A Short Defense of Markets, Investors, and Algorithms

Recent market turmoil has brought the bombastic rhetoric and hand wringing from all corners about the state of modern financial markets.  Whether it is the “volatility” or algorithmic trading that is either killing the market or taking it to ever further extremes, depending on your bias, there is something for everyone.  However, the recent gyrations have if anything proven just the opposite of how robust markets are, the lack of investor herding, and benefits of algorithmic trading.

Despite the hand wringing over market volatility, non-Chinese markets have been by a variety of measures almost boring.  For instance, if we look at the S&P 500, FTSE, Nikkei, Hang Seng, and Shanghai indexes, of the 100 largest absolute daily movement in 2015, 75 of them come from either the Shanghai or Hang Seng with 60 coming from Shanghai.  As the Chinese market has convulsed in near violent gyrations not to mention emerging market currency and commodity declines, all but25 individual trading sessions in major markets outside China have stayed between +-2%.

These results are borne out by more widely viewed statistics.  Various measures of volatility indicate that not only are Chinese markets 3-10 times more volatile than other major markets but that these other markets are near boring.  For instance, the absolute median daily volatility for the S&P 500, FTSE, and Nikkei is between 0.6-0.8%.  Even after last weeks “volatility” the high-low differential for the entire year is only 14% on the S&P 500 implying rather tight trading range for the year.  Considering the yearly average since 2010 has been 24%, there is little reason to think markets are somehow broken or contagion is running rampant.

Even by historical standards volatility does not appear to be outside normal ranges.  Of the top 25 most volatile day to day swings of major markets outside Shanghai since the beginning of 2010, three of the S&P 500 happened in 2015, three for the FTSE, two for the Nikkei, and five for the Hang Seng.  Only in Shanghai where 17 of the 25 most volatile trading days happened in 2015 has there been a notable uptick in volatility.  In other words, most markets seem to be going about their business in a business as usual manner.

Nor do investors appear to be herding.  In 1997 and in 2008, one of the aspects that caught many people by surprise is how closely correlated all markets and outflows became.  Now, at least so far, investors appear to be differentiating between countries, businesses, and a variety of other factors.  There is little evidence of herding.  Certain emerging markets and even developed market economies like Australia and Canada are facing pressure, but investor decisions appear to distinguish rather than herding against broad classes of countries.  Even looking at specific companies, investors appear to be distinguishing by business model, major assets, and revenue sources.  Some companies have been pushed down due to their exposure to China whether it is commodity focused companies or even Apple.  However, there is little evidence of mass herding.

Finally, given their importance in the market whether it is stocks or currencies, there is evidence that algorithmic trading has played a significant role in stabilizing the markets.  After falling relatively sharply beginning on August 21 for a number of days, major markets outside of China began sharp recoveries that have returned them largely to the point they were on August 21.  While we cannot say with certainty that algorithms are responsible, the rapid rebound from a fear induced sell off would seem to seem to match with how many of those types of programs especially when many of the economic fundamentals of the major markets presented here are better than China.

One final note, markets outside of China have robust day trading, short selling, and algorithmic trading firms.  China does not.  China has volatility measured any number of ways ranging from 3-10 times higher than other major markets this year.  While this is not to say it would disappear or converge to the range of other markets if they allowed these trading strategies, China certainly isn’t making a strong case that arresting short sellers, prohibiting intra-day trading, imposing price limits, and algorithmic is lowering volatility in China.

It seems a little perspective on trading volatility, investor rationality, and algorithmic trading is needed in these times of albeit above average stress.

Note: The data cited is here

Friday Thoughts on Crazy Nonsense

  1. Caixin and George Chen of the South Morning Post are both reporting that the China Security Finance Corporation is borrowing another 1.4 trillion RMB to prop up the stock market. Now considering they already had access to 3 trillion RMB, it would only make sense that they are requesting additional borrowing because they need more money.  If you are keeping score at home sports fans, that would bring us up to 4.4 trillion RMB in support.
  2. I have a piece coming out on FT Alphaville about output in the Chinese economy today which will basically detail why it is probably Chinese growth is near zero. The one thing that I will jump the gun on here is the divergence between official retail sales data and output in consumer products from clothes to electronics.  Garment, footwear, leather, textile, passenger traffic, and consumer electronics output in China are all flat to falling significantly.  Especially in a deflationary price environment, as we are for these categories, how is retail sales growing 10%+ annually?  What are retailers selling if consumer product output is down?  This to me seems a glaring inconsistency because it certainly isn’t coming from a flood of imports.
  3. As I have said repeatedly, watch liquidity. The PBOC is shoveling liquidity into the market as fast as possible indicating bank liquidity is in extremely short supply. I haven’t even kept up with the near daily injections 100b RMB.  Watch this, major issue.
  4. I have increasingly become convinced that there is a policy divide in Beijing. The PBOC appears resistant to propping up the stock market but is willing to accept injecting liquidity and defending the RMB.  It is interesting to note that most capital to prop up the stock market coming from commercial banks.  This is exposing the banks to enormous risk as this is essentially a type of margin loan but probably without the asset security.  Beijing appears very divided over how much to defend the stock market and even how much to defend the RMB.  Though not large, the RMB fix has been weaker everyday this week.
  5. Pay close attention to the 500+ stocks in China that are still frozen. Earlier it was reported virtually all these firms borrowed money with pledged stock near the peak of the market in May and June.  If these reports are true, it is likely that given the length of time these stocks have remained frozen, that these firms would be in technical bankruptcy.  That would be a major blow and cause all kinds of panic so clearly something will be worked out to soften the blow here.  These 500 firms might be the epicenter.
  6. Catch me on the BBC World Business Report today at 12:30 Hong Kong time talking about the

recent market turmoil in China.

