Little Treat Before Tomorrow’s Chinese PMI’s

So I do some ongoing side work for investment clients interested in getting more technical information on the Chinese economy.  I don’t post much of it here for numbers of reasons but definitely draw inspiration from some of that work and do use some of what I do as blog posts.  From time to time, when the mood strikes me, I may drop some of this research on to the blog for the more data interested reader.  I should emphasize, I won’t be doing this on a regular basis.

I have developed some data indicators that will come from more high frequency and granular points than the more opinion like poll like nature of the PMIs.  This report uses actual operating data from actual Chinese industries that is as current as a couple days ago.

Based upon the data I’m seeing, I think there is a high probability we will see at least a stabilization in PMI’s and most likely an uptick in PMI’s.  There has been a pretty clear increase in operating rates and capacity utilization across Chinese industry from basic PTA straight through to heavy sectors like steel and coal.  Whether or not this will be sustained or whether this is more of a post-Chinese New Year bump, remains to be seen but the evidence is pretty clear that we should expect to see positive PMI numbers tomorrow.

Couple quick notes, this data is compiled at a variety of intervals and in some cases daily but is quite recent.  Furthermore, it is compiled by industry groups or companies and shows much greater variance (read: it isn’t a straight line like official data) so even if it is not perfectly accurate it should give us a much better idea about the direction of industry even if the levels may not be perfectly accurate.

Most Chinese industry remains at very low rates of operation.  If most industrial investments require operating rates upwards of 80% to be profitable due to the large capital costs, there is almost no specific industry that would be considered profitable.  There is simply massive over capacity all throughout Chinese industry.

This uptick in activity seems to correlate with other evidence of a quiet stimulus and growth in credit.  That is not a long term positive but this seems to be what is likely driving this uptick in operations.

I am skeptical this will be a sustained increase and is more likely due to season factors of returning to work and the stimulus but as my kids remind me: I have been wrong before.

You can find the file here.

Some Stories and Things to Read on the Chinese Economy

Having lived in China for almost seven years, I started blogging about China I believe about 4-5 years ago because what I was reading in the popular press was just not representative of what I was seeing on the ground.  There were too many important details that were left out.

I actually believe today that the level of understanding on China among interested people, still has a ways to go, but is actually a lot higher than it is given credit for.  I still see some people go on major outlets and talk about the Chinese economy with little more than an appreciation for General Tso’s chicken as qualifications, but I think the frequency of this type of “expertise” is falling relatively rapidly.

One of the primary dangers in trying to throw your arms around the Chinese economy is becoming too laser focused.  The most obvious example is that most foreigners tend to live in Beijing, Shanghai, and Shenzhen and use that as their window on China.  Those three municipalities have 47 million residents, which is a lot but when placed against the backdrop of a country of 1.3 billion that amounts to only 3.6% of China’s population.  Just as everyone knows that New York City and San Francisco do not make the United States, it is important to understand the Chinese economy outside these cities.  Whenever you see a graph showing housing prices in tier one cities like Beijing, Shanghai, and Shenzhen just remember how small a percentage of the country and even urban areas they really are.

As a professor and data junkie, I also think it is vitally important to add perspective by talking to as many people as possible about what is going on inside the Chinese economy. Both of these points were brought home to me yesterday by a conversation with a businessman friend of mine recently who regularly travels around China.  Travelling even less than an hour outside major cities like Shenzhen, you feel like you can step back in time and China is still a developing economy.

He relayed a story to me about a small town he had recently been to with about 250,000 people that had a not insignificant “international” airport and was preparing for high speed rail station.  However, his final destination was a town of about 75,000 a little further up the road which also had an “international” airport that was actually larger than actual town. He says if you look the town up on Google Maps, the runway is longer than the city itself.

He proceeded to relay the following story after questioning how on earth all this is being paid for or will pay for itself.  One of the local bigwigs in the city of 75,000 in this poor part of China where subsistence farming was still common would drive around town in a new Bentley was also a major construction boss and linked to the government (I didn’t ask details).  After securing money to install concrete lined rain ditches all over town, hence the new Bentley, during his last trip to this town my friend saw workmen jack hammering holes into the drainage ditches.  Puzzled by this, he asked what the problem was with the ditch.  Come to find out, there is no problem at all.  However, by destroying what was just built is the surest way to get money to build it again.  This nearly matches the old adage about increasing GDP simply by digging holes to refill them over and over again.

