Follow Up on why Capital Controls Isn’t a Good Idea for China

Here is my regular follow up to my work for BloombergView on why capital controls are not a good idea for China.  I write these follow up pieces for my blog only because due to space considerations I may not be able to get deep enough into ideas as I would like.  Very thankful to Bloomberg for giving me the platform and my editor Nisid Hajari makes me sound better than I really am, so always start there before coming here.

Before I launch more specifically into why I do not think capital controls are a good idea, I want to note two further background points.  First, I am a business school professor so I will admit to having strong leanings towards free markets.  However, I think I am also pragmatic and realistic enough to be able to examine situations on their merits.  I am also willing to change my mind if superior arguments are presented or if situations change. I know markets are not perfect or can sometimes be irrational, for instance, you do not need to convince me. I just want to confess my bias but note that as you will see, I think my arguments here are distinctly more pragmatic and empirical than ideological.

Second, this piece was driven by a number of articles I saw in the past week calling for or strongly suggesting capital controls for China.  The Economist, Financial Times, and Bank of Japan have all suggested that China should impose capital controls to prevent a further slide in the RMB.  This is primarily a response to those pieces. Now, let us begin.

In my personal opinion, the arguments I are codswollop which is British for non-sense (I’m currently in London and trying to learn the language).  Let me detail why in no specific order of importance.

  1. Many people have assumed that since the IMF admitted that capital controls had some place in global financial flows, they could and should be used much more widely. However, this betrays a very poor understanding on many levels of what the IMF actually said.  The technical parts of what the IMF actually said are vitally important.  The IMF said that capital controls could be during periods of crisis on a temporary basis focused on slowing or restricting outflows of international money from previous periods of large inflows.  There are many important things there.  The could means that it is not required or necessary but may depending on circumstances be useful.  The IMF does not suggest making capital controls a knee jerk reaction. It also said capital controls should be limited to periods of crisis.  I am pessimistic and concerned about the Chinese economy and finances for empirical reasons but I have to ask: what crisis? An economy not growing at 7% is not a crisis.  A country with downward pressure on its currency is not a crisis. I could write this list all day long but the point is, if you are arguing that China right now should impose capital controls, there is virtually no country on the planet you wouldn’t be able to make the same argument for.  It is an awful precedent to recommend countries impose capital controls because their economy isn’t growing quite as strong or because their currency declines.  (I am going to focus on the other parts of the IMF recommendations later). The important point is that it betrays a very poor understanding of what the IMF actually said and how to apply that to the real world even if you are recommending capital controls.
  2. I have two fundamental objections to the arguments for capital controls that I have heard so far. First, I don’t believe capital controls will address the problems that need to be solved or even the problems raised by those arguing for capital controls. I will get into the specific arguments shortly, but I mean simply if you need to fix your knee you don’t operate on the shoulder.  The arguments all seem to fall back on capital controls with no clear link to whatever problems they see as needing to be solved.  Second, I do not believe that capital controls have any realistic chance of success.  Even if we assume a tenuous link between capital controls being able to solve a specific economic/financial problem, it is important to ask, what are my expected chances of success by using a specific policy?  In virtually every case, for multiple reasons, one would have to believe, the chances of capital controls resulting in a successful outcome is exceedingly low.
  3. Now let me turn to some of the specific arguments. Bank of Japan governor Haruhiko Kuroda called on China at Davos to implement stricter capital controls. I only have access to the FT article on what he said so if there is more nuance or detail not captured, I apologize in advance. The FT writes the following about his comments:

“Mr Kuroda suggested capital controls would allow Beijing not to waste its foreign exchange reserves defending the currency while allowing its domestic monetary policy to stimulate consumption at home. ‘Capital controls could be useful to manage [China’s] exchange rate as well as domestic monetary policy in a constructive way,’ he said.”

Noting the use of FX reserves, capital controls, and monetary policy is implicitly the widely known trillema.  He is essentially saying to manage that contradiction, China should use more monetary easing and impose tighter capital controls.  By using more monetary easing, Kuroda, and this is the important part if we are asking what will be accomplished by a policy, says this will stimulate “consumption at home”.  Just on the face of it, I believe it is highly unlikely that monetary easing in China will stimulate demand to any significant degree.  Just as a point of economic theory, it is tenuous at best to say that imposing capital controls would boost domestic consumption.  If people are scared by the future due to capital controls and economic concern, they are not going to engage in a consumption spree.  The link between those two things is very weak. If we break this up into consumer and business consumption and introduce empirics, we can see what we mean.  Business demand is very low and being propped up primarily government driven stimulus projects.  Loan demand is low and continuing to fall even as the PBOC has lowered interest rates.  This is due primarily to surplus capacity.  Very hard to see how capital controls will impact this.  Looking at consumer behavior, it might shift existing consumption to domestic producers, however, given the low single digit growth in consumer product output and sales, there is little reason to believe that imposing capital controls and lower interest rates would prompt a consumer rebound.  A weak labor market which continues to deteriorate, simply won’t give people reason to go spend money.  I see very little link between imposing capital controls and boosting consumption and even less chance of success.