Is the PBOC helping traders short the RMB?

This morning it was announced that the Hong Kong Monetary Authority, Hong Kong’s cental bank, had injected RMB liquidity into Hong Kong’s banking system to stem the increase in RMB deposit rates.  This may seem pretty innocuous news as it only amounted to about $1.6 billion USD, a pretty paltry amount in today money markets.  However, this is very important news given the context.

  1. Over the past few weeks, there has been a widening divergence between the onshore RMB and offshore RMB trading rates. The RMB was trading at a significantly lower rate in Hong Kong and other offshore centers than in onshore markets.
  2. This meant traders in offshore markets were shorting the RMB expecting further declines.
  3. Shorting interest had become so large that banks didn’t have enough RMB to feed the demand to short.
  4. To attract additional RMB deposits, bank do what banks do, and started raising RMB deposit rates rising as high as 20%

Now here is where it really get’s interesting.

  1. The HKMA injecting RMB liquidity into the Hong Kong banking market is having the perverse impact of helping traders short the RMB in the offshore market putting more pressure on the PBOC to intervene.

Now here is where it gets really, REALLY interesting.

  1. There is a high degree of probability the HKMA got its RMB liquidity from the PBOC itself via a standing swap agreement.

Now put this in perspective, the PBOC might be injecting RMB liquidity that helps traders short the RMB in the offshore market!  Though we can’t say for sure this is exactly what is happening the evidence seems to support this.  There are two final points here.

  1. Is it possible the PBOC wants to push the RMB lower and knowingly injected the liquidity for short traders or that they wanted to stop gray market capital outflows?
  2. The PBOC and China are caught in a classic policy tangle. There are no good options so every action is prompting more significant negative outcomes.

Have a happy Cr(Ash) Wednesday HT Patrick McGee.

China contagion and the rate cut

Too many things going on today and too many questions, so again just another grab bag of quick hits on events covering contagion and the just announced rate cut. As global markets enjoyed some ups and down, with some down and then up, some just down, and some just neutral, the new question du jour is how much risk China poses to potential contagion on other markets and thoughts on the rate cute.

  1. Financially speaking, China is relatively isolated from the rest of the world. There is relatively little debt or equity investments in China from the rest of the world and vice versa.  With that said, a relatively small amount with regards to China can still be an absolute large number.  For instance, non-RMB debt in mainland China still amounts to $1-1.5 trillion USD.  Taken however against the backdrop of the larger Chinese capital markets and where that $1-1.5 trillion is coming from, it is a relatively small though not insignificant amount.  Even in equity markets, foreigners hold relatively small amounts of Chinese equity.  In short, there is little risk of financial contagion.
  2. With regards to international trade exposure, the picture is decidedly more complex and lumpy. Many people have taken to looking at exports to China as a way to look at potential contagion risk metric, but this is somewhat misleading. Let me give you two extreme examples. Australia and South Korea/Japan both have high trade exposure to China as a percentage of their total exports.  If we stop there, we are left with the impression that Australia and South Korea/Japan share similar trade exposure risks to China.  However, this is a deceptive matrix for two specific reasons.  First, Australia exports mostly products that are not re-exported from China like iron ore.  South Korea and Japan both export high amounts of electronic and other components used in assembly manufacturing that are then re-exported from China to the rest of the world.  The demand for Australian exports to China is much more dependent solely on China, while demand for South Korean exports to China is much more dependent on global demand.  Second, commodity prices face much greater pressures than component manufacturing.  In other words, countries like Australia are going to see their volume and price of exports decline more than non-commodity countries.  The international trade contagion effect needs to be considered in more detail to know the industrial make up of products rather than simplistic designations.
  3. Interestingly, many markets are returning to relative rationality. Commodity markets are going to remain weak but most of the stock and debt markets that saw some pressure seemed to have realized that China won’t spill over to most of them. Japan, Korea, and most of Europe are all economies that really will have minimal fall out.  Commodity exporters like Australia and Canada are going to have a much harder time as well as many emerging markets.  China is interesting here in the fact that its impact will not felt in a neat developed versus emerging market breakout.  What is interesting is that many markets outside of China maintaining a pretty reasonable degree of rationality though watching events here with a close eye.
  4. The PBOC this afternoon announced it was cutting interest rates, reserve rates, and liberalizing deposit rates longer than 1 year. This is two steps forward and one step back with Chinese characteristics.  From a purely economic stand point, this is spot on as I have covered numerous time.  With producer prices deflating around 6% per year and on a four year losing streak, real interest rates are topping 10% in China.  Lower interest rates are desperately needed.  The problem however is simple. Lower interest rates are going to place even more pressure on the RMB/$ peg.  The PBOC is already spending enormous sums of money to prop up the RMB, lowering interest rates is going to place that much more downward pressure.  The reserve rate is more complicated.  Despite regular assurances to the contrary, all indications are that Chinese banks are experiencing serious liquidity problems.  The PBOC has been pumping in large sums of money almost daily via reverse repos and MLF lending so that the RRR cut seems almost expected.  The problem again relates to the RMB/$ peg.  While RRR cut is designed to give banks more liquidity, there has been a significant correlation between RRR cuts and capital outflows.  I am absolutely not saying it is causative, but given the lack of good investment choices within China, declining interest rates, enormous over capacity, economic worries and a collapsing stock market, it is very likely much of this additional liquidity will make its way out of China.  That again places downward pressure on the RMB.  Freeing deposit rates is a bit more complicated but I think we can see what the PBOC is doing here.  In an attempt to keep RMB from leaving the country, they are allowing banks, not just shadow banks, to offer higher deposit rates but only on deposits longer than one year, essentially locking up the money.  They are trying to entice people to lock their money up.  Be interesting to see how deposit balances on these accounts.  Wouldn’t surprise me to see growth here as people don’t consider the risk.  That may stem some of the outward capital flow pressures.  The thing to watch here is this: how high do these interest rates go? With RMB offshore rates in Hong Kong jumping to 16% due to traders looking to short the RMB, it is possible we could see a rapid and large jump in RMB deposit rates for a variety of reasons.  Though shorting the RMB is not allowed in China, I’m sure 16% deposit rates in Hong Kong will provide a small amount of competition.  However, just because banks offer the best rate doesn’t mean they are the best bank.  Banks needing funds the most might pay the most for them but also might be the riskiest.  Watch the deposit rates.

