Catching up to the Chinese Economy

So I haven’t been writing that much the past two weeks primarily because of a minor wrist surgery two weeks ago.  In addition to some forced time off, forced me to play a lot of catch up to my existing commitments.  Drove me nuts, because there are so many interesting things going on in the Chinese economy right now that I really wanted to write a lot more.  So for the moment, you’ll be stuck with a grab bag of thoughts.

  1. China released its 2016 economic plan yesterday and while I’ve only read the news reports at this point, it quite frankly sounds pretty well reasoned, like they read this blog (definitely joking but also probably somewhat true), but very unlikely to actually occur. One thing I always tell people trying to understand the Chinese economy is that you absolutely should not take press releases as fact.  If they announce a GDP figure of X, only believe it after you have verified it.  Same thing goes for the economic plan.  From everything I have read, it actually looks rather sensible.  However, I believe the likelihood of it happening is quite low.
  2. I don’t say this for pure skeptic reasons but a variety of reasons, not least of which is just pure mathematics. Let me give you one example.  The plan notes the importance of deleveraging. However, they simply cannot deleverage and maintain GDP growth of anywhere close to 6.5%.  Let me give you a slightly oversimplified model that will explain why.  (I should re-emphasize this model is using easy ratios in an oversimplified model but it will clearly convey the idea).  Let’s assume that that GDP growth is 6% and credit is growing at 12%.  If they only want to slow leverage build up, not even delever, and cut credit growth to 8%, in our simplified scenario that would cut GDP growth to 4%.  Now let’s add in another wrinkle, one recent report had (again using a nice round number) 50% of credit being used to pay of old debts.  Let’s now assume that 6% of credit growth goes to GDP growth and 6% to paying off old debts.  If they cut credit growth to 8% (leaving 4% to fall on the 6%/6% division), if the entire 4% reduction fell on credit growth to pay off old debts, that could easily trigger a wave of defaults.  Conversely, if the brunt of that credit cut fell on GDP expansion and new capacity expansion (already problematic), that could easily torpedo any growth targets for 2016.  Remember, this still assumes total leverage is rising, just slower than before.
  3. This is the key point: I see absolutely no evidence that the Chinese government is prepared to either accept or even recognize that those types of trade offs are necessary. Beijing wants to believe that markets move in one direction and do exactly what you want them to do and that just isn’t reality.  One of the most fundamental laws of economics is that man has unlimited wants and limited means.  There is a very small number of people, firms, or governments to whom this does not apply in the course of human events.  Tradeoffs have to be made and at this point, I see no evidence that Beijing is prepared to recognize that tradeoffs need to be made and then make difficult decisions to make them.
  4. I have a profound belief that when the government of China wants something to happen, they will make it happen. This is not universally true but mostly true.  If they really aren’t interested, they will nod and agree and ignore.  As the saying in China goes: in China there are a thousand ways to say no, including many where people say yes.  Don’t watch the press releases but look at the results.  That is the only way to judge what is going on.
  5. Beijing is going to face some battles on implementing these plans like deleveraging for a few reasons. First, I truly believe they don’t really know what is going on throughout the country.  Even banks don’t know what is going on in their branches throughout the country sitting at the home office in Beijing.  News reports of major GDP fraud in the north east is the tip of the iceberg.  Imagine how bad the data is at lower levels that receive less public or major official attention.  Second, Beijing has not fundamentally changed the promotion incentives so officials have an incentive to focus on the old line metrics.  Before I get a bunch of nasty emails saying otherwise, ask yourself if a city official would get credit for improving environmental welfare by shutting down a polluting low capacity coal plant and putting people out of work and restructuring the assets and recognizing some bad loans? Are you kidding?  Consequently, even if Beijing really wanted this (which I don’t think they do), they would face real problems pushing this plan.
  6. I don’t like to say told you so but this is one time I will say it: I told you so. A week or two ago, Beijing released details of how badly inflated north east Chinese provincial GDP. There are a couple of things to note about this situation.  First, if you believe this is limited to the north east provinces, please get stronger meds.  Second, China who has been a serial adjuster of GDP upwards, hasn’t made any indication they plan to revise the problematic GDP downwards.  That would be unharmonious.  Third, faced with overwhelming even self admitted evidence the new defense of Chinese cherry red kool-aid  GDP drinkers is that, “this was at the provincial level not at the national level. National level data is still good.”  There are two separate and enormous problems with this argument.  A) This assumes that government statisticians in Beijing are pure as the driven snow, as ethical and honest as Mother Theresa, and have the conscious of St. Augustine worrying over the proverbial pear tree.  I just have to ask: who are you kidding?  A friend of mine who used to teach in China, told me a story about a Chinese class he taught where Chinese high school students believed the same thing about government officials (stop and ponder smart people holding the same opinion as indoctrinated Chinese high schoolers for a minute). When he pointed out that central government officials came from provincial appointments, the students would argue that they were promoted because they were so pure and untainted, at which point he would stop arguing.  Again, if you believe that central government statisticians are pure as the driven snow….get help.  B) Potentially more problematic, this assumes that even if central government statisticians are pure as the driven snow they can calculate what the true level of GDP or other statistic should be.  In other words, if you are an honest Beijing statistician, how to do you adjust data you believe to be faulty to what it’s true number is?  This is harder than it sounds for many reasons.  A Chinese auditing report earlier this year found state owned (at the central and provincial level) falsified financial records, no surprise so far.  What was surprising was that some falsified them to look more positive and some to make them look worse.  They did this depending on whether they were trying to hide money or get money.  In short, just assigning a 3-5% downward adjustment, as a simple example, wouldn’t work.  Furthermore, if Beijing suspects that the data they are receiving is false but then the submitter would know that Beijing would know that, so they clearly wouldn’t submit false data.  In short, there is a lot more randomness and one would have to assume super natural power of clairvoyance if official data is accurately corrected.  That also for many more reasons, is an enormous stretch.