My friend, a smart guy who has held senior business positions at major firms, looks at me and says two things of note.  First, imagine this problem multiplied by 1.3 billion.  I forget which Chinese leader said it, but any small problem multiplied by 1.3 billion is a big problem.  What is worse is that these are not small problems.  Second, how does this not end in a fireball?  This is someone that has worked in China for a number of years with years of senior business experience.  As he pointed out, cities are building massive airports for a few flights a day with nearby cities getting airports and high speed rail stations everywhere.  He took his family on vacation on a high speed rail to a popular destination for a price that would much too small to cover the costs.  You can only continue to lend so much money out for unprofitable projects before you hit a limit.

Carmen Reinhart has a great piece on China’s Incompatible Goals about the impact of debt.  Too many people have read her previous work has mechanistically predicting either crises or growth slowdowns.  I think this is a serious misreading of what she and others have found about debt.  I would recommend reading this piece about how economic slowdowns with calls for monetary stimulus frequently place central banks in positions to allow greater credit growth precisely at moments when bad loans are rising worsening the eventual outcome.  China will find it difficult to run accommodative monetary policy and maintain a stable exchange rate.  The reason this matters is simple: “banking sector problems have regularly set the stage for currency crashes.”  Though I think a financial crisis in China is a low probability outcome, the scenario that scares me is a credit and currency crisis combining forces.

Eric Burroughs also has a good post on what we know about the bad debt in China making a point that many overlook: “what is private sector vs. public sector debt almost doesn’t matter. The state’s hand is everywhere.”  Too many, primary foreigners and financial analysts, try to make fine distinctions about debt in China.  To onshore investors, there is almost no distinction for most investments.  Holding an SOE bond is considered by investors in China as almost equivalent to holding a Beijing bond.  Think this is a small, irrelevant point?  Junk local government debt is being priced in some cases better than sovereign and many SOE’s enjoy similar pricing as onshore investors believe these companies are equivalent to Beijing.  Why does this matter?  Beijing will have a hard time credibility wise distancing itself from these companies as they go bust.  Before I get messages talking about increasing defaults, note that virtually every default has received some form of a quasi-state led bailout.  As is my belief, Beijing will attempt to keep bailing out companies as long as possible because losing credibility is the bigger risk than financial losses.

Finally, the Financial Times has produced a great video on “The End of the Chinese Miracle”.


This is a great piece that combines on the ground reporting with solid academic references about the big pictures structural drivers at play here.  In addition to the significant temporal headwinds like rising debt and NPL levels, there are major structural issues like an aging population and falling urban migration.

Probably what I find most amazing in many of the pieces I have cited is how much the discussion on China has shifted.  Even among more bullish commentators, the talk is no longer about the poor Chinese economy but rather arguing that China will not face some type of financial crisis or hard landing.  The human cost associated with a hard landing or financial crisis would be enormous, but it is clear even Beijing is increasingly worried about the economy and it is not getting resolved any time soon.