Pre-Market Thoughts for Tuesday

  1. Watch the RMB fix at 9:15. Though I would still bet at a relatively unchanged fix, say +-0.2%, I don’t think you can rule out a larger move.  Two things to note about all this. First, with the stock bailout, I never got the sense that the PBOC’s heart was in it.  Most funding moved through other entities and even most capital came from commercial banks. The agency with $3.7 trillion in reserves was essentially standing on the sidelines.  I suspect that the PBOC is pushing a less state led funding model and would not mind letting the RMB move (read decline) more.  The stock market prop up has already lost probably at least 400b RMB and the RMB prop up has probably cost at least $50 billion, both of which have achieved very little.  Second, there are very real risks to both releasing the RMB and intervening.  If the PBOC announces a lower fix and is too loose, I don’t think given the fear in the market you could see significant downward movement.  The offshore and onshore rates are diverging significantly and China is spending enormous capital to keep the offshore rate from moving too far.  Conversely, by trying to maintain an unrealistic value of the RMB it is having to spend lots of money to accomplish nothing.  In short, if the PBOC is too loose the RMB could become the next rout but if the PBOC is too rigid in defending the RMB, they will likely spend lots of money to accomplish nothing similar to the stock bailout.
  2. Watch the first hour of the stock market. While Beijing has typically used its firepower late in the day, today I would look for any early signals public buying.  Beijing can’t wait until the end of the day to start buying otherwise it will likely be well under 3,000.  If Beijing is giving up, look for them to tell you early in the day.
  3. My real concern is all the associated debt. Focus for sometime was on rapid rise in margin lending. However, as a pointed out previously, when margin lending began to decline, that didn’t mean leverage related to stock purchases vanished only that it go reassigned to other forms of debt.  The CSF, the primary purchasing agent here, received most capital from commercial banks and has proceeded to lose probably upwards of 400b RMB. There is no word on who will bear the losses, but given the decline and amount of bank lending associated with stock purchases, stock related leverage is probably higher now than ever before.
  4. Given the debt concerns and stock price falls, any firms that are still suspended are probably technically or near technical insolvency. My understanding is that there are nearly 200 firms with suspended trading at the moment, given the length of time and debt obligations that had on pledged stock near the peak, it is likely those firms are technically bankrupt or near that point.  This is going to present a major problem in any effort to stabilize the Chinese stock market.
  5. Thanks to the Financial Times Alphaville group and David Keohane for posting my piece on the importance of credibility in financial regulation focusing on China. This is an enormous problem in that people simply don’t believe Chinese economic leadership. The market, both Chinese and foreign, is giving no credibility to anything the PBOC or others are saying or doing.
  6. Apparently, Chinese stock futures are down significantly pointing to a lower market open. If there is another push downwards, it is quite reasonable to think of 2,500 or less by later this year.