  1. The Economist in three separate pieces (here, here, and here) argue in favor of capital controls in China. What I find most puzzling is that they do not make a strong argument as to what problem capital controls would solve.  Honestly, it feels like they are not even convinced capital controls would accomplish much and that they are arguing for capital controls out of laziness rather than conviction.  In one piece they argue that depreciation would “puncture the PBOC’s air of invulnerability.”  First off, what’s wrong with the RMB falling? (more on that later though). Second, the PBOC air of invulnerability is lying in tatters by the side of the road having been run over multiple times.  Probably only the CSRC and NBS have worse reputations in Beijing policy making.  The problem here is simple and will not be easily fixed.  The PBOC has very little credibility and has let the RMB fix out of the bottle.  If they behave like the CSRC in the past 8 months, trying to make small commitments to deal with the problem, the RMB problem will linger on, consume lots of capital to its defense, and most likely still lose in the end. Not a winning strategy.  The Economist elsewhere argues that capital controls would give China “freedom to clean up the country’s bad debts and push through structural reform”.  There are numerous problems with this argument.  First, this is not remotely close to “temporary”.  Banks have recently gone public with bad debts from the lending binge more than a decade ago.  Second, there is absolutely no evidence that Beijing and banks are taking concrete steps to address the bad loan problem.  Credit continues to expand at approximately twice the rate of GDP, companies continue to get bailed out despite a small rise in the number of defaults, and even Chinese bankers admit NPLs are radically understated. To their credit Beijing has now said they want to “deleverage”, there is however, no concrete evidence of steps to address this. Policy needs to be made on evidence and facts, leave hope and faith to theology.  Third, unless there is concern that capital outflows will create a liquidity crisis in banks, something that cannot be ruled but it is not currently happening or the most likely, it is unclear how imposing capital controls would prompt this change.  The causative link between imposing capital controls and prompting better bank management is weak at best.  In fact, lots evidence points to the idea that more financial repression would inhibit restructuring and reform.  The problems Beijing is facing were created by Beijing through financial repression, not international investors or market forces bubbling, but by Beijing financial repression.  Seems unlikely even more Beijing financial repression will solve this problem.  Finally, they argue that imposing capital controls would help Beijing “prepare financial institutions for currency volatility”.  This is a specious argument for third very empirical reasons.  First, Chinese firms already deal with currency volatility they just do it in essentially an n-1 world. By that I mean, they already deal with currency volatility in the trade weighted currency basket for all currencies except the USD.  The Euro, the Yen, the GBP, etc etc are all managed for currency volatility. The USD is the biggest but it is blindness to think Chinese firms do not deal with currency volatility.  Second, Chinese firms owe relatively little in absolute terms of foreign denominated debt and it is shrinking everyday and international firms hold in absolute and relative firms, little in the way of liquid Chinese assets (this excludes FDI assets like plants).  In other words, foreign investors even if they really wanted to, won’t be impacted by capital controls.  Third, if as Beijing is proud to announce and push, international transactions with China are in RMB, this essentially pushes the currency risk to the foreign party rather than the Chinese firm.  The Chinese firm is has both its expenses in RMB and sells in RMB.  This lowers, does not eliminate but lowers the risk to Chinese firms.  In short, the arguments presented by The Economist are weak at best.
  2. Even the Financial Times has decided to toy with the idea of capital controls writing. To be fair, they just toy with the idea and do not seem convinced by the arguments.
  3. There is one last piece that just got sent to me written by former PBOC Monetary Policy Committee member Yu Yongding where he advocates “reinforce(ing) the Chinese governments market oriented reform plans and allow the RMB to float.” To briefly sum up a good piece, the path has been set and since we know the destination, all other options just delay the inevitable with large costs. It would be best to move there deliberately, carefully, but quickly.
  4. There are a number of economic points that are vital, to reincorporate the earlier points from the IMF and one that was also noted by the FT piece. It is important to understand the nature of the outflow.  The IMF is worried about outflows from large destabilizing inflows.  The current capital outflows leaving China are not due to previous rapid/destabilizing capital inflows nor are they due to international investors.  This is a vital and  absolutely fundamental difference to understand.  There was no large international investor capital inflow into China and the money leaving has very little to do with international investors.  Most international investment in China, overwhelmingly so actually, is in the form of FDI.  We do not see that this FDI is being sold off or used up and transferred out.  International investor portfolio asset holdings are tiny in relative terms and have not changed nearly enough to make any appreciable impact.  The capital outflows are driven almost entirely by Chinese citizens and firms voting with their RMB.