Thoughts about Chinese GDP, M2, and Why it Matters

  1. For all the hand wringing about GDP, which virtually everyone at this point recognizes has enormous flaws, it is important to understand why it matters and how to place it in the proper context. There are a couple of reasons that it matters but today we are only going to deal with one and that is the fact that GDP is used as the basis for many comparisons that we use to understand the economy.  For instance, recently SoberLook pointed out the rapid increase in Chinese M2 while Simon Rabinovitch of The Economist noted that the SoberLook view point omits economic growth.  Simon argues that if we correct for economic growth, then Chinese money supply nearly mirrors US M2 growth.  Both are excellent points and need to be understood for what they are.
  2. It is very common to use GDP as a basis for a variety of indicators especially cross country comparisons and this is why GDP accuracy is so important. For instance, another common indicator people widely cite is the debt to GDP ratio.  However, what if the GDP is inaccurate for either poor quality statistical work or more nefarious reasons? Due to how indicators like debt to GDP is calculated, this has an enormous impact on our understanding of the Chinese economy.  Let’s use simplified but vaguely accurate numbers to illustrate the point.  Assume that Chinese debt total 20 trillion RMB and the nominal value of GDP is 10 trillion RMB.  We would say that China has a debt to GDP ratio of 200%.  However, let’s assume that China has been fudging GDP figures every year just a little bit for the past decade, not an unrealistic assumption at all, and that nominal GDP is really only 9 trillion RMB.  Now, debt to GDP has jumped from 200% to 222%.  In other words, absolutely nothing has changed other than the value of the denominator but the debt to GDP ratio jumped more than 20%.
  3. If we return to the original point, I think there is strong evidence that GDP has systematically undercounted inflation in about the past decade. I should say, I think current prices indexes like CPI and PPI are relatively close to accurate.  For instance, from my own research, the CPI urban cost of housing increased only 6% from 2000 to 2011.  Let me emphasize that is not 6% annually but total.  Even if we extend this forward, we would only be in the low teens for housing CPI increase between 2000 and 2015.  This and other evidence implies that Chinese statistics bureau were smoothing (read hiding) inflation over the past decade something that Emi Nakamura and Jon Steinsson have also shown.  This gets us back to the SoberLook and Rabinovitch comments on money and GDP growth.  If we take the GDP as perfectly accurate, then we would have to believe that Chinese money growth is not necessarily excessive.  However, if we make even small adjustments to GDP, again not unreasonable based upon all available evidence, many of these numbers jump enormously.
  4. The evidence is everywhere that money supply and the follow up lending has grown well in excessive for GDP growth. Virtually every market you could name shows serious signs of froth with the proverbial giant ball of money just rolling between asset classes.  The rapid growth of the entire financial services sector that places it (as a % of GDP….notice the base) only comparable to countries like Luxembourg, Singapore, Hong Kong, or the UK which have outsized financial services sector to serve a broad international client base, something which is definitely not true of China.  These are all indicators that liquidity, money, and financing has far outpaced real economic activity.  A tight money environment does not produce the type of over capacity, loan growth, and asset prices we currently witness in the Chinese economy.
  5. Too many people when considering these questions start from the proposition that Chinese data is infallible and has to be falsified. Though I believe it is very fallible (bias alert though you likely knew that), I am contending we do not even need to falsify the data to have a better idea about what is really happening with the data and economy.  Think of it this way.  Assume I am a medical doctor and a patient comes to me who is obese.  It is medically possible that the patient suffers from a medical condition that causes their obesity but that is far from the highest probability reason.  Rather than saying what is far away the highest probability reason behind the economic outcomes we are witnessing, some still try to argue for extremely low probability medical reasons.   We should look first at outcomes rather than beginning with “infallible” data.
  6. There are many many reasons this matters that have already mattered but let me focus on one. Money growth puts downward pressure on the currency.  In fact, we are seeing this exact process playing out in China.  Bond prices for junk local government debt is trading at high quality sovereign prices, real estate has rental yields of 1%, capacity throughout much of Chinese industry is at 50%, and let’s not even go down the Alice in Wonderland rabbit hole that is the stock market.  What are Chinese investors going to do with their money?  Try and move it out to seek better returns elsewhere and that is exactly what they are doing.  Again, whether you believe the GDP and money numbers is entirely up to you, as you know my thoughts on the matter, but even if you do look at the outcomes supposed associated with nominal GDP.  Is a rare medical condition causing morbid asset obesity and outflows we are witnessing? Possible yes but likely no.  What is much much more likely is simply that Chinese money growth as far outpaced GDP growth which drives up asset prices and pushes money to leave.

Why is Reform So Hard in China?

This is my usual follow up to my BloombergViews piece on why is reform in China so hard?  As usual start there before coming here to get more detail or analysis.

One of the most common mistakes of even seasoned China watchers is to confuse the announcement with actual change.  This definitely does not mean a number of things but too many times, people equate the announcement with fait accompli due to the perception of government announcements as commands handed down by God.

The Chinese make an analogy that China is like a duck on a pond.  Above the water, everything is peaceful and serene leading the outside observer to believe there is nothing interesting happening or that everyone is falling into line.  Beneath the surface as the duck swims the water is in constant turbulent chaos as the duck swims in a variety of directions.

In fact, many of the so called reforms like push to enforce the rule of law and corruption crackdown, leaving aside the blatantly political nature of these reforms, actually have some very real grounding in governance.  By that I mean, China is such a hierarchical society and how an organization is so dependent on the leader that enforcing policy or laws is in reality a very difficult proposition. If a leader does not want to follow a rule or law because of a specific situation or they simply do not want to, they did not.  Consequently, the push to enforce the rule of law can be seen as a response to this inability to enforce policy and laws handed down by Beijing.