If I can’t write again before Christmas….Merry Christmas to everyone.

Thoughts on the RMB

  1. I am a frequent critic of Beijing policy ineptitude but it simply cannot be underestimated the magnitude of what they are trying to accomplish with regards to the RMB. If you look back on the history of transitions of not insignificant countries transitions from fixed to floating or near floating currency regimes, the shift is rarely smooth.
  2. If we make a simple assumption that the RMB is going to behave more like an EM currency against the USD, or even vaguely similar to the EUR/JPY, it is probable that over the past 12-18 months, the RMB would have lost 20-40% of its value. Consequently, even if you take the low end of that range, that would imply that the RMB needs to decline 15%+ to reach a more appropriate value.  There are other ways to look at this but they all imply the RMB is overvalued by a not insignificant amount.
  3. One of the numerous worrying aspects here is the apparent lack of understanding Beijing demonstrates with regards to markets. For instance, Beijing is a fan of markets on the Mainland when they go up, but not when they don’t do what the Party wants.  Price setting is one of the Beijing’s most treasured privileges in every market.  However, the international currency market will not obey Beijing dictats.
  4. You can see this battle being fought in the regular PBOC announcements and in the markets. PBOC announcements are filled with announcements how strong the economy is, the strong fundamentals of the RMB, and no reason for depreciation or outflows.  While they understandably have an interest in not triggering panic, these releases give them an image that they have no idea what is going on in their own economy they are so detatched from reality.  Then in the offshore market, there is this repeated intervention game going on where the CNH moves sharply away from the CNY and it stays diverged for a few days continues to diverge then the PBOC comes in and typically in the span of a few minutes moves the CNH back to near parity with the CNY.  Most worryingly for the PBOC, these currency guerillas keep coming back for more.  They keep coming back because they know fundamentally the RMB is overvalued by at least 15%.
  5. The biggest risk is pretty simple: the PBOC is trying to gently steer the RMB lower. This is going to be difficult for a variety of reasons.  First, the market knows the RMB is going in one direction and they like those odds.  Even if a hedge fund just shorts the CNY/CNH overnight with a not insignificant leverage and sells at trading open, recently, they would be making solid money.  Second, external factors which played into Chinese policy objectives are going against them.  Probably the last thing China or the RMB needs is a Fed rate hike but that is likely what’s coming.    Third, the domestic economic environment is such that capital wants to leave.  It is no coincidence that the giant ball of money rolls between asset classes in China, one seemingly crazier than the previous fad.  Chinese investors, retail and institutional, know that quality investment options in China are limited and are very interested in moving money elsewhere.
  6. I don’t see the slow slide in the CNY having much of an impact on FX depletion. The decline will likely come in counterfactually slightly better but the difference is enough to have a significant impact.  In fact, there is a strong possibility that the lower CNY rate while lowering the direct need for FX intervention is actually going to worsen it indirectly.  If investors believe that the RMB is going lower, they will move more money out of China.  To counteract this pressure, the PBOC is required to intervene even more just to keep it from plunging even more.  There is some evidence of this phenomenon of this, even though I’m not ready to pronounce it as definite.