Grab Bag of Thoughts for Thursday

  1. Chinese liquidity is tight and bank quality under increasing question. The PBOC injected approximately 230 billion RMB yesterday via reverse repo and MLF.  Interestingly, the PBOC refused to name refused to name the 14 financial institutions that received the MLF funds.  This comes only days after a group of Chinese shadow banks in Hebei near Beijing threatened financial immolation on billions of RMB worth of wealth management products.
  2. Interestingly this situation stems from a bankrupt credit guarantee firm. Despite the belief that China does not have credit default swaps, they utilize a system that could be called “credit default swaps with Chinese characteristics.”  Most non-major SOE’s as part of the loan package then purchase credit insurance from a credit insurance firms who guarantee the loans who typically charge 1-2% depending on the industry and firm characteristics.  There are a few reasons this matters.  First, the credit guarantee firms are the first to absorb losses, so if credit guarantee firms are going bankrupt, this means enormous stress is currently plaguing the Chinese economy with more to come.  Second, though I have no systematic data to support this, from my own anecdotal experience and conversations with risk and credit guarantee people, I strongly suspect the risk is being significantly underpriced.  Third, Chinese banks are not even absorbing all the credit risk so when their NPL (though worthless) are rising so quickly, this is beyond a canary in the coal mine warning.  Third, the official interest rates significantly understate the interest costs paid by corporate borrowers.  Major SOE’s will pay the official or near the official rate.  However, others will typically pay 1-3% higher and then pay an additional 1-2% for credit guarantees.  Bank loans to LGFV’s were paying 7-9% so if we add on 1-2% for credit guarantees, that means a large number of firms are 8-10% nominal interest rates when producer prices are declining by almost 6%.  That brings the real interest rate up to 14-16%.
  3. The PBOC is in full currency allocation mode. In the FX market, it is selling dollars and buying RMB to manage the FX rate.  Then after buying the RMB, it is putting back out into the market via revrepos and MLFs.  Think of the financial plate spinning with Chinese central banking characteristics.  The key issue here is this: the FX rate transaction is being used to grease liquidity wheels domestically.  I have warned previously that the reason the FX rate and RMB liberalization matters is the potential for RMB outflow which would drain the banking and shadow banking system, the primary financing industry in China, of liquidity causing enormous stress.  To avoid this problem, the PBOC is snapping up RMB via USD sales and then pushing those RMB back into the banking system.
  4. Speaking of the PBOC and the RMB/$ peg, we are back to standard operating procedure. After three days of devalued RMB price setting by the PBOC, we have returned to the days when the daily price setting was as eventful as watching wall paper peel.  Not only the that, the PBOC is intervening enough that intraday volatility is essentially non-existent.  In recent days movement of about 0.2% and then returned to the exact or near exact previous setting rate.  So much for the market having a bigger influence in RMB price setting.  As Patrick McGee of the FT put it, the real test of RMB marketization will come when the RMB moves against the will of China.  Guess we have the answer.
  5. The “non-stimulus stimulus” with Chinese characteristics is the result of enormous financial and economic support. Beijing is propping up the debt markets, the equity markets, and the currency markets which according to my count (more on this later) to the tune of $2 trillion USD.  According to Ambrose Evans-Pritchard, money supply has risen by 20% in 3 months.  Just stop and ponder that for a minute.  One of the facets that has been largely overlooked by pundits is the impact of good old fashioned money supply stuffing.  Next to basket case countries like Russia and Argentina with rapid inflation of major developing countries, China has overseen the most rapid increase in the money supply and far in excess of anything that would be considered necessary for real economic growth.  In short, despite all the talk of management prowess, a large amount of the economic growth has likely come from rapid expansion of the money supply more than robust management.
  6. One of the theories going around is that the commodities crash was only delayed because China levered up during the financial crisis in 2008-2009 while others did not. I disagree with this hypothesis but by degree rather than by principle.  Here is what I mean.  I think it is inaccurate to call Chinese policy in 2008 fiscal stimulus.  I believe fiscal stimulus on steroids with a meth/coke chaser is more accurate description.  2008-2012 resulted in an orgiastic feast of debt fueled construction and commodity consumption that probably has never happened previously in either absolute or relative terms and probably never will again.  There are so many statistics on the epic scale of this time such as concrete consumption that I won’t repeat them here.  The point is that rather than shifting the time period for price highs and lows, what I believe is more likely is that prices were pushed to greater extremes at the higher end and consequently will see lower prices extremes on the downside and for a more prolonged period of time.  Again, I disagree by degree rather than by principle.
  7. There is a subtle form of “this time is different” floating around Chinese economic analysis and it is overconfidence in the ability of direct the economy and prevent problems. I am absolutely not predicting a crisis but the continual build up of risks that are not being addressed is worrisome.  Whenever you are thinking about some news announcement, run a thought experiment: if I removed the country/province name of China/Hebei, what would I think this indicates about the state of economic/financial affairs?  There are many ways that this shows up like as Andrew Batson points out about the echo chamber of Chinese economic policy debates.  The debates which I can confirm are about as wild as they get, argue over whether the target should 6.8% or 6.9%, real crazy stuff for sure.  There is no talk about the reforms necessary to shift the economic landscape or control the risks.  China needs a much better level of economic policy debates than this to keep the juggernaut going.

On the Quantity and Quality of Chinese GDP

A lingering question about the Chinese economy is the reliability of GDP data but a less studied question the quality of Chinese GDP.  Let’s begin with questions about the accuracy of Chinese GDP data.  Last week the Peterson Institute of International Economics and Nicholas Lardy wrote a blog post criticizing anyone casting a critical eye at Chinese GDP data.  Lardy make three main points.  First, why did China wait so long before devaluing the RMB? Second, China is transitioning its economic growth. Third, a lack of high frequency data.

While I think highly of Nicholas Lardy and PIIE, these are straw man arguments that do nothing to build up the accuracy of Chinese data and only weakly make the case against critics. To briefly rebut the Lardy points. First, China has been unveiling a wide range of economic and financial support measures the entire year. The RMB policy is merely one intended to support growth. Second, transitioning economies do not throw basic mathematics aside. If the data does not support the headline number, the data does not support the headline number. Third, there is large amounts of high frequency data whether it is from official or quasi official agencies through to better recording of unofficial data.  This is why people work so hard to compare a mountain of data to official Chinese GDP and are so concerned when they simply do not reconcile.

The bigger problem with the Lardy argument is that there is no evidence that he has clearly considered or even attempted to rebut the clear and convincing data compiled by a variety of people demonstrating the problems with NBSC data.  I will draw from my own research on the topic as I know it best, though there are a variety of others from consulting firms, investment banks, and academics that have raised a variety of very specific and technical concerns about data manipulation in Chinese GDP that are ignored by Lardy.