  5. This seemingly simple and straightforward conclusion however has a number significant implications. First, do not compare China to Asia 1997.  Stop now. Do not say Malaysia, South Korea, Indonesia, Thailand.  The details of the financial flows are radically different.  There are some similarities due to the rapid expansion of credit/investment, but the prescriptions need to be crafted individually for China.  Second, the capital outflows are most likely not short term outflows but rather a structural shift in capital flow directionality.  The IMF argument about capital controls can be understood if “short term” capital inflows have suddenly reversed causing “short term” capital outflows leading to a disruption.  However, we know that there were essentially no short term inflows that have reversed.  The outflows being driven by Chinese citizens and firms are going to buy real estate and outward foreign direct investment (as simple examples).  Neither of those are remotely close to being considered short term outflows.  Capital leaving China is likely leaving essentially permanently.  Furthermore, this trend is most likely unlikely to see a reversal anytime soon.  In other words, the capital outflows are not going to reverse and turn into capital inflows anytime soon.  This is another reason why the “temporary” moniker seems to make little sense. If the outflows were temporary or purchasing temporary external assets, there is some justification, however, neither holds here.  It is worth noting that China is now the largest exporter of immigrants to the United States and most likely other countries also.  This is not a temporary phenomenon. Third, if the East Asian crisis could potentially be thought of (in very crude, overly simplistic terms) as countries that liberalized their capital accounts too quickly and then gorged on available capital, China is almost the opposite.  The imbalances are caused by a closed capital account gorging on capital because the money supply and credit, due to current account sterilization, grew so rapidly to such enormous volumes.  If restricting capital account openness was the recipe for countries that had opened their capital accounts too much or too rapidly, it would seem to push openness for China that hasn’t opened its capital account.  Fourth, the somewhat amusing cliche coined by Tracey Alloway of Bloomberg that has been coined is the “giant ball of money” that rolls between asset classes pumping up prices until it moves on.  This is due to the closed capital account where capital simply cannot be used effectively.  It pumps up prices until that goes out of style and moves on to other classes.  Loan demand is down because there simply are no good projects because China is so overbuilt.  In the past decade China has expanded money supply at enormous rate even after accounting for official real GDP growth.  We see this in elevated asset prices across China that money supply has rapidly outpaced the real demand.  This furthers this idea that the outflows are very unlikely to be temporary.
  6. There is one final point that is very important and that is how much would a fall in the RMB matter? I am only going to focus on China here as this is an issue you could many very long papers or books about and I am already quite far into this.  I am honestly much more sanguine about the possibility of a lower RMB.  Let me give you a number of reasons.  First, most economies against the USD have fallen in the past 12-24 month pretty substantially and surprisingly, the world continues to spin on its axis, commodity dependent EMs are battered but that is due to falling commodity prices from surplus capacity and weak demand, with the significant problems less related to USD than other problems.  DMs like Japan and Eurozone have fallen against the USD with almost no discernible impact on economic outcomes directly attributable to exchange rates.  Taking Japan as one example, the Yen has fallen significantly against the USD in the past two years and there has been virtually not discernible change in trend economic data.  You would be hard pressed to say any changes are anything other than statistical noise.  Second, if we look empirically at China’s trade, any RMB fall would have a relatively muted impact on imports.  Speaking simplistically, let’s classify Chinese trade as processing for re-export, commodity, and other assuming it is all for consumption (it’s not but work with me).  The re-export and commodity imports will largely be unaffected by any change in the RMB, for different reasons though.  This would likely leave at most let’s say 50% of exports up for grabs in our analysis.  Since China already produces most the mass market products its consumes, whether it is cars to shoes, there is little reason to believe this consumption will be impacted and if anything will cause consumers to shift to domestic producers as imports become more expensive though likely a very small effect.  People or firms on the upper end of the scale will still buy luxury products or specialty goods at a higher prices point as they tend to be less elastic in their purchasing decisions.  In other words, while a fall in the RMB will undoubtedly bring additional pressures and stresses, it seems poorly informed to believe this would create a crisis or anything resembling such dislocations.  Third, as I have already covered for BloombergViews, I believe it is very unlikely that a fall in the RMB would result in any sustained boost to trade or growth in China.  Fourth, if China wants to become a major international currency, which I am still unsure if they understand what that entails, they absolutely must allow capital outflows.  This doesn’t entail profound economic insight to understand: how can the RMB become a major international currency if there is no RMB in the rest of world and no one outside of China can use it?  Fifth, currencies rise and currencies fall.  That’s what they do, are supposed to do and should not be forgotten.  Many people even international economists with regards to China, and really most similar situations, develop a degree of analytic Stockholm syndrome adapting the arguments of their kidnappers regardless of how non-sensical.  As capital has left China and the RMB has declined, with no true crisis in sight, smart people are running around like chicken little calling for capital controls.  It would definitely mark a change if the RMB floated, but that’s it.  Most major currencies have fallen against the USD because of underlying economic issues and the streets of Tokyo remain oddly untouched by pillaging, fire, and villagers storming the castles.  To have this degree of fear you would have to believe that China is an enormously fragile economic state which implies you don’t believe the finances or economic data.  Very real possibilities, but avoid adopting the Chinese mantra of stability above all else.  Sixth, the Chinese are moving capital out of China because they see long term economic problems.