If we get back to the current state of affairs, we need to place the intentions of Beijing against this larger back drop. While I have been critical of Beijing and their policy making, I think it is important to provide some important context.  Economists can always argue about how big or small numbers in policy proposals should be, but especially if we look at the current state of China, I do not think even among senior Chinese policy makers that there is a lot of dispute about the basic problems.  I will even go one step further saying we can even accept the numbers Beijing has put forth about reform as reasonable and a good starting point.  In other words, let us leave aside debates about the size of proposed reforms.

If we take that as the general starting point, this leaves us with two basic questions.  First, does Beijing (and by extension China) actually want to enact the reforms?  I would strongly caution anyone against offering up an unqualified yes or no.  I think most people see the problems, but I am not personally convinced that Beijing is completely behind the reforms.  I want to emphasize that does not mean they are against the reforms.  For instance, Beijing has a long history of announcing reforms that they intend to mean different things that what most outsiders hear when they hear those words.  As a simple example, what Beijing means by rule of law and what most outside China understand by rule of law are two entirely different things.  My general sense is that Beijing wants the reforms but doesn’t want the tradeoffs/costs/tough decisions that come with reform.  Like a dieter who says he can lost 20 pounds and still keep eating ice cream and brownies, they want to lose weight without the sacrifice.  I think Beijing wants to lose the weight but does not want to give up the brownies.

Second, even if we assume that Beijing was completely and firmly in favor of reform and the tough decisions that would mean, do they have the power/influence/ability/levers to push through reform?  Again, I would caution anyone against giving an unqualified yes or no. I think once you leave Beijing, the picture becomes much more questionable and for many reasons.  For instance, even if we believe that GDP growth is not the dominant factor in promotions, even now you will not get promoted in China as a banker, politician, or bureaucrat by shutting down low capacity plants.  You will not get promoted by doing things that cause problems or rock the boat.  Furthermore, however perverse, many local governments are heavily dependent on a very small number of industries for most of their revenue.  Consequently, even if the firm has to borrow even more money to stay in business to pay the tax bill, the local governments incentive is to prop up the firm even longer so that tax revenue can continue to flow.  As local governments control about 85% of all public spending in China, reform will stem from policy execution by the local government and not Beijing press releases.  Given that one of the driving themes of political reform is to force the Party, cadres, and governments to follow Beijing edicts, that should give you some idea how well Beijing feels the provinces are doing in getting on board the reform train.  There are already reports of provinces pushing back against the policy initiatives of Beijing.  Again, the primary problem is that while most people recognize the problems, everyone wants someone else to make the sacrifice.  In short, I think even if Beijing is completely behind the reform plans, which I would say yes with the qualification that they do not want any pain to accompany the reform, I do not think you can expect a high probability of success of the reform plans out in the provinces.

I believe China needs significant reform but I would be willing to accept the Beijing starting point for reform if I believed that Beijing was firmly behind the reform push and would accept the difficult choices that needed to be made and that the reforms had a high probability of success.  I do not currently believe either of those propositions and that more problems will come.

Good & Bad News: 3% Inflation Target Hit and Totally Unreliable

I don’t normally write two blog posts in one day but given the CPI data released today, I wanted to detail in brief why these numbers are so absurd because we can clearly tell these are absurd numbers with no basis in reality.  When I first saw the data on CPI increase to 2.3% I was stunned and when I saw that food was up 7.3% more than twice the change of any month in the past year my mouth hit the floor.  I never rule anything out in China but given the magnitude of the change only a few days after Beijing released a 3% inflation target, I thought it would be wise to just double check some numbers.

Before I explain why, let me give you a little background on China and CPI.  Numerous studies have found large problems with Chinese price data.  Emi Nakamura and Jon Steinsson (PDF) of Columbia found that official price data was much too smooth when compared to how household surveys indicated that households were spending money.  From my own work (PDF), the housing component of Chinese CPI shows that urban housing prices only increased 6% (let me emphasize that it total not annually and not asset price but rather how much more housing costs to obtain) from 2000-2011 and even if we added on 2012-2014 would only slightly raise that number.  There are many many problems with Chinese inflation and CPI data.

