlying data and official reaction indicate much more profound reason for worry.  To provide some perspective, I have calculated the value of economic  or financial market support measures announced by Beijing in approximately the last 6-8 weeks.

According to my calculations (taken from sources here, here, and here) China has announced market support in the past two months totaling approximately $692 billion USD.  Now as with any announced stimulus or government support financial aid, and specifically in China, there are some important notes.  First, this is only based on press releases and news articles of official numbers.  It is assumed that these measures specifically are targeted, short term, and will be completed but also recognizes it does not count unofficial or unannounced flows such as lending from state owned banks.  Second, this is not necessarily new money.  For instance, the mandated provincial debt bailout takes the form of a forced debt restructuring rather than new money.  Third, this does not cover soft capital less quantifiable announcements such as reductions in the reserve rate and official interest rates designed to increase lending, liquidity, and cut capital costs. However, if we include just additional cash stimulus from cuts to the reserve ratio and their estimated impact, this would increase total market support by 1.5 trillion RMB.  This would bring the total market support announcements in recent history to a staggering $933 billion USD.

Leaving disagreements about data quality, Beijing’s omnipotence, or market movement aside, all of this data invites a fundamental question and challenge.  If this relative data was provided blind (removing the country name) to any economist with the question does this represent the characteristics of an economy slowing from 7.1% to 7.0%, would they answer yes or no?  There is not one economist or analyst that could say with any shred of intellectual honesty that this is characteristic of a healthy economy reducing expected GDP growth by 0.1%.   Forced government debt restructuring, stock market support to prevent firms from defaulting on debts, near trillion dollar stimulus packages, and central bank asset purchases to prop up prices are not the characteristics of a growing economy.

To put these measures in perspective, the official stimulus package in 2008, absent bank leverage, was only 4 trillion RMB.  The measures outlined above total approximately 5.8 trillion RMB.  In other words, official support measures are now almost 50% higher than during the 2008 global financial crisis.  The TARP program in the United States in 2008 only purchased $426 billion USD of assets.  While these headline number omit key details and should not be used as a straight comparison, it is instructive in informing us about the underlying economic problems that so many refuse to acknowledge the seriousness with which Beijing is approaching the downturn.

I may be old fashioned and out of step but I believe that facts and economic fundamentals ultimately matter.  This time is not different and even Beijing cannot continue to ignore that laws of economics forever.  Focus on the actual data and not the press releases to see what the data says.  It isn’t a pretty picture.

What are the Real Risks of the Falling Chinese Stock Market?

The world has become increasingly focused on the rapid fall of the Chinese stock market.  However, this interest risks losing sight of the much more important big picture issues involved in economic and financial management.  As I have written before, a 30% drop in the stock market even in about two weeks, after a 150% run up is like declaring a financial crisis after winning the lottery and the government tries to collect the taxes.  The flurry of activity from Beijing suggests that they are enormously worried about the political fallout from any drop in stock prices.

Holding all other things constant, I see minimal impact on the broader Chinese economy, companies, or consumers from a 30% decline in the stock market.  However, nothing happens with all other things constant and there are reasons to consider that this drop may be merging with some of the other problems in the Chinese economy.  Even Beijing doesn’t typically give this much consideration to just political risk from small time investors.

Beijing is dealing with enormously indebted economy with debt continuing to grow at more than twice nominal GDP.  Not even two months ago, China via the MOF and PBOC mandated a large forced restructuring of provincial debt (for background read about it here and here).  At the time I asked, if we changed the name from Chinese provinces to Greece, would lawyers be arguing to enforce credit default swaps with Chinese characteristics (yes, they do exist).  Even officially, debt is a very real problem in China.

The Chinese economy is absolutely not growing at 7%. Electricity growth is even according to official number at 0.2% YOY; imports by volume are collapsing; commodity consumption and demand is falling or flat; corporate profit growth is essentially flat or even falling with companies relying on the stock market for profit growth; inventories in goods like cars are rising rapidly; real estate outside of the tier one cities is falling in price with large backlog of homes; real official GDP only hit 7% due to about 2% worth of deflation; producer prices are falling by almost 5% annually. Nothing here points to a robust economy growing at 7%.