In compiling inflation data, the National Bureau of Statistics China (NBSC) has clearly manipulated the data.  According to official inflation data compiled by the NBSC, urban housing CPI rose from 2000-2011 by 6%.  Let me emphasize, that is 6% TOTAL over 12 years, not 6% annually.  Even extending that through the latest available data year brings the total to only around 10%.  That number is so patently absurd that no one believes it.  Rather than using third party and independent data to convince you how absurd that number is, which I could do, I am rather going to show you how the NBSC manipulated the data so badly that cannot even reconcile its own data.

To arrive at a low national housing CPI number from 2000-2011, the NBSC utilized an 80/20 urban/rural housing CPI weighting.  The NBSC was assuming in 2000 that China was already an 80% urban country.  It did this because according to their data, rural housing prices were rising much faster than urban housing prices.  Only by using an 80/20 urban/rural weighting can the NBSC arrive such amazing final numbers.  Now elsewhere, the NBSC is reporting that that China was only approximately 35% urban in 2000.  In other words, the NBSC inflation data did not match their own nationwide population data.

I could write at length about how obviously manipulated Chinese economic data is but I feel this ground is well covered and want to move on to other issues but I will leave this topic with a few brief points.  First, if you want to criticize people that are skeptics or critics of Chinese GDP data, then at least examine the very high quality work that has been done on the topic and be prepared to rebut it.  Second, read the numerous and varied work on Chinese statistics.  This isn’t a case of sour grapes or uneducated speculation.  Third, given the enormity and obviousness in one major line item, it is extremely unlikely that this is not happening throughout a variety of other areas of national statistics. Fourth, the size of the discrepancies here are not minor or rounding errors.  These are nothing less than clear and blatant examples of statistical manipulation.  Fifth, this specific line item matters because if plausible adjustments are made to inflation factoring in reasonable housing inflation, this would reduce total real Chinese GDP by a little more than 10% or one trillion USD.  Sixth, whoever wants to defend Chinese GDP statistics needs to begin by agreeing with 6% urban housing CPI in China in 12 years and an 80/20 urban/rural weighting beginning in 2000. After that I will gladly discuss or debate anything the author wishes including but not limited to unicorns, a Beatles reunion tour, and whether Donald Trump is too withdrawn and wonkish to be considered a viable presidential candidate.

I think a factor that received decidedly less attention is the quality of GDP.  The old simple example of what I mean by quality of GDP is this: two guys make up a country decide that they are going to drive up GDP.  One guy decides to pay the other guy to dig him a hole.  The other guy decides to pay the first gentleman to fill up the hole for him.  This process repeats itself infinitely and GDP rises rapidly.  Now very little has been accomplished but GDP goes up.  Now before proceeding, it must be emphasized that this is a very simple example.

While not fitting this exact pattern, there is significant evidence that the quality of Chinese GDP has been quite low.  There are multiple ways to consider the quality of GDP.  First, there is capacity and pricing data.  The Chinese economy remains heavily dependent on the steering of the Chinese government.  Though many companies are by lax accounting standards “private”, an issue covered in , large amounts of economic activity and investment direction remain steered by the government.  We see this quality of GDP showing up in lower pricing, surplus capacity, and failing government debt.  By official accounts, approximately 30% of the 2008-2009 debt fueled fiscal stimulus was wasted and local governments just received a 3.6 trillion debt restructuring that kept them out of default.  Especially in commodities like steel and other metals which had been targeted for expansion by Beijing, surplus capacity is enormous causing deflationary pressure on global markets.  Most airports in China are losing money and there are examples of vast sums of money being spent on airports that see few travelers.  Even in real estate, there is nearly three years of unsold inventory waiting for buyers.  While this binge may push up GDP in the short term, this is difficult to maintain over the long run and is low quality GDP.

Second, while there is no specific data on this, there is evidence that a Chinese variation on hole digging and refilling is occurring.  As an anecdote, the Shenzhen airport where I live is was recently unveiled and it is beautiful.  The problem is this.  The Shenzhen airport that was closed was only approximately 20 years old and having travelled through it frequently was a fine airport, definitely nicer than Los Angeles International. Though straining at capacity, the decision was made to shutter the old airport rather than upgrade it even though it was in fine working order.  This is nearly the airport version of redigging the hole even though the other hole just needed to be bigger.  Having lived in China for six years, one witnesses this type of replication work constantly.  While new capital is being created, there are also enormous capital losses regularly.  People have paid great attention to the new infrastructure, but there is little attention paid to whether it is being used and how quickly it is being replaced.  The capital losses associated with both are simple staggering.  Though I know of no explicit study on the issue, I would wager significant money that depreciation and capital losses are much higher as a percentage of GDP than other countries, whether measured against developer or emerging market.

The reason this matters is that most talk of economic health are both dependent on maintaining high growth rates and high quality growth rates.  I have serious doubts about both in China and I believe that all non-official data supports this position.

End of Week Thoughts on a Big Week

While I generally don’t like to write just quick hits, preferring to provide more detail and analysis in my writing, based upon the rapid evolution of events and number of questions swirling around, I feel it more appropriate to try and answer specific important questions I see being asked.  With that, let’s delve into a bunch of the questions I see floating around about RMB policy.