I apologize for the length of this but I wanted to address some of these issues in a more detailed and technical manner.  Once I got going, I was like Skynyrd on Free Bird.    Balding out.

Follow Up to Bloomberg on Chinese Devaluation

As usual, I want to provide a little follow up to my BloombergView piece on why devaluing the RMB won’t solve Chinese economic problems.

  1. I am not saying that the PBOC and Beijing should defend at all costs the RMB if there is a large sustained outflow of capital. A lower RMB may very well be in the future of China.  The futures market certainly thinks so and based upon the creeping capital controls, it is likely Beijing sees the same events unfolding.
  2. I am saying that it is an enormous mistake to think that a lower RMB will kick start the Chinese economy and restore peace and justice to the universe to grow at 10% annually again. Simply won’t happen.
  3. This is most empirical reasoning much of which I outline in the piece. For instance, though a large trading country in absolute terms, it represents less than a quarter of the entire economy.  Consequently, even if it grew fast, it would represent a small fraction of the overall economy.
  4. Given the large amount of processing trade and reliance on imports to build other exports, a not insignificant amount of the gain to export volume would be eaten up by more expensive imports. Exports might become cheaper, but that means imports are more expensive.  When you need both to trade, you’re not gaining nearly as much as you think.
  5. Given the products China exports, still very reliant on low value products, China needs to compare itself to Indonesia, Vietnam, Thailand and Brazil not its basket of currencies. The basket is comprised primarily of USD, Yen, Euro, etc.  Ask yourself this, though how many Mercedes (or high value cars) does China export? Not many.  The Chinese export basket is still dominated by low value products like garments and electronics assembly.  Changing yes but still dominated by those products.  Consequently, demand for those products is rising but definitely slowly.  This has two enormously important implications.  First, Chinese exports can only increase rapidly by taking market share from other EMs.  This has been happening in recent years but simply not fast enough to push trade.  When global trade was rising rapidly China was a significant beneficiary.  Now with global trade growing slowly, China can only rely on exports by taking market share in large amounts from other EMs.  Second, which flows directly from the first point, is that to drive exports, the RMB would not need to fall against its basket of USD, Yen, EUR, but rather relative to a basket of EM currencies.  That means that to regain competitiveness against its largely EM competitors, it would need a very large devaluation.  Let me give you a simple example.  Let’s assume that all currencies were at an index value of 100, EMs and China in this case.  Over the past year let’s assume that the other EMs have drifted downwards so they are now at 80 (indicating weakening) while China remains at 100 compared to its basket of mostly DM currencies.  For China to regain cost competitiveness against other EMs, it would need to drop to say 70 or 60 before there was a significant benefit. (I want to emphasize, these are just simple numbers to illustrate the point, not intended as a currency forecast).  As other people like Paul Krugman and Bloomberg’s Tom Orlik have pointed out, a mildly weaker RMB will simply have no impact on trade.  Tom Orlik has estimated that the RMB would need to fall to at least 7.7 TMB/$ before there was an appreciable impact on trade.
  6. Given the level of debt, as foreign debt represents a very small percentage of the overall whole, the deflationary spiral is very difficult position for China. Without stimulating some type of inflation, the debt deflation spiral China finds itself will be very difficult to solve.
  7. The problem is that loosening monetary policy only pushes money out of China. The PBOC has recognized this problem and rather than lowering interest rates or RRR, they are trying to push liquidity via reverse repo injections.  I see that as another band-aid over a gunshot that likely solve a short term problem but nothing to solve the real problem.  The more it loosens, the more pressure it places on the RMB.
  8. As I wrote in a previous BloombergViews piece, though it goes entirely against monetary orthodoxy, I would argue that if China wants to stimulate inflation, it should raise interest rates and be prepared to deal with a not insignificant number of firms.
  9. The overall problem is that China is no longer left with good and bad options, but an array of bad options. The policy options are dwindling.  Everything they are doing is really just placing a band aid over a gunshot wound.  The latest is to limit MNCs taking money out of China.   That’s not exactly the way to encourage more investment.
  10. Capital outflows are a Chinese phenomenon, not a foreigner or hedge fund problem.