So how does a fall in the stock market matter to the real economy and risks to China going forward? First, in the 2008 financial crisis cross market correlations became extremely high and there is the very real risk of similar occurrences in China.  Falls in the equity markets were predated by falling real estate, commodity, RMB, and credit pricing.  There is every reason to believe that multiple markets face high levels of downward pressure in China and significant falls across other assets besides equity would likely have an enormous impact.  There is evidence this process is already beginning though one that Beijing is working hard to avoid.  If equity market falls gather momentum and join with other markets, this could really create economic and financial turmoil in China.

Second, as the BIS noted via the FT recently, in emerging markets “credit booms and real exchange rate appreciation…have historically coincided with a shift of resources from the tradable to the non-tradable sectors of the economy.”  This is most certainly true in China and contributing to the increased correlations in assets discussed.  With 16-20% of GDP accounted for in real estate in recent history and rapid growth in the financial sector from booming credit to arbitraging international interest rate differentials, a large portion of Chinese GDP is unrelated to the tradable economy.  This means that any drop in asset prices, like real estate and stocks, is going to have a significant real impact.

Third, as the economy has slowed well beneath 7% with producer prices falling by almost 5% resulting in real interest rates for the best Chinese corporate of approximately 10%, China finds itself in a very difficult position with regards to interest rate and debt management.  It desperately needs to lower interest rates but failing to attract continued capital inflows risks prompting domestic investors to flee China in even greater numbers and international investors to never come at all.  In short, lowering interest rates to help lower costs for heavily indebted companies with falling prices risks turning a rapidly slowing economy into a currency crisis.

Fourth, whether the 2008 global financial crisis or the Asian financial crisis which shaped a generation of Chinese policy, asset and data quality is not what it seems.  China is facing the same problem.  China maintains official growth is 7% but enormous amounts of secondary data fails to support this and NBSC inflation data claiming urban housing residents in China enjoyed total housing CPI of only 6% from 2000 to 2011 reveal systematic data deficiencies.  Even the state auditor in China has released reports about trying to find out how much debt Chinese provinces actually have and the enormous discrepancies between revenue and profitability of state owned companies.  These hidden risks are high because we generally accept data but are surprised when what we believed is revealed as false.  In short, we don’t really know, and I don’t believe Chinese policy makers have vastly superior data to outsiders, what is happening in the Chinese economy.

The drop in equity markets, most obviously, risks joining the credit market fallout from the provincial government bond program.  To briefly recap, over indebted provincial governments in China received a reprieve when the MOF and PBOC mandated banks turn 6-8% 2-4 year loans into 5-10 year 3.5% interest loans and continue lending whether borrowers were making payments or were expected to be able to repay.  Reports now indicate minimal investor interest in these provincial bonds paying only slightly more than Chinese sovereign debt. These bonds aren’t being sold due to lack of investor interest due to pricing and the inability to repay debts even with significantly extended durations.  Bailing out indebted provinces will cost approximately 2 trillion in bond issuance to investors sapping capital from the same firms expected to provide liquidity for stock purchases  This solution, however poor in quality, allows Beijing to lower interest rates without driving investors out of China.

However, the stock market blood letting also risks joining forces with other credit problems.  The PBOC and CSRC have declared repeatedly that they intend to provide liquidity to the market throughout the downturn in stocks.  However, there is significant evidence that liquidity is strained and interest rates are being kept high to attract capital.  With a large percentage of debt short term and significant evidence of large rollovers, the already strained definition of questionable and non-performing loans in China is raising doubts about ongoing repayment.  Officially, Chinese banks are well capitalized, liquid, with low loan demand which raises the question why the PBOC would focus so consistently on increasing liquidity if banks and insurers have such large amounts of liquid and investable capital.  Provincial debt problems are merely on example of liquidity strains on banks that may be rippling throughout the institutions that would typically be buyers.

I remain relatively sanguine about the direct effects from a drop in stock prices on the Chinese economy holding all other things constant.  However, what concerns me now is not the fall itself but the impact this might have on these other markets.  Given the amount of hidden leverage, data quality, reliance on non-operational income for firms, and downward pressure on real estate to name just a few issues, raises the issue that this could spur other movement in the Chinese economy causing additional problems.  A drop in the stock market even in a weak economy is interesting to watch but won’t cause the gut wrenching gyrations and flurry of policy announcements we have witnessed.  When combined with other problems that stock drop becomes major economic issues.