These problems have not gone away.  As Nakamura and Steinsson point out, as a country grows richer, they should spend less on food as a percentage of their income.  In simple terms, if you make $1,000 in a year, you might spend 40% of your income on food.  However, if you make $100,000 you would probably only spend say 5%.  This is important because since 2011, China has raised the weight of food in the CPI basket every year from 31.4% to 33.6%. You would be hard pressed to find another country in the world that experiences rapid growth and every year spends a higher percentage of its income on food.

All this is good background but also ties in directly to why we can tell today’s CPI data is nothing short of a fabrication.  With food comprising 33.6% of the CPI basket and food CPI running at 7.3%, this means that food inflation was responsible for 2.45% of the 2.3% CPI rate.  In other words, if you strip out food, inflation was actually -0.15%.

However, that’s not the worst of it.  It gets sooooo much better.  If you look beneath the hood of the CPI basket you will see that actually most food product prices were actually quite small.  Grains were up 0.6%, oils and fats 0.7%, aquatic products 3.5%, milk 0.1%, and beef 0.3%.  Mutton and eggs were down 7.8% and 3.6% respectively.

So what was up enough to account for the food CPI number?  Fresh vegetables and pork, registering increases of 30.6% and 25.4% respectively, were the only products with increases above the average.  At this point, it would be tempting to say that over the Chinese New Year holiday people celebrated with friends and bought the best food so makes sense.

There are only two problems with this theory.  First, do you want to tell me no other food prices went up? The only food people ate more to justify such a shift in prices was pork and fresh vegetables?  Skeptical that they would be such extreme outliers but let us set that aside for a moment. Second, the related data on pork and vegetables tell a radically different story.

Let stop a second and talk about ways to verify Chinese data. A key tenant of mine is to look for numbers that should come close to the number in question.  This does not mean we are looking for a perfect match but numbers that are I the ball park of each other.  Let me give you a simple example. If electricity production declines 10% but industrial consumption goes up 10%, you have to ask what is going on. If electricity production goes up 1% and consumption goes up 2.4%, that’s good enough for me and move on.  For almost any data point, there are many related data points that we can match up that will give us an idea what up and downstream things are doing.

What is interesting is that in reality, fresh vegetable and pork prices appeared to have gone up by roughly the amount indicated.  For instance, the Wholesale Price Index of Qianhai Agricultural Products of Vegetables from February 2015 to February 2016 was up 34%, only slightly more than the official CPI amount for fresh vegetables.  There are a wide variety of prices to choose from on that cover pork and pig prices from conception through to table and they are also roughly in line the 25% increase.

So what’s causing the discrepancy? Bad math.  If we take the official CPI weights for each category and plug them into the price increase of each product for the food category (remember food was responsible for more than 100% of the official CPI or 2.4% of the total 2.3% CPI) equals only 1.41%.  (By this I mean for instance, meat was up 15% and comprises 4.33% of the total CPI basket and repeat for other food categories.) What makes this even worse is that if we remove pork and fresh vegetables, food prices for which we have official basket weights and official inflation numbers shrank slightly at 0.06%.  Given that the CPI basket covers meat, grains, produce, dairy, flavoring and others and the food that we do not have official weights for was flat like the non-pork and fresh vegetable categories, it is very difficult to see where this supposed food inflation came from.  However, as the CPI contribution of pork and fresh vegetables only amount to 1.4%, this means we still need to find an additional 1% from the food category as the implication is, it does not come from the non-food basket.

What is so amazing about this is that inflation statistics in China do not add.  China says non-food inflation in February was 1% and food inflation was 7.3%.  Given a non-food weight of 66.39% and a food weight of 33.61%, this would sum to inflation of 3.12% or more than 0.8% more than the official rate.  In other words, Beijing tops in Communist efficiency has already met the 3% inflation target it set just last Saturday and they exceeded their target.  The only way you can have food inflation of 7.3% with a 34% food weight is to have deflation throughout the rest of the CPI.

However, even then, given the weights of the CPI basket and the price increases in those specific products, the numbers do not add to what Bejing says.  If we take Beijing numbers and assume that non-food need to deflate slightly and pork and fresh vegetables were the only food items that really increased in price, we still can only arrive at inflation around 1.4%.

There simply is no way for the numbers to reconcile. Let me emphasize in closing that everything here is official data and statistics.  The only math used was simple math done in an Excel spreadsheet.  All you have to do is try and do something as simple as add the numbers up to see that they do not add.