Data Diving on Inflation

So now that we have had some new data releases and I am back from vacation, we get back to what I still consider the meat of this blog, focusing on the data of the Chinese economy.  I have developed a general rule of thumb that if you a read about a Chinese statistic in the headline of a news article, it is most likely heavily manipulated.  To rephrase this slightly, if it is top line data, it is heavily manipulated.   One of the problems for people who have not spent enormous time looking at the data is that, to give credit to Chinese artists, they are very skilled at manipulating the data in a variety of ways that can make it difficult to detect.  Many times, you can only detect the manipulation looking at much more granular data, which in all fairness, simply aren’t available to most people. However, in some cases, even just looking at granular data on the NBS website and comparing it to top line data that should be a summation of lower level data, one can see the discrepancies.

One of the biggest ways that Chinese officials manipulate real GDP growth is by manipulating the pricing indexes.  There has been recent skepticism about the unchanging nature of the PPI flattening at 5.9% over the past few months given the continuing price declines in a range of products.  However, for the moment, I want to focus on the CPI basket weighting.

When building inflation rates, one of the key questions is how to weight each and every product of the basket.  Ideally, you have lots of micro-level data that gives you a very clear idea of how to weight individual products and classes of products.  For instance, food prices should still comprise a major portion of the CPI and budgetary basket as despite Chinese economic development, it still comprises a significant portion of most people’s spending.  The CPI weight should closely resemble people’s spending habits.

There is one other thing that impacts how we want to approach the Chinese CPI basket, there is something called Engel Curve that should provide us a good basis of comparison about how people spend their money.  The idea is really pretty simple in that the more money a household or country makes, the less they will spend on food as a percentage of income.  It is really quite intuitive.  Assume you make $1,000 per year, you will probably spend a pretty high percentage of your income simply keeping yourself nourished.  Now assume you make $100,000 a year, you will probably  spend a higher amount of money in absolute terms, say $500 increased to $2,000, but you will spend a significantly lower percentage on food in absolute terms, going from say 50% to 2%.  As households and countries become wealthier, they will spend less as a percentage of their income on food.

Emi Nakamura and Jon Steinsson of Columbia, currently on leave at MIT, have actually written a paper studying the Engel Curve and Chinese households (PDF).  They write about recent Chinese inflation that “official inflation rose in the 2000’s, but our estimates indicate that true inflation was still higher and consumption growth was overstated over this period.”  If true inflation was higher this would mean that real GDP growth was in reality overstated.  In addition sound empirical and theory based research that inflation is significantly underestimated, we can again look inside the Chinese inflation data calculations.

China began releasing its CPI basket based upon food and non-food items, though in 2011 it released the weightings for the non-food sub items.  In 2011, the CPI food weighting was 31.39%.  This 2011 weighting had fallen from the 2006 number of 33.60% and was expected to keep falling and relatively rapidly.  History, intuition, and wealth of global economic data said that this number should pretty quickly fall beneath 30% of the budget.  Right? Wrong.

In 2012 the food weighting in the CPI basket jumped almost to 32.21% and has risen about 0.5% every year since.  For 2015, the food weighting of the CPI stands higher than the 2006 number at 33.61%.  This stands is such complete contradiction to everything we know about economics that is belies any credibility.

There are a couple of empirical points to look at here.  First, from 2011 to 2014, average urban wages officially grew 34.8%.  From 2006 to 2014, urban wages officially grew 170.2%.  Oddly though, during this period, the amount of money spent on food, according to official statistics, actually increased as a percentage of income.  In reality, this seems distinctly unlikely as it would spell morbid obesity with Chinese characteristics for most of the country.  It isn’t rising that fast.

Second, if we actually believe these numbers, from 2011 to 2014, the Chinese consumer will have seen wages go up 34.8% but food spending go up by 44.4%.  Put into absolute terms, they would have spent about an additional 2,880 RMB or 5.1% of their income on food than if the CPI weighting had dropped by a similar amount instead of going up.  That is not an insignificant amount of income.  I know of no other country that would plausibly claim to triple wages and have people spend the same percentage of income on food as before.

Third, I can’t honestly explain why the food weighting has gone up though I have some guesses.  Given that food inflation in China runs higher than non-food inflation, which given PPI deflation isn’t a surprise, it could be they are trying to obfuscate realized deflation.  Another possibility is that food inflation is actually higher than admitted but by allocating a higher percentage of the CPI weight they can obfuscate the true impact by allocating the same absolute expenditure amount but change the internal percentages.  I will be honest in saying, I’m not really sure why.

Fourth, the inflation basket is riddled with other problems but this is one good example.  For instance, the residence component is only 17.8% of the CPI basket.  Not only is that number incredibly low by really any standard, I think you would be hard pressed to find anyone in China who would say that food has risen as a percentage of their income while housing is only 17.8% of their income.  Until 2011, Chinese residents supposedly only spent 13% of their income on housing, an absurdly low number for any country but definitely one in the midst of one of the most rapid price increases in housing in modern history.  The point however, is that how a CPI basket is weighted internally can have a major impact on the final number depending on what you are trying to accomplish.