  1. Did China free the RMB to market forces? Yes and no.  China is allowing the market to influence the RMB price that the PBOC announces every morning but the PBOC still retains ultimate authority over the official trading price.  The PBOC will take into account the actual trading price of the RMB from the previous end of day when setting the new official price.  The gives the market influence in setting the new price but the PBOC retains ultimate authority.  Think of this as China’s Solomon like attempt to allow the market influence while also limiting its influence.  There are three specific issues of notes.  First, this is Beijing’s way of having its cake and eating it too.  It can say it is increasing market influence while maintaining ultimate control.  Second, while the PBOC does appear to set the daily price based upon the previous days trading price, it is also intervening in the market to influence the near end of day price.  Third, interestingly, the PBOC appears to be setting the price with a clear nod towards the offshore market which has been priced at an even larger discount than the onshore rate.  This would appear to recognize the importance of the global market for RMB or Beijing’s willingness to allow the RMB to sink lower, probably both.  In short, Beijing and its critics can both claim that it is brining the RMB closer to the market and maintaining tight control.
  2. Did China take this action with the RMB to try and join the treasured SDR, jump start growth by increasing exports, or due to increasing pressure on the RMB? Probably all of the above in happy coincidence more than masterful design.  Let me rephrase the question to make my point.  Would China increase market influence on the RMB to please the IMF if the economy was strong and capital was not rapidly leaving the country?  I think that would be considered very unlikely.  China had no problem thumbing its nose when complaints were flooding in that the RMB was undervalued, so I would consider it unlikely that China is doing this to please the IMF with an eye towards joining the SDR.  Rather, I would posit that multiple factors came together that made this move logical.  As the Financial Times has pointed out via Patrick McGee, the real test will come when the currency moves in a direction that goes against Beijing’s wishes.
  3. Is China starting a “currency war”? Yes and no but more no than yes.  Journalists and politicians have fallen back on the tired cliche that Beijing is starting a currency war as a way to stimulate growth at the expense of other countries.  There are multiple problems with this narrative though.  First, the total decline so far is a little more than 4%.  That isn’t enough to seriously stimulate Chinese exports Paul Krugman has pointed out.  For the worlds second largest economy any increase resulting from 4% would be little more than statistical noise.  Second, a significant share, though less in recent years, of Chinese exports is processing trade of imported inputs.  Consequently, while export prices may decrease, import prices will increase essentially washing any advantage.  For instance, a large percentage of “high tech” exports rely heavily on imported components acting effectively as an assembly center.  This further reduces the impact of any devaluation.  Third, most regional neighbors, and business competitors, have largely fallen in line with the RMB reducing any cost advantage China may gain from the lower RMB.  Both for political and market based reasons, emerging market currencies and Chinese competitors are falling with the RMB negating any real impact China hoped to gain.  What China may or may not realize is that the falling emerging market currency battle was seen over the past 12-18 months when Beijing refused to unpeg the RMB.  Beijing chose to appreciate with the dollar and now is fighting a war that is already over.  Short of a massive devaluation, Beijing is stuck with the consequences of its own policy decisions.  Fourth, though US politicians may release catchy press releases complaining about the devalued RMB, they have gotten part of their wish, even if it isn’t the outcome they hoped for.  Being pro-free market means being more worried about the methodology than the outcome.  Beijing have given the market a bigger role in determining the price of the RMB, even if US politicians don’t like the outcome that produces.
  4. China can devalue the RMB because it doesn’t need to worry much about foreign denominated debt. Yes and no.  As a percentage of GDP and financial markets, China has relatively little foreign currency denominated debts.  According to a recent estimate, China has approximately $1.3 trillion in foreign denominated debt.  While that may be small in relative terms, given the nature of a credit stressed economy, the relative concentration in strategic sectors like real estate and carry trading, and the Beijing hope that foreigners would buy a lot of government bonds at friendly rates, the lower value of the RMB is going to have an oversized impact.  Given that approximately 500 firms still have suspended trading in shares due primarily to debt covenants that would require additional collateral after share price falls, 3.6 trillion in in provincial debt restructuring due to loans coming due, and now $1.3 trillion in foreign debt, the Chinese economy should be considered a very credit stressed economy.  Any significant problem would risk triggering a wave of collapses or defaults.  I would add that given the long term inviolable stance China took to the RMB/$ peg, all evidence indicates that Chinese traders and firms are unhedged or poorly hedged.  While it is not a large relative part of the economy, there are many real reasons to not overlook the risks.
  5. With $3.6 trillion in reserves, China will have no problem defending the RMB and imposing its preferred value on the market. Yes and no but more no than people think.  One of the most common mistakes people make looking at Chinese data is distinguishing between absolute and relative data.  $3.6 trillion is a large amount of reserves in absolute terms but much smaller in relative terms.  According to my calculations, reserves relative to nominal GDP for 1997-8 Asian tigers is 23% compared to China’s current 34.7%.  However, if you compare reserves to M2 money supply the picture is much different. By that measure, China only has reserves equal to 17% of M2 versus 28% in 1997-8 Asian tigers.  Given the large demand to move assets out of China, primarily by Chinese firms and individuals it should be noted, the $3.6 trillion in reserve assets looks much smaller against the enormity of its wealth and asset base.  If Chinese investors and individuals start to feel significant concern about the RMB, the demand for foreign assets could turn into a flood rapidly if the PBOC fails to arrest the decline.  $3.6 trillion is a large number but in the world second largest economy with 1.3 billion, that should be thought of as a small $3.6 trillion.
  6. What is driving the downward push in the RMB? Confidence in the Chinese economy or more accurately, the lack thereof.  Beijing officialdom and the PBOC can insist until they are red in the face that the economy is fine and there is no basis for the market pushing the RMB lower, but much like the official 7% GDP growth or Chinese milk powder, no one is buying it.  Well heeled Chinese have been moving assets abroad for some time, a process which has sped up, and Chinese firms, especially those with international interests, have been stashing cash abroad as well.  Debt and stock markets being propped up to avoid collapse coupled with deflation have never been known to be an investor paradise.  These are characteristics of an economy that investors and citizens seek to take their money out of and put it elsewhere.  Interestingly, Beijing has said it seeks to better control the offshore market where it exerts less control and unsurprisingly sees an even weaker RMB than the onshore rate.  This cuts to the heart of Beijing and the PBOC’s complete lack of credibility as it is hard enough to manage the RMB market Beijing has the most control over much less a global market in trading centers in Hong Kong, Singapore, Taipei, London, Sydney, and New York to name a few.  Beijing and the PBOC simply don’t understand the market or the enormity of the FX market if it seeks to control the offshore RMB market.  The real risk is that Beijing does not understand global financial markets, as demonstrated by the inept response to the stock market fall, and will turn a declining RMB into a collapse.  The PBOC reset expectations about future policy and prices which risks becoming a self fulfilling prophesy.  The PBOC will have to rapidly improve its communication and market credibility if it wants to establish confidence in the Chinese economy and RMB pricing.  Right now and based upon recent history, that is a risky bet.