  7. The PBOC and RMB are benefiting in one clear way from its link to the USD. The current account surplus has ballooned, primarily due to falling import prices and steady global demand. This has helped ease the need for intervention to hold the RMB steady, even if this was not their design.  Consequently, capital outflows are unintentionally being softened due to a favorable environment.  Should there be any reversal, due to a variety of factors in this favorable current account surplus situation, the RMB could face enormous and rapid pressure.
  8. I differ philosophically from many of the IB’s and traders in RMB predictions. With everyone releasing 2016 predictions, every prognostication eventually tells the same story with slight degrees of difference.  The RMB will be 5% or 8% lower in 2016, a very linear process.  I see the RMB, and many financial assets, moving in decidedly a non-linear and choppier manner.  For instance, I think that say 5% RMB decline is a relatively reasonable prediction.  However, I would say something more like: there is a 90% probability of a 5% decline with a 10% probability of a 40% decline. Let me emphasize: this is not my prediction, I am only trying to give an example of how I view this process and the movement processes at play.  Furthermore, the more the PBOC moves the RMB down, I see the pressure build on the RMB for additional weakening and additional pressure for rapid and violent movement.  I see the incremental downward movement as adding incrementally to the probability of a sudden dislocation.
  9. I had someone email me about how a trader might profit from this and part of the strategy, to me depends on what type of strategies you like. However, let me give two examples.  First, I think there is a very low probability the RMB will start appreciating.  Consequently, as a low risk strategy, one strategy might be shorting the RMB with leverage near the end of the day, especially if the trading day has seen a downward drift, and closing out after next morning fix.  Second, buy long dated out of the money options on the RMB say at 7 RMB/$ playing the less likely probability of a large RMB movement at some point in the next 6-12 months.
  10. Pressure continues to build.

Separating Out Regional Differences in the Chinese Economy

I was recently asked by someone to help on a project they are doing about China, which you will learn more of in the future, and look at some data.  Always willing to help interested parties and always willing to look at new data that might give me some new perspective on what is going on I said yes, and boy am I glad I did as it gave me a new appreciation for just what is going on in different parts of China.

I put together some data on specific provinces, industries, and much narrower slices of data so I want to stress at the outset standard caveats about reading too much into this for the entire country and economy.  Maybe I will extend this analysis at some point, but for now this was intended to focus on specific regions.  The division is really pretty simple: I gathered data on the Chinese rust belt comprising the provinces of Hebei, Jilin, Heilongjiang, Shanxi, Inner Mongolia, and Liaoning to compare against the coastal provinces of Guangdong, Fujian, and Zhejiang.  For anyone unfamiliar with China, the divisions here are rather stark.  Rust belt provinces are in the north and north-east area of China and dominated by heavy industry like mining and steel.  The coastal provinces are much more manufacturing and trade focused.  Guangdong for instance is known as the workshop of the world with Fujian and Zhejiang having major export industries.

As coincidence would have it, our simple breakdown of provinces also have roughly equal populations with the rust belt and coastal provinces each having around 200 million people.  Between the two of them, this means that our small sample has a total of about 400 million people or about one-third the population of China.