Whenever you read of a headline number in China, do NOT, I repeat do NOT just accept it as fact but try and go beneath and figure out what is going on.  There is tremendous and important detail lurking just beneath the surface.

Random Thoughts About the Chinese Economy and Research

  1. Fear seems to be gaining a foothold. Whatever your thoughts about economic data, hard vs. soft landing, or prospects heading into 2016, fear trumps all.  If people fear the economic future, it frequently becomes a self fulfilling prophesy.  I am not saying yet fear is pervasive throughout the Chinese economy, but it is gaining a foothold fast.  If Beijing does not get its act together fast, they will lose control of the story.
  2. For many reasons, I cannot publicly relate all the stories I hear from different contacts but I will just gently say that almost every time I hear a story about Beijing policy making, I am going to laugh or cry at the end and not in a good way. Whether Beijing wants to admit it or not, the quality of policy, the objectives, and communication strategy needs to change.
  3. Nobody knows what to believe out of Beijing. I’m not just talking about skeptics, bears, or speculators, I’m saying even the people who want to believe Beijing has a handle on the situation and will be able to come to the rescue.  People I know that I wouldn’t consider distinctly pro or anti-Beijing are now starting conversations about how Beijing messed something up.  When even people who would typically defend you are apologizing on your behalf, it’s bad.  I had been pessimistic for a while but the rate at which China bulls have become bears is startling even to me.  I’m not just talking about people that might be known but friends and contacts.
  4. I am very reluctant to assign a lot of weight to arguments about communication but in this case, there is a lot of truth. As a point of comparison, whatever you think about the Fed decision to raise rates, that 25 bps hike was one of the largest non-events ever.  It happened that way because the Fed and Janet Yellen communicated very clearly with the markets about what to expect, when to expect it, and based upon the criteria.  The Beijing policy apparatus offers conflicting statements a few times a week, changes its mind, and surprises the market as if they are not worth the time.  Beijing: call some press people from London or New York and figure out what you are doing.  Financial markets are not the People’s Daily who do what you tell them.
  5. Doing time series research on Chinese data using public sources is simply pointless. One of the many problems China doesn’t even disclose unless you know, and believe me most people don’t know, is that they have regularly “updated” major data points.  Consequently, as an example (though I don’t remember the exact dates and I’m sure these are wrong), GDP from 1998 is not comparable to GDP from 2004 is not comparable to GDP from 2009, is not comparable to GDP from 2014.  This is true of many key time series even though most people don’t know this.  So whenever someone uses a time series on key pieces of headline data to prove to you they have come prepared, just ignore them, pat them on the head, and move along.
  6. A lot of people looking at China wondering its impact on US and Europe, but the real concern is not whether GM plants located in China will earn less, which is likely, but not earth shattering news. The real concern is over how China will impact other emerging markets.  If we divide those EM’s into commodity and non-commodity countries, it is pretty clear there is some real weakness.  Commodity price declines, in all fairness to China, are at least as much more due to excess supply even if Chinese demand was growing as much as expected.  In fact China in some commodities is experiencing a minimal slow down if any.  In non-commodity EM’s, China continues to take market share in export markets.  The problem, both for China and other EMs, is that international demand isn’t as weak as believed, but the pie is growing very slowly so they are cannibalizing each others sales building deflationary pressures.  If Chinese domestic demand was bigger, which it isn’t sorry rebalancing bulls, that would at least soak up some domestic supply.  In other words, if China spills over, watch the EMs not the DMs.
  7. China watchers are missing the primary story that capital outflows are a domestic vote of confidence not and international portfolio issue. Portfolio investment by foreigners remains very limited, and I apologize I don’t have the number in front of me.  Direct investment in China isn’t rising  but there is no evidence that there is any real selling of operations  to take capital out.  The vast majority of capital outflows and pressures on the RMB come from Chinese voting with their RMB.  Great piece in the WSJ illustrating this point.  If just 1% of the urban population used their quota, that would result in $369b USD in outflows.  Watch the January February numbers as the spike in international travel and people with obvious opportunities to move capital abroad, will tell us something about their thoughts.

Why We Shouldn’t Overestimate the Probability of a Chinese Financial Crisis

As with most everything I write for BloombergViews, I want to write a little follow up especially as I have already gotten a number of messages asking follow up questions.