Update: I have been told by Alex Frangos of the Wall Street Journal Hong Kong that the NBS reduced the CPI weight of food by 3.4% by my calculation to 30.2% of the CPI basket.  I have not seen that and given that this would lower the combination of non-food and food inflation rates to 2.9%.  Given that I was working with 2016 component weights for products like meat or pork, this does not alter the other parts of the analysis.

Collection of Thoughts on Chinese Economy

  1. Simon Cox and others, I apologize as I don’t know the commenters only via email address, have raised some issues about my previous post about my posts on trade balance, payment flows, and growth. Scroll through the comments sections here and here. To briefly summarize, the basic objection is that the payment discrepancy does not change the “actual/true” trade surplus that China generates and as Simon points out this would still generate Chinese savings by holding assets abroad.  I am trying to faithfully represent their views as they are reasoned and logical so my apologies if that doesn’t accurately capture their views in one sentence.  I disagree with part of this and agree with part of this though with caveats.
  2. When a country runs a nominal trade surplus, especially one as large as China’s in 2015, there are certain things that happen. For instance, the surplus financial inflow creates additional liquidity, demand, wages are pushed up, the currency appreciates, and other spillover effects.  To be very kind absolutely none of these things are happening in China.  In fact, the exact opposite is happening.  If China was running a trade surplus, then the PBOC would have to be pushing the RMB down not keep it from dropping.  This brings us back to the difference between actual/true, real, and nominal growth.  China may have actual/true official growth of 6.9% if we consider the trade surplus actual/true.  However, based upon the financial flows that accompany a trade surplus and the spillover effects, we absolutely cannot say that China has a nominal/cash trade surplus and this has significant implications for what we see in the economy.  One way to think about this is   an accounting trick companies frequently use to boost their profits.  A common trick of companies the world over if they need a quarterly profit boost is write up the value of some of the assets on their books.  There has been no real change to the company other than an accounting trick.  That is essentially what is happening here.  The domestic cash flow, both for firms and surplus cash flow into China, simply is not present to associate with a trade surplus equal to 5.5% of GDP and the accompanying GDP growth.  What is happening is essentially an accounting trick. You can’t say growth exists but that none of the positive things that go with it do not.
  3. Simon raises the very real issue about the capital flight being savings, which whether it is kept in China or the around the world, boosts national wealth and income. From a national accounting perspective, he is totally correct.  If it is a simple matter of portfolio diversification, then the savings relationship in national income accounting still holds and growth goes up.  However, for many reasons I think the story is more complicated and not as positive.  The primary reason is that money leaving China is not a simple story of portfolio diversification.  Foreign assets owned by China from September 2014 to September 2015 are essentially unchanged.  In a year when nearly $1 trillion left China via fraudulent payments, official assets are unchanged.  This matters because the money leaving China is designed to stay off the grid, underground, out of sight, unknown to Chinese authorities.  Why does this matter? If it was a simple matter of portfolio diversification, like companies want to expand abroad, we would expect it to show up in official statistics even in China.  However, it is not a simple matter of portfolio diversification.  The intent behind this money, I strongly suspect and related data supports the idea, is permanent expatriation of capital out of China.  By that I mean, this money is leaving China and never coming back.  Wealth managers survey of clients for a number of years have found that wealthy clients are actively looking to leave China.  The number one sending country of immigrants into the United States is now China and it would not be surprising if other countries like Australia, New Zealand, Canada, and the UK (just to name a few) were not experiencing similar influxes.  The Chinese immigrants into these countries however are not the poor, hungry immigrants that arrived in Ellis Island but families buying businesses to obtain visas or attend graduate schools that lead to permanent residency.  They bring with them large amounts of capital that is coming from China.  According to some data, 90% of Chinese students that go to the United States for either college or graduate school, stay there never to come back except for vacation or to visit their parents.  Stories of cities seeing real estate prices sky rocket and Chinese become a primary language are common from Sydney to Vancouver and London but more importantly, the visas and residence permits that come with them.  Anecdotally, everyone in China above a certain income threshold has either plans to ultimately leave or contingency/fall back plans in case they need to leave.  Getting back to the point about how to interpret this financial flow, if it was pure portfolio diversification, there would be a case to incorporate some percentage of this outflow into national accounting based upon GDP.  However, based upon the illicit method of its departure, the accompanying asset purchases, and simultaneous emigration I do not think you can say this is standard portfolio diversification.  A major portion of the money leaving China that we are discussing here, the nearly $1 trillion in fraudulent payments, is not for domestic business expansion but rather permanent or quasi-permanent capital flight. Real portfolio diversification has no reason to use this channel so at the least this needs to be called a hedging strategy and much of it permanent capital flight.  The other thing is that despite people just waking up to this capital flight, this started in 2012 and has been growing every year.  It did not reach a critical mass until about 18 months ago, but this is not a new phenomenon.
  4. Capital outflows are a long term phenomenon. The one game winning streak put together in February is little more than a reprieve.  What reason does capital have to stay in China or flood in from abroad?  To everyone who hangs on what a 0.1% means in China, learn the concept of long term trend and statistical randomness around a trend.  The long term trend is clear and hasn’t changed.
  5. It is amazing how the conversation about China has changed. There almost is no such thing as a China bull anymore, there is only bulls trying say “it isn’t that bad”.  Their biggest argument now is that it isn’t as bad as Kyle Bass makes it sound, like that is a ringing endorsement.  The big key going forward is I simply don’t see what the signs for optimism are.  Fiscal stimulus? Great, more debt and things people aren’t going to use. Monetary easing? Great, stoke capital outflows, break the RMB peg, and deplete FX reserves. VC funds to drive entrepreneurship? Great, cause throwing vast sums of money with little oversight never created problems and definitely not like stimulus projects in China.  There are sectors growing in China and doing well but for the economy as a whole? No.  Rebalancing in China is a scam much like the rule of law or human rights.
  6. Everyone who essentially hangs their hopes for an improved Chinese economy on the policy making brilliance of Beijing: please up your meds. The problem is simple. It was easy to seem brilliant when you had an undervalued asset (fixed currency) and people bought into your story.  Now that people have wised up and are asking difficult questions, Beijing has no clue what to do or handle the questions.  Now that they actually have to make decisions and trade offs, the reality has come out.  Like they always say about managers, it is easy to seem brilliant during the good times, but you prove your worth in the bad times.  We are getting an answer about Beijing’s ability and they are not doing well.