Putting the 2% in Context

The 2% RMB/$ devaluation by the PBOC yesterday sent shockwaves through the global economy and there is confusion and disagreement over what exactly it means.  Here I am going to try and provide some big picture analysis of how to think about this moving forward.

  1. The PBOC went to great lengths to portray its move as market oriented. Does this represent an opening up or market freeing action of the RMB? Too soon to tell, but we should have a good idea pretty quickly.  It cannot be stressed enough that if you just read Chinese press releases on economic policy, or a variety of other issues, you would gain a very distorted view of China.  It is much more important to watch the behavior.  For instance, China recently expanded the band on either side of the announced daily trading price to +-2%.  However, daily volatility immediately collapsed to almost 0, meaning that even though official policy allowed +-2% movement, the PBOC was intervening to limit any movement.  Officially the new daily price is supposed to account for the end of the previous day pricing.  Given that today’s price movement was steadily downward, tomorrows price, if using the mechanism should reset at an even lower price.  However, if the PBOC is only using the mechanism in the press release for a one off, expect to see higher RMB prices.  At the moment, the RMB devaluation can be portrayed as either promoting a freer market  or a less free market, depending on your bias.  How the PBOC executes its supposed pricing mechanism will be very telling.  I think it will be increasingly difficult for the PBOC to maintain its desired RMB price level, meaning this very well could mean China has reluctantly freed its exchange rate.  I will reserve final judgment until time has elapsed on the execution of the new pricing mechanism. However, if China moves the RMB towards a more market determined rate as the mechanism indicates, this should help its chances of joining the SDR, though it remains to be seen how the mechanism will work in practice.
  2. What does this move say about the future of the RMB? The PBOC can insist all day long and send police after people who say otherwise, but this significantly increases the probability of future devaluations either by fiat or market pressures.  In fact, overnight, traders seem to be pushing the RMB lower and lower.  Not only that but the onshore/offshore RMB valuation seems to be widening implying that the freely traded price is diverging from the restricted price.  In other words, the market is already pricing in future devaluations.  There are a few specific issues here.  First, by most every reasonable metric the RMB is relatively significantly overvalued.  Beijing can blame only itself in this position as it opted to remain firmly linked to the USD as it steadily rose against most world, including emerging market, currencies.  Second, while a devaluation seems in order this invites a host of financial and political problems.  For instance, just as China devalued, neighboring and emerging market currencies lost just as much value offsetting any benefit to China.  Any attempt to significantly offset the overvaluation against competitors is unlikely to succeed or end disastrously for all concerned.  Additionally, while China does not have large amounts of foreign debt in relative terms, it has nearly $1 trillion in foreign currency debt and was hoping to take on more in provincial bond sales.  The real estate sector especially cannot see a large devaluation without large problems.  Third, the major problems the PBOC is fighting are expectations and a lack of credibility.  By springing this on the markets, the PBOC has reset expectations about the future and specifically the expected value of the RMB.  Honestly, this should come as little surprise to readers as I had been warning, though not knowing specifics, that the RMB was under pressure.  Already fighting credibility issues over their role in the bungled stock market rescue, the PBOC is now trying to convince investors it really means something that most people simply don’t believe.  Fourth, the PBOC is in a much weaker position to defend the RMB against downward pressure than most people believe.  While the PBOC does have $3.6 trillion at its disposal, that amounts to a much lower percentage of GDP than in 1998 Thailand/Indonesia/South Korea.  The PBOC recently spent $300-400 billion propping up the RMB when it wasn’t even under serious pressure and talk of devaluation.  Add in downward market pressure, Chinese investors concerned about future devaluations, and the PBOC could easily spend a trillion USD to accomplish nothing.  Winston Churchill said of Americans that they could be counted on to make the right decision when all other options were exhausted.  Don’t be surprised if pressure mounts on the RMB to see the PBOC wash its hands of the peg.
  3. What will be the impact of a 2% devaluation on the RMB? The economic impact is likely to be muted.  Tom Orlik at Bloomberg has estimated that a 1% decline in the RMB will lead to a 1% increase in exports, but I believe that overstates the impact.  Given the degree of overvaluation and the subsequent weakening of competitor currencies, there seems to be little real price gain to Chinese exporters.  Additionally, as a significant amount of trade relies heavily on exported inputs, the devaluation benefits will be mostly lost the revaluation of import prices.  While this is clearly not true of all industries, a 2% devaluation in current circumstances will take many months to impact trade data and will be facing strong headwinds to impact Chinese trade.  The real impact is in the signal it sends to global markets and also the Chinese public.  Along with a lengthy raft of other economic and financial support measures, Beijing is clearly enormously concerned about growth and finances.  Despite the oft repeated chant that Beijing is propping up the stock market for political credibility, the mountain of economic and financial policy supports unveiled reveal profound concern about the entire state of China, Inc.  This is merely one additional policy measure though it is unlikely to have a significant impact at only 2%.
  4. What does this imply for the direction of Chinese policy and supporting the economy? The problem Beijing has is simple: it has no good options.  There are no painless solutions. There are no easy answers.  Though I have criticized China for the bungled response to provincial debt restructuring and stock market support, I do understand the difficulty they face in supporting their economy.  There are simply no good options and every choice carries a significant downside risk.  Without propping up the stock market 500 or so firms faced the risk of technical default; without mandating a debt restructuring and investors to buy local government debt that should carry junk rating at AAA sovereign rates, provinces were staring down the barrel of collapse; without additional stimulus to build more unneeded infrastructure or unused capacity, growth would falter and employment lag prompting social unrest.  This continual cycle of market crushing policy simply builds up pressure and puts off the hard decisions until they cannot be contained any longer.  As an example, the RMB by some estimates is overvalued by 40-50%.  This overvaluation was created by Beijing pegging the RMB to the US dollar even as it strengthened against a the Euro, Yen, and virtually every emerging market currency just to name a few.  Now Beijing finds itself in the unenviable position of having a currency significantly overvalued, a weak economy, and unable to significantly devalue its currency with setting off a global financial crisis and kill a weak real estate sector responsible for more than 20% of GDP.  Beijing is essentially trying to plug holes in a dam that one by one creates other holes.  The enormous indebtedness stems from the 2008-2009 credit orgy to drive SOE and government growth during the financial crisis.  Each of the predicaments can be traced back to Beijing policies designed to cover up rather than address other problems.  Beijing is running out of credible options to solve its problems and there are no good options remaining, only less bad choices.