Let me highlight some of the stark data we see coming through.  Government finances are starkly different between the rust belt and coastal provinces.  In the rust belt, government revenue through September has fallen 9% compared to the same period in 2014 while expenditure has grown 7%.  Hebei and Inner Mongolia actually witnessed moderate revenue gains of 6% while Liaoning has seen government revenue absolutely collapse by 27%.  What is even more amazing is the size of public deficit.  Provincial expenditures are 105% larger than revenue in these provinces with Heilongjiang recording expenditure 212% of more than three times higher than revenue.  In other words, in Heilongjiang for every 1 RMB of government revenue, they spend 3.12 RMB.  Conversely, coastal provinces are almost pedestrian and boring with revenue and expenditure growth of 15% and 16% respectively.  Additionally, the public deficit is quite restrained with expenditure only 2% higher than revenue.

This data has a couple of important implications. First, it seems incredibly difficult to believe that in rust belt provinces, economic growth is positive with government revenue falling by almost 10%.  Second, despite talk that local government finances are being tightened, it is quite clear that certain provinces are running very large deficits.  Third, there is an enormous difference between province economic health.  Fourth, it is difficult to see based upon other data, some of which I will get to, what is causing coastal province government revenue to increase by 15%.  Maybe governments are simply pursuing revenue they are rightfully entitled to but while economic activity in the coastal areas is not nearly as bad the rust belt, there is nothing to indicate strength that would precipitate a 15% increase in government revenue.

Let me turn now to specific provincial data on business revenue broken down by industrial sector.  Let me note one important things about this data.  It does not include service industry data, like financial services, but does account for the manufacture of many consumption products like garments, electronics, and appliances.  In other words, while it does not provide us with a complete picture of the Chinese economy, it would be an enormous mistake to intellectually limit this data to heavy industry.

The difference between provinces is again stark.  Rust belt provinces registered an industrial firm revenue decline of 10.6% from January through October 2015 compared to the same time 2014.  Every province registered declines with Inner Mongolia witnessing the smallest decline at 2.8% and Liaoning registering the largest decline at 19.9%.  Conversely, Coastal provinces clocked in with a small but positive 2.1% revenue gain.  Fujian saw the strongest at 7.8% with Zhejiang registering a small decline of 1.3%.  The economic divergence between provinces has been stark for many years and continues.

There are a couple of follow up points worth mentioning.  First, given Chinese nominal GDP accounting proclivity to closely track revenue growth, it is very difficult to see how Rust Belt provinces, and at least specific provinces, aren’t in outright recession.  For instance, in service sectors like financial services where financial firm revenue is closely correlated with financial service GDP sector growth, if this were to translate to areas like secondary industry, this would require significant nominal falls with the GDP deflator and productivity among other factors to make up the difference. For instance, Liaoning registers GDP growth of 2.7% but industrial revenue collapse of 20%.  Those two things are very difficult to reconcile.  In other words, very real questions about GDP accounting persist.

Second, it seems highly unlikely that service sector growth is so strongly negatively correlated with industrial revenue growth.  Let’s take a simple example where every RMB of revenue is equal to a unit of GDP and there are only two sectors industrial and service with each comprising 50% of the economy (again, overly simplified but definitely not grossly distortionary).  If Liaoning industrial revenue falls by 19.9% and they register GDP growth of 2.7% this means that the service sector needs to register revenue growth of 28.3%.  Now I don’t mean to be skeptical but I’m going to call bull dung.

Third, there is no evidence that the difference can be explained by either output remaining slow to moderately positive with large falls in prices keeping real GDP constant.  All evidence on output on a variety of industries indicate low single digit growth or declining output growth across most sub-industries. There simply is very little evidence that GDP growth in these provinces or nationally can be explained by the measured economic activity.  The real GDP gains announced by official departments would require enormous deflation and productivity gains that are unlikely in a declining environment.

Fourth, even if through some magically economic accounting trick GDP is at 7%, it simply does not matter.  As I have repeatedly stressed, to some degree any debate over GDP is irrelevant as firms and people do not earn money in GDP or repay debts with fictional GDP credits but with cash.  On a cash flow basis, firms in China are hurting and in large areas.  No province in northeastern China saw industrial and manufacturing firms as a whole see declining revenue, for the entire area by 11%.  Even the more prosperous and stable coastal provinces saw total revenue growth of only 2%.  Let’s use the national figure that debt growth is still 10-12% for these provinces and real interest rates are let’s say 10%.  It does not take a Phd to figure out that double digit revenue declines for business in a region with 200 million people as debts go up by 10% at some point will come to an end and typically unpleasantly.  Even with cash flow growth of 2%, debts simply cannot continue to see 10% growth, and pay a 10% real interest rate.