Follow Up to Whether China has a Trade Surplus

I wanted to write a follow up to my previous post about whether China has a trade surplus because I received a number of very good questions and I felt there were some confusion about the implications of what I was trying to say.  Let me emphasize that in some areas here my thinking is still fluid and there are good arguments are both sides, so I won’t say that my thinking is final by any means.

  1. This is not misinvoicing. This is related to misinvoicing in that it achieves the same ultimate objective of disguising capital flows but it is not misinvoicing.  Misinvoicing is the process where a $100 export from Hong Kong to China turns into a customs reported $200 Chinese import from Hong Kong.  This is a mis-payment scheme.  In this case, Hong Kong reports a $100 export to China, China reports a $100 import from Hong Kong.  However, now when the Chinese importer goes to the bank to pay the Hong Kong exporter, the importer tells the bank to pay $200 rather than the $100 reported to Customs.  This may happen by the importer presenting forged Customs documentation to the bank or by bribing bank officials.  This may seem like a semantical difference but it is important to understand the difference and I will explain why the difference matters a little later.
  2. There has been some confusion about whether I am arguing whether this means China has a real trade surplus or whether imports are actually higher than reported. I think it is highly unlikely that that other countries are exporting to China $2.7 trillion worth of goods but Chinese customs is only reporting $1.7.  The reason is simple: that discrepancy would easily be caught by comparing Hong Kong/Australian/German/Japanese/US exports to China and Chinese imports of Hong Kong/Australian/German/Japanese/US products.  We do not see that discrepancy.  This means that that the value of physical goods imported in China is most likely $1.5-1.7 trillion.  I have dealt with Chinese data and nuances long enough to never rule anything out, however, it seems unlikely that China is actually importing $2.7 trillion worth of goods.
  3. However, we need to be careful about immediately jumping to the conclusion then that China has a real trade surplus. Though it may be fair that the market value of the goods trade would have resulted in a surplus, net exports for national accounting purposes are not based upon physical output or a market value but essentially on a cash basis.  For instance, if physical oil exports rise 10% from 100 to 110 but the price of oil drops from $100 to $50 then the cash value of exports drops from $10,000 to $5,500 for a 45% drop. The “real” increase in export shipments is irrelevant in some ways.  It helps inform our understanding of the whole but for national income accounting with regards to net exports (X-M) is irrelevant.  In real terms yes I think it is fair to say continues to have a trade surplus, but in very real ways this does not mean anything as cash is how trade balances are calculated and pass through to GDP growth.  In other words, people no longer trade seashells but cash and on a cash basis, China does not have a trade surplus.
  4. My thinking on what this means for GDP growth is more fluid and I would appreciate comments from someone who is a true national income accounting expert. I lean towards the argument that this has direct and negative pass through effect on the GDP growth and let me explain how.  In nominal terms, Chinese official data says GDP was 67.67 trillion RMB at the end of 2015 compared to 63.59 trillion RMB in 2014 for total nominal growth 4.08 trillion RMB.  Now the nominal RMB Customs reported trade surplus was 3.69 trillion RMB.  Now if reverse the Customs reported trade surplus and account for the trade balance on a cash basis including the service deficit, this turns into a trade in goods and services (emphasis not current account) deficit of 226 billion RMB.  This means that nominal growth when using the cash basis net export trade deficit turns into nominal growth of only 168 billion RMB or less than 0.3% in 2015.  