Grab Bag Thoughts for the Day on China

  1. As I noted earlier, the Chinese stock market has been and continues to be extremely bifurcated. During the run up, I wrote that while a large number of stocks were definitely well into bubble territory, a large number of stocks and more importantly those responsible for a larger share of GDP output were potentially even undervalued.  While the Shanghai index was down relatively minimally at 2.4%, that actually masks enormous differentials.  Out of the entire Shanghai index, only 20 stocks enjoyed a positive day yesterday.  Almost 900 were losers and 656 were down more than 9.5% with the 10% limit.  This means that the stocks that matter in the entire index are a very small number of major SOE’s.
  2. The state continues to dominate the economy. Virtually every company that matters in China is state owned and most that don’t matter have state ownership somewhere in a cross holding.  Despite the widely trumped narrative of the free Chinese economy, the market is saying otherwise.
  3. Reporters and investors who read Party press releases about reform and then report on that as fact need to stop. Economic and political policy has been to consolidate control.
  4. The widely reported fact that nearly one-third of Chinese stocks have stopped trading has enormous implications. While most people are focusing on the stop trading part, they are overlooking the fact that a large amount of losses have yet to be recognized.  In other words, there is still a lot more blood to be spilled.
  5. Margin debt reductions have not kept pace with stock market and more specifically the stocks they were probably invested in. That means there is probably a lot more pain to be inflicted.
  6. Deleveraging? What deleveraging?
  7. I don’t see evidence that the flurry of activity to prop up the stock market is driven by more systemic economic or financial risks, yet. However, the more resources the Chinese government throws into propping up the stock market and cracking down on reporting on the topic, it further prompts questions about what is really happening behind the scenes.  Right now, I believe it is purely political.  The longer this goes on, the more concern should focus on other known or hidden risks.
  8. Other market news presents increasingly concerning data. Car inventories are rising rapidly throughout China. Basic materials like copper and rebar are collapsing in price even after large short positions by Chinese short sellers are closed. Coal shipments are being turned back and collapsing in volume.  Electricity consumption is essentially flat YOY.  This is no longer just real estate development inputs but a growing list of products and industries with bad data.  This economy is absolutely not growing at 7%.  Given the debt levels of the economy, this is a real concern.
  9. Interest rates and currencies are the end game here. Beijing has to keep interest rates high to support the banks and attract capital to maintain the RMB/$ fix even if that means real interest rates for the most preferred borrowers of 10%.  This is strangling an economy that is heavily indebted.  However, lowering interest rates is going to place enormous pressure on the RMB/$ peg.  While foreign appetite for Chinese assets may not be big right now, interest by Chinese in moving assets abroad is.  That would really place pressure on Chinese banks and financial markets.  Though neither is an immediate concern, they are something to keep an eye on the longer this continues.

Musings on China Market Mania

Given the absolute flurry of activity, I won’t even try and recap all the announcements and plans or breakdown the economics of them.  I am just going to try and provide some perspective on the Chinese economy and financial markets.