Fifth, Chinese public finance deleveraging or restraint is a myth.  Firms in the northeast are making drunken sailors on leave before a kamikaze mission seem like bastions of restraint.  The average rust belt province is spending more than twice as much as they take in with some spending three times what they take in.  Outside of the divergent underlying economies, it isn’t clear when public finance policy is so different between provinces, but is clear they are vastly different with weaker provinces in serious fiscal imbalances.

Deflationary Prospects for China

I want to follow up on my Bloomberg Views article about how loosening money is not the method to reverse the deflationary pressures in China.  For space and technical considerations, I can’t quite go into the level of detail that as an economist I might otherwise.  Let me expand on some of the ideas I presented there.

  1. Deflationary pressures are driven by enormous surplus capacity. We could go industry by industry but there has been plenty of research on the topic of enormous historical investment.  Businesses are fighting to stay alive and how they do this is by lowering the price of their products.  I think one of the absolute clearest economic events currently is that Chinese industry is experiencing very low capacity utilization.  Numerous IB’s have produced charts on the relationship between the output gap and deflation and it is very clear.
  2. One of the ideas which I am still working through in my head and exploring in the academic research is that monetary policy is typically designed to address demand driven shocks. By that I mean, maybe the global economy reduces demand for a countries exports or there is some domestic shock that lowers demand.  Prices fall to meet the new demand equilibrium.  However, that isn’t what is driving deflation in China.  Yes, export demand is essentially flat but there has no specific change in the domestic economy with many arguing that consumer demand is increasing, something I do not believe the data supports.  Furthermore, the deflation pre-dates any change in demand (Chinese economy ‘new normal’) by a number of years.  All signs to me point that this is not demand driven deflation but supply driven producer deflation.  I’m not entirely sure that monetary policy is well suited to manage supply driven deflation.
  3. I don’t think it is entirely misplaced to say that China is in a deflationary environment. Producer prices are declining significantly at 6% and appear to only be accelerating.  Non-food inflation in China is under 1% and even consumer food CPI is under 2%.  Retail prices are essentially flat actually registering small decline in October YOY.  Given the extremely low CPI, RPI, and PPI numbers, here is why I say we should probably consider China to be in deflation.  The primary concern over deflation is the link between prices and debt.  For instance, if a family purchases a home and borrows some money and then they start making 5% less every year, the real price of that debt increases.  However, in China the vast majority of debt is linked to corporations, SOE’s, and government.  Household debt as a percentage of the total pool of debt in China is minimal.  So even if CPI isn’t truly deflationary yet, given where the debt lies, this simply doesn’t matter that much.  If debt and prices is the key link when considering the impact of deflation, we need to consider China in deflation because PPI, where most of the debt is held, is clearly in a prolonged and serious deflationary spiral.  If you weight prices based upon the debt breakdown, I would suspect you would have deflation of at least 2%. We need to rethink what we consider deflation.  Just because Chinese CPI isn’t negative, doesn’t mean China isn’t in full fledged deflation.
  4. Due to the deflationary pressures, it is quite clear what is happening in the Chinese economy is that loose money is being used to both continue to expand capacity (furthering deflationary pressures) and keep struggling firms alive (even further adding to the deflationary pressures).  In this environment, short of taking the monetary policy to grossly excessive stimulus levels and essentially inflating away the debt, it is very difficult to see how a stimulatory money policy pushing demand growth is going to prompt an increased price level.
  5. My thoughts are still somewhat fluid but I am beginning to be swayed that the deflationary period facing China is going to be quite prolonged and painful. This likely holds true for not just China but for the global economy from spillover effects in a variety of markets.  The enormous investment in the past decade that is still ongoing essentially time shifted large amounts of investment.  If China even returns to some type of normal for investment, this would have large implications.  For instance, this would signal a sustained downward shift in demand for investment inputs.  Given that 50% of Chinese GDP is still linked to investment, this would have an enormous impact on GDP.  Furthermore, given the enormous increase and overhang this implies many years of working through the overhang.  Even if China was to just stop building new things, it would take time to work through the surplus capacity through the trend increase in demand and retirement of depleted capital.  Conversely, if China attempts to keep growth rates high by maintaining incredibly high investment rates, we can expect greater deflationary pressures as more capacity comes on line.  Thinking even longer term, if you take an even longer term view and assume that China works through these deflationary pressures by 2020, at that point, China will be facing even greater population pressures.  Working age population has been falling since about 2012 maybe even 2011, so let’s say by 2020 the capacity issues are resolved, at that point China will have ten years of falling population furthering deflationary pressure. In short, I don’t believe there is any reason to believe that this is just a minor period that will quickly be reversed and prompt higher inflation.
  6. Ultimately, what do to is a purely political question. The PBOC is not independent and does not pretend to be.  Given the complete lack of real economic leadership or imagination in policy making and the necessity of political expedience, I believe you can fully expect investment to remain elevated and deflationary pressures to remain enormous.  This implies that not only will deflation be prolonged but there is little chance of it reversing and policies will quite probably exacerbate this.