I should strongly emphasize that I am implicitly assuming that China is counting net exports as equal to the trade balance reported at customs as part of the old equation Y = C + I + G + NX. Now here is the primary reason I believe this has a negative impact on growth and that growth should be reported, and again my thinking is fluid here.  Running a trade surplus implies that there is surplus cash flowing into the economy.  This cash is creating additional savings, investment, jobs, and demand throughout the economy.  However, because there is no surplus cash there is no additional savings, investment, jobs, and demand.  In fact, we see the impact pretty clearly.  When trade surpluses were high and the PBOC was sterilizing, China was awash with cash and investment was booming.  Now Customs reported trade surpluses are at record highs, but liquidity is tight and rather than sterilizing the PBOC is propping up the RMB.  Furthermore, as previous noted, because NX are always thought of on a cash/nominal basis, it seems that the impact on growth needs to be considered on a cash/nominal basis rather than a real basis.  Before I published my original post, I consulted a couple of very knowledgeable people about some of the implications like this and they all came back to me and said they really didn’t know and would have to think about it.  I say this definitely not to blame anyone I consulted as all errors are mine, but rather to note that this is a thorny issue about the implications and that this is what I currently think about the implications for growth but I am open to changing my mind and these are not deeply held convictions.
  5. This is also why capital controls would not work. For all the chatter about China imposing capital controls, it is obvious they simply wouldn’t work.  Let me explain.  Impose the most draconian capital controls you could imagine and money would still flood out of China via the free currency transactions via the current account.  I can already hear people saying, just tighten capital flows on the current account side.  The only way that could be achieved is by bringing goods and services flows into and out of China to a near standstill.  Think I am exaggerating?  Imagine customs inspectors having to count every physical unit into and out of China; establish an independent market price for every good and service into and out of China; verify the agreement between importer and exporter is at the independent market price; follow the importer exporter to the bank to verify that the payment or receipt perfectly matches the customs approved value.  In other words, at every possible step for every unit, everything would have to be verified and approved by the government.  This would necessitate bringing goods and services trade into and out of China to a complete standstill.
  6. Finally, I think there are a couple of things driving this shift in flows. First, China opened up the current account in 2012 to relatively free currency transactions and the data shows this discrepancy began growing rapidly in 2012.  That should not come as any surprise.  Second, in late 2012 and early 2013, China had a power hand over and it is likely that a not insignificant part of this outflow is driven by security concerns.  Chinese brokerages who survey their clients regularly find that high net worth individuals are concerned about a variety of issues with large numbers of them looking to leave China.  Third, investment returns in China have been declining for about 18 months.  For instance, 10 year local government Chinese debt is lower yielding than good quality US corporate debt.  Given the junk/near junk status of local government offerings, the risk return there is easily worth examining closer shall we say.  Fourth, I don’t think this is temporary in the least or about the stop or reverse.  This has been picking up speed since 2012 and shows no sign or reason to stop.  Outward FDI or official capital flows have no reason to use this channel.  This should be thought of as long term or permanent removal of capital from China.  Whether someone is moving from China to Canada or a small to medium size business is expanding elsewhere, most companies have no reason to use this channel.  This is not short term opportunism but rather long term to permanent capital expatriation.  Yet another reason, capital controls are very unlikely to work.
  7. I apologize if I missed any issues as I tried to cover them.