China Devaluation Thoughts of the Day

Every time you think the Chinese economic and financial situation is starting to stabilize, Beijing goes and upends everything.  The good news is that regular readers will be familiar with these issues and will be somewhat prepared. The 2% devaluation by the PBOC today has sent shock waves through the Chinese markets today.  I believe there are a number of implications of this move.

  1. Despite all the cheery talk in the press release about market orientation this move reeks of desperation to jump start and export market falling faster than a Party official jumping to his death. This reveals profound concern about the state of the economy.
  2. While the PBOC is trying to sell this as a model based readjustment to better align with market prices, the reality is it is opening itself up for further devaluation pressures. There is nothing worse than a central bank that has no credibility.  Want evidence the PBOC is losing credibility?  The trading rate was already near the new official rate almost 2% away from the old official rate prior to the devaluation.  That means the market was already moving outside the band.  If the PBOC loses the financial markets, this will get ugly fast.
  3. The biggest currency risk here is that be resetting expectations on the RMB/$, it is creating future expectations of devaluations. The PBOC can talk all day about market conditions and their models, but markets don’t like to be surprised and the PBOC has just created future expectations.  It will be very hard for the PBOC to put this genie back in the bottle.  The real risk is that China is going to be forced to release the RMB.
  4. This is going to hit a lot of companies hard such a real estate developers and LGFV foreign currency bonds. While the general perception is true that overseas borrowing is not a large part of China’s credit, certain sectors are heavily exposed and you can expect those bonds which are already in high risk sectors with little onshore legal recourse, to see real hits.
  5. China might be giving up on its SDR aspirations with this move. It should come as no surprise that it was only late last week the IMF released its report noting their concerns about RMB inclusion in the SDR.
  6. It should come as no surprise that this is announced a day after awful trade data. Don’t think the two aren’t related.
  7. If China is trying to attract foreign capital to buy into its stock market, LGFV bonds, or propping up its banks, this isn’t the way to do it. The 2% devaluation is unlikely to have any impact on export volumes and definitely not in the near term.  The real problem here is that it will make it more difficult to attract long term investment capital.
  8. The plunge in emerging market currencies will come under only greater pressure placing enormous downward pressure on prices throughout emerging and developed markets. Think of this as a true beggar thy neighbor competitive devaluation.
  9. The real storm will come when the Fed raises rates sucking capital out of China and other emerging markets. In other words, the real turbulence is yet to come.  The market is unlikely to be satisfied with 2% and the PBOC just reduced its credibility by surprising the market.
  10. Remember: the stock market is the side show. Credit and currency are the real trigger points. There is absolutely a lot more weakness and building pressure on all these markets.