  1. Unless the equity market fall is somehow converging into the black hole of debt China built up into an exploding supernova, I see little evidence of knock on financial risk. While the major Chinese indexes have fallen by about 30% in two weeks, they are all still up by 141% and 51% since June last year and the beginning of year respectively.  This is the equivalent of winning the lottery and then declaring a financial crisis because the government wants its 30% in taxes.  Taken in isolation and looking at the known and related data, I see little evidence that the falling stock market presents a financial risk worthy of the attention being paid it.
  2. In the absence of more conspiratorial theories as to the importance of the stock market fall, the most obvious risk is political. Many investors bought into the booking stock market because key Party mouthpieces kept talking it up.  Though it is foolish for most anyone to stake their credibility to stock price movement, it is even more so for governments to do so and Beijing is facing a massive loss of confidence in their ability to move financial tides.  Given the weak housing market throughout China excluding tier one cities, Chinese households are nervous about financial matters and looking to Beijing for answers. (Note: excluding tier one cities like Shenzhen, Shanghai, and Beijing which likely benefited from a wealth effect, the total housing market remains extremely weak).  Beijing’s credibility has become attached to the stock markets and failure to at least arrest the collapsing stock prices will create a lot of angry investors who bought on the buy recommendation of Party appartchiks.
  3. The event that really set the tone for current economic and financial policy was about a month ago when the government, MOF, and the PBOC mandated a forced bailout of over indebted provincial governments after banks balked at buying underpriced long duration bonds. There are two specific reasons this is really defining moment in recent Chinese economic policy.  First, despite all the fantastical and widely believed press releases about pricing risk and allowing defaults, the Chinese government clearly demonstrated the absolute lengths they would go to in preventing any problems.  The bankers pushing back on buying enormously underpriced official debt were given their marching orders.  There is no market in China and the quasi-market is one directional.  Second, it implicitly revealed the rickety nature of official and government linked Chinese finances.  If the banks who know the state of LGFV and provincial finances are refusing to buy public bonds, that should tell you everything you need to know.  While there is no current indication that these two events have morphed into a Predator meets Aliens super-demon, the absolute flurry of meetings over the weekend does raise the possibility that Beijing is trying to patch problems much more profound than the stock market fall.  However, until I see some hard evidence of this, I am going to believe they are worried about political risk of protesting pensioners.
  4. I have long been a critic of Chinese data. What concerns me about the current situation is that much of the hidden leverage or data discrepancies within the system could be coming out.  Chinese banks have low NPL’s due to the extraordinarily liberal definition of NPL. Stock swaps that are essentially leverage and audited accounts that even the government auditor says contains discrepancies in the billions of dollars eventually cause significant problems.  The problem with this type of data is that while you may suspect it, as is obviously the case here, as an outsider you never know what is going to turn a data discrepancy into a major issue.   With firms pledging their own stock as collateral and banks accepting most any asset for repo transactions, I think the risk from unknown financial risks is quite high.
  5. Government intervention into financial markets, whether into propping up stocks or currencies, has a pretty dismal record. I am very skeptical the Chinese stock market will enjoy anything other than a dead cat bounce.  The two key issues in any successful market intervention are size and credibility.  On this count the reports about Chinese efforts are weak on both fronts.  The reports currently are expected to have a 120 billion RMB ($20b USD) fund for stock market stabilization.  This size, in the absence of additional capital, will do little more than provide a speed bump on the way down.  While there are reports of significantly larger infusions, given the enormity of the capital market, discussions so far seem to underestimate the enormity of what Beijing is up against. Beijing’s credibility to stabilize the market, much less begin a rebound, is currently weak with many buyers seeing it as a good time to exit the market leaving Beijing to absorb the gambling losses.  However, if Beijing did nothing more than absorb the losses and slow the market decline, that probably counts as a win in their book.  Credibility is also important in that people have to believe the government will continue to engage and backup their policy.  If people start selling to stop their losses or take their winnings off the table and Beijing doesn’t keep buying  lending the policy credibility, this will destroy any hope of this market intervention succeeding.  That will require however enormous market intervention.  Given the nature of interventions that quickly revert to trend prior to intervention, I am deeply skeptical given the size and credibility concerns that this time will be different.
  6. The Chinese government has a profound misunderstanding of how markets work. During the global financial crisis, they executed a stimulus package equal to roughly 10% of GDP.  Now they are putting forward a stock market stabilization fund that other than the press release is only slightly more than a rounding error on any given day in the Chinese stock market.  This does however reveal their bias.
  7. Despite all the comparisons between market intervention by the US in the global financial crisis and China events, there are some enormously important similarities but also differences. First, all on the fly policy decisions are political in both countries.  Second, fiscal stimulus was small in the US and large in China; market stabilization was large in the US and small in China.  Third, in the US, the government bailed out the market; in China, the market is bailing out the government.  Please note, especially investors in Chinese banks and brokerage houses: your money is being used to bail out excessively indebted governments and investors so Beijing can maintain credibility.
  8. I am betting that at best, the Beijing mandated fund will prompt a dead cat bounce or help the stock market tread water for a while before resuming its downward trend. Unless the psychological multiplier is enormous, after which Beijing’s credibility will be even more invested in stock prices, the stabilization fund seems merely to act as a buyer of last resort for people wanting to exit their positions.  This means imposing enormous costs on public or quasi-public institutions.  I doubt even Beijing can reinvigorate Chinese appetite for stocks.