Unpacking Financial Services in China

Most debate about the Chinese economy now does not revolve around whether Chinese GDP is accurate but the importance and take up of the rebalancing into services.  In fact, as of today, I know of only one (non-official DC) institution or firm that estimates Chinese GDP remotely close to official Chinese data.  A primary driver of the supposed service sector shift is financial services responsible for roughly 17% of the service sector or about 9% of total nominal GDP.  Consequently, due to its size, especially in the service sector, financial services are key to our understanding of the supposed rebalancing and what is driving this shift.

Let’s try and unpack the various aspects to the financial services industry.  First, despite the attention paid to the investment banks and securities firms, financial services remain dominated by much more pedestrian firms.  Commercial banks and insurance comprise roughly 92.5% of revenue among listed firms with similar patterns including unlisted firms.  This does not mean at all that these other industries are irrelevant at all, but we need the proper perspective when looking at this important industry.  Along with that, employment is even more dependent on the commercial banks and insurance.

Second, there are vast differences between revenue size or growth and profit size or growth between sub-sectors.  By net profit share of the financial sector, the division is even more stark.  At the end of Q3 2015, commercial banks were responsible for 80.4% of all net profit in financial services with the remainder divided between capital market and insurance at 10.4% and 8.9% respectively.  What is important to note is the growth rate differentials, for the moment focusing on share, between these industries.  At the end of Q3 2014, commercial banks were responsible for 89% of all FS net profit.  In that same period capital market and insurance accounted for 3.8% and 7.2% respectively.

Third, over the past year, the growth rate differentials have been quite stark.  For instance, while commercial banking revenue grew at a healthy 10% it was also the slowest of all other sub-sectors by a large margin.  For instance, capital market and insurance revenue grew at 173% and 27% YTD YOY respectively with all financial service growth through Q3 growing at 20%.  If we focus on net profit growth, there is an enormous discrepancy.  Commercial bank net profit is up 2% (more on that later) while capital market and insurance net profit is up 213% and 40% respectively with all financial services up 13%.

On the surface, financial services looks rather healthy but as I always urge, let’s look beneath the surface.  There are in fact numerous issues that disguise the weakness of the financial services industry.  Let’s look into some of these.  First, Chinese banks are in much worse shape than their top line revenue growth indicates.  As I have covered elsewhere, Chinese banks appear to be rolling over loans, capitalizing unpaid interest, and counting the unpaid/capitalized amount as interest revenue.  Let me put the perversity of this behavior in some perspective: by refusing to recognize a bad loan but counting the capitalized  unpaid loan amount as higher revenue, unrecognized NPL growth is contributing positively to revenue and Chinese GDP growth. Let me repeat that: unrecognized NPL growth is positively contributing to the Chinese GDP growth. We see another outgrowth of this the change in profit.  Commercial bank net income from operating activities grew by 0.1% and net income grew by only a slightly better 2.2%.  The difference between revenue and profit growth stems from rapidly rising NPL growth which directly impact profit growth.  In other words, neither the revenue or profit side of commercial banks is encouraging.