  1. I am not saying there will never be a financial or economic crisis. I am saying that a financial crisis will only happen as after all other options have been exhausted and no other options are left.  Beijing will employ every tool possible to prevent some type of major dislocation.
  2. As an example, while we can debate the reasons and wisdom of it, the US was willing to let significant financial institutions go bankrupt. Right now, I think it highly unlikely that Beijing would let any financial institution of any real significance collapse.  They won’t let any firms collapse much less the stock market.  I see little to no evidence that Beijing is willing to even seriously address some of their economic and financial problems despite press releases to the contrary.  Their entire strategy appears to be paper things over and deal with it later.
  3. It cannot be stressed enough that this is not because I think China has chalk full of top flight economic policy makers. It is primarily because if you look simply at the economic indicators, yes, the risk is elevated and increasing.  However, this clearly overlooks the political imperative.  Whether it is propping up every bank or firm just so they don’t have mass layoffs or shutting down the internet to prevent communication about economic problems.  The political calculus about how a government will handle any potential economic or financial dislocation is radically different.  The objectives of Beijing policy makers and other policy makers are very different.
  4. The current leadership is acutely aware of its place in history and the comparisons to the USSR. They are absolutely determined to not suffer the same fate.  Despite talk of delveraging, credit growth continues to expand far more rapidly than GDP growth because quite simply, they are not willing to tolerate any type of official real growth slowdown.  Given their concern over this, it isn’t that China will never see a crisis of some type but rather that they will exhaust every means necessary before they yield to something they just cannot stop.

Given everything that is happening in the Chinese markets, I want to hit a couple of major points

  1. One of the things that you cannot quantify, though I am sure you could but I’ve never seen it done, is the enormity of the psychological weight attached within China appreciating and being fixed to the US dollar. Some have tried to point out that against a basket of trade weighted currencies, the RMB is essentially flat.  Psychologically within China, that is completely irrelevant.  Chinese firms and people have been taught for a long time about the stability of the RMB because it is fixed to the USD.  Even if there is good economic logic to the basket argument, you are essentially telling 1.3 billion people there is no Easter Bunny, Santa Claus is a fraud, and they don’t get any candy.  This is going to cause significant worry and concern.  A few weeks after the August devaluation, I talked with a Chinese friend and asked him what he was up to and without missing a beat replied “getting all my money out of China.”  PBOC for a long time had absolute confidence of people, today, they do not anymore.
  2. There is somewhat of a debate about whether the RMB is witnessing a devaluation or a depreciation. Devaluation being an official lowering, depreciation being market driven.  I would personally call it a “devreciation” or “depaluation”.  What we are witnessing is effectively two sides of the same coin.  The market is clearly pushing the RMB lower as capital flees China.  That is completely and entirely true.  However, nor is the RMB value established by the market.  The daily PBOC fix has become much less correlated to the previous days close since December 1.  The PBOC is spending large amounts of USD, more than $100 billion in December, to support the RMB. What country spends almost $4 billion USD a day propping up the price of something if it is strictly a market driven price?  The value of the RMB is clearly not set by the market.  If anyone believe this is a market driven depreciation solely, ask yourself what would the value of the RMB be if it was solely market driven tomorrow and the PBOC stopped spending USD?  In other words, if CCTV announces on the 8 o’clock news the RMB will be freely tradable beginning at 9:30 tomorrow morning, what is the new value? 7.5 or higher would be a good place to start.  What my take would be is this: like with the stock market or other markets, Beijing is happy to allow the market to move when it moves in Beijing’s direction.  The market wants to push the RMB lower and Beijing will release some press releases saying “no, don’t, stop. Everything is awesome.” Then set the fix lower.  They tap the breaks and set the fix flat, regardless of the market prices as HSBC pointed out, just to keep traders on their toes and hopefully prevent what they hope will be a gradual landing from turning into a 25% break.  Clearly isn’t strict market movement, but nor is Beijing letting market do what it wants.  Hence, depaluation.
  3. Inflation data is both PPI and CPI data is bogus. More on the specific later this week.

China Kicks Off 2016 in a Big Way

So while waiting in the airport to fly back to Shenzhen my Twitter feed was going crazy as the RMB and Chinese stock markets decided it had been a while since they had a proper freak out.  So let’s get back into things and tell you what I’m going to do with the blog in 2016.