Second, insurance growth was initially very puzzling.  There was no obvious shift into insurance products throughout Chinese firms and consumers nor were they allowed to invest in the stock market.  However, a look beneath their financials provides us the key details.  Insurance premium revenue was up 20% and listed insurance revenue was also up 27%.  However, as premium revenue is a relatively small percentage of total revenue and with insurance companies in China declaring operational losses every year, profit is gained from investments.  Insurance investment is typically quite conservative  with strict limits on equity market investments.  Even in China only recently was regulation floated that would allow insurance companies to invest in the stock market.  From April 2013 through August of this year, the last date available for insurance data, bank deposits and bond assets held by insurance companies have grown by 13% total.  Conversely, non-bond  assets have grown by an astounding 159%.  While we do not know for sure what assets these are, we can say that Chinese insurance companies were not allowed to directly purchase stocks.  What is most likely happening, as commercial banks did the same thing, they purchased various trust and wealth management product securities.  Though there is no such thing as a standard wealth management product if we generalize we can say that a not insignificant money indirectly made its way into and was tied to the stock market, significant leverage was added, and in higher risk debt type offerings.  Commercial banks have rapidly expanded their purchases of the same types of assets.  To provide some perspective, as non-bond assets of insurance companies rose 159%, the Shanghai index would have gone up 47% over the same time frame.  Now what is worrying is that insurance holdings of these non-bond assets have not declined with the stock market and from the end of June to end of August have declined only 0.7%.  This would seem to imply that the underlying assets are at high risk of large losses which have not been recognized financially by the accounting firm and if they are purely some type of collateralized debt obligation limiting downside but providing higher upside, significantly higher risk of the underlying borrower defaulting.  In other words, the non-bond investment has not been marked to market because there is no market and they can continue to price it at face value even if the underlying risk is enormous.

Third, capital market revenue essentially tracks stock market turnover and is up enormously.  Given that most additional revenue translates very closely into profit as there is little marginal input cost growth, the pass through impact has been large.  Capital market revenue is up 173% with net profit up 213%.  This tracks very closely with what they do and our understanding of their business.  As they have very little risk exposure to assets but are much more closely tied to turnover, there is little macro-industry risk here.

Fourth, if we remove the specifically accounted for net income from investment, we get a very different view of financial service profitability.  For instance, commercial banks would have realized a net profit of less than 0.6% even though net income from investment rose 71% and all financial services investment income grew 91%.  I should note that just as I emphasized insurance companies saw rapid increases in non-bond investments that was most likely invested in trust and wealth management products.  Banks and insurance companies saw identical growth in investment income at 71%.  While the change in commercial bank investment income does not make a major impact, it has an enormous impact on insurance net profit.  Due to the 71% investment income growth, net profit saw a rise of 40%.  However, let’s make a simple assumption that investment income grows only 10% instead of 71%.  In that case, net income actually falls 97%.  Let me repeat that: if insurance income from trading does not increase 71% but rather 10%, net income would 97% lower.  In fact, if we strip out commercial bank and insurance investment income growth of 71%, their combined net income would fall 7%.

Fifth, as this passes through to GDP, China appears to be using a measure that pretty much just tracks operating revenue.  Financial intermediation was up 23% YTD and listed financial services revenue was up 20%.  Given increases in the unlisted firms, specifically securities and shadow banking activities, the difference between 23% and 20% is either small enough to ignore or disappears completely.  This method of nominal GDP accounting however would appear problematic not as much for financial services but for other areas, where revenue growth is firmly disconnected from the nominal GDP growth.  Also remember that perversely, rolling over unrecognized bad loans is increasing GDP growth

Broadly speaking, it is probably accurate to say that financial services grew at the approximate rate the NBSC claims.  However, there are enough underlying problems in the financial services sector, revenue and profit accounting, and nominal GDP measurement in other sectors using the FS method to give one real concerns.