  1. The PMI data releases and concerns about GDP growth might be on people’s mouth but that has nothing to do with what caused the past two days drop in the stock market. Like many recent violent up and downs, I don’t think you can pinpoint one factor.  However, if I would point to one culprit, I would focus instead on the easing of lockup period from summer buying to prop the stock market.  Now let me emphasize, that is just speculation, but that is a much more likely culprit than people all of a sudden waking up and seeing poor PMI data.
  2. Despite so much focus on the decline in margin lending, as I have repeatedly noted, most of the buying over the summer to prop up the market was done with debt financed capital. Remember, the actual amount of equity capital used to buy equities was pretty small.  Most of the capital came from commercial banks, which I still haven’t heard how they are accounting for this in their risk capital weighting, or from the PBOC lending directly to firms.  One contact actually told me at the time that the “loans” were no obligation loans.  Meaning, the public was essentially bearing all the risk.  There are a couple reasons this matter.  First, not that there are lots of great investment projects in China but this is tying up liquidity.  Should come as no surprise that the PBOC began pumping back in liquidity earlier this week.  Second, leverage is being created upon leverage.  As Michael Pettis notes, this is like a thousand central banks creating money.  Third, this increases the correlation between assets and risky assets at that.  The more this goes on, the more the debt markets become correlated with the equity markets increasing the risks of a disorderly unwinding.  Fourth, China finds itself in a difficult position in that it needs equity capital to buy equities but international investors won’t touch the stuff and the only people propping up the market are the public institutions with debt capital.  China can NOT deleverage and keep the stock market up. Period.
  3. The PBOC is in a difficult position of trying to let the RMB depreciate either by steering it that way or letting the market move it that way but without letting the drift become a route. Patrick McGee of the FT who is as smart as they come has a great short piece about how the PBOC is managing the RMB. Now I actually have some minor disagreement with his interpretation, but I want to emphasize, this is a case where reasonable people can have reasonable disagreements.  Noting that the market price of RMB actually increased yesterday and why the PBOC lowered the RMB fix0.2%, he cautions not to read too much into a one day data point.  Completely fair point.  I actually interpret this slightly differently.  For the past few weeks, the PBOC has been setting the RMB fix 0.2% lower daily, following the market which would end the previous day even lower the 0.2%.  The PBOC would then set the fix 0.2% lower, until today when it was still set 0.2% lower even though the market was higher.  Here is how I would interpret this, though I want to emphasize this, I see and understand where he is coming from.  The PBOC was the RMB to glide lower very softly but they also likely have some type of target they want to get to.  As with virtually all Beijing economic and financial policy, they are content to let the market play the dominant role if, and this is a big if, if the market does what Beijing wants it to do.  When the stock market goes up, Beijing is happy to let the market play a dominant role. When the market goes down, Beijing wants to step in and stop the market.  Consequently, when the market increased the price of the RMB that went against Beijing policy designs, they decided to keep the relative downward trend in the RMB price.  A major belief of mine is that you cannot believe the Beijing press releases but have to watch what they do.  The PBOC may say they want the market to play a greater role and I believe that with the caveat that it is true when the result is one Beijing wants.  However, anytime Beijing sees a result in the market they do not like, they will swiftly, adjust it.
  4. One of the things that amazes me is just how dependent on Beijing even smart people become to direct the state of the economy. China is in the middle of truly epic and historical asset price bubbles across essentially every asset class.  Real estate, stocks, and bonds are all wildly over priced.  Why I mention this is that so many people both Chinese and foreign essentially buy into the concept that that the laws of economics and finance do not apply to Beijing and as long as Beijing says it won’t be, it will never come to pass.  The price of assets and imbalances are essentially ignored because well, Beijing will handle it.  Anyone that points out the emperor has no clothes or that assets are over valued is called a doomsayer and not a true believer.  Now I personally think the risk of a Chinese financial crisis is low, for very technical reasons, but I have no doubt that assets are wildly overvalued and will correct at some point.  I have no doubt that the economy is in incredibly poor shape.  I have no doubt that finances throughout China are highly stressed.  There are very few things I think in economics and finance qualify as absolute laws.  One of them is this: if something cannot go on forever, it will eventually stop.
  5. After a break over the holidays with some time to refresh, I have come up with some new ideas to keep the blog fresh and interesting and more than anything, keep my interest. I still plan to do some granular detailed data work, but I also want to expand into writing about some bigger picture issues.  By that I mean this: I originally started writing this blog about China to try and educate because I generally thought the level of knowledge of the Chinese economy was quite poor.  I started it almost to try and educate.  Now I feel some of the big picture data issue battles have been won.  People no longer accept Chinese GDP data, in fact everyone takes it pretty much as art.  What I can’t figure out are who are these people on surveys that still believe Chinese GDP data.  I know most everyone that should be surveyed and no one believes it.  People that know very little about China now know not to trust.  However, there are more big picture issues that people don’t understand about how the Chinese economy works so rather than trying to focus so heavily on data and empirics, I’m going to include some broader issues.  As an example, one issue that I plan to write about soon as the importance of seasonality when looking at Chinese data.  By that I mean, people are talking about the Chinese economy stabilizing in December but that so obviously forget that this mostly likely is nothing more than the pre-Chinese New Year bump as companies stock pile for the one month shut down.  I’ll get into questions like that in more detail.  The basic idea is simply trying to help people understand the Chinese economy better, but if there are questions you might want answered, please feel free to email.  Happy New Year.