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.

11 thoughts on “Collection of Thoughts on Chinese Economy

  1. Some interesting points but your accusations against Deutsche Bank seem overdone. Their note mentioned the same import over payment issue but came to vastly different conclusions. You were also hardly the first person to highlight the discrepancy between the trade and bank receipts data. This blog post published a few weeks before yours is one example:
    https://concentratedambiguity.wordpress.com/2016/02/01/chinas-hidden-current-account-deficit-invoicing-decisions-and-liquidity-effects-on-ems/
    I also saw the issue being highlighted by some sell side analysts last year.

  2. Professor Balding —

    Thanks again for the wonderfully valuable information and analysis.

    Regarding the Deutsche Bank thing, I just wanted to say that they could plant their name all over analysis about China, put gold seals on it, and have their entire firm genuflecting to it and I would still consider you the best and most authoritative source by far. Given that other people notified you of it in the manner they did, I’m guessing there are a lot of people out there that feel the same way.

    You da man!

    Perhaps a header on all your columns saying something along the lines of “Hey Deutsche Bank, don’t forget to cite me as the source if you use my analysis” might make plagiarism a less appealing course in the future.

  3. Hi Chris, I hope you’ll forgive me for having another crack at correcting you on this point. This is not criticism for its own sake – I’m a long-time fan of your sleuthing (from back in the day when the accounting of THAT SWF was your favourite target…) so please take this as friendly and constructive feedback.

    You are still conflating two very different concepts here, namely: 1) value creation (GDP); and 2) value transfer (capital flows). To use the accounting analogy there is a crucial difference between the flow of assets – an income statement – and the stock of assets – the balance sheet. Let’s take a simple accounting example to flesh it out.

    Company ABChina imports processors from Taiwan to assemble into phones, which it then exports to Taiwan. Say the processor costs $100. When ABC buys a processor the accounting entries are:

    Debit Inventory $100
    Credit Cash $100

    The processor is then “consumed” in manufacturing, resulting in the following entry:

    Debit COGS $100
    Credit Inventory $100

    ABC has consumed $100 of imports and that value is now embedded in cost of goods sold, presumably for profit and thus value creation.

    Now say that ABC makes an “error” one month and pays $120 for a $100 component. The honest & responsible (let’s pretend) management accountant picks this up. How does he account for it?

    Debit Inventory $100
    Debit Prepayment $20
    Credit Cash $120

    Again, when that processor is “consumed” in manufacturing, you get the following entry:

    Debit COGS $100
    Credit Inventory $100

    Same result: import of $100, now embodied in inventory. But, hang on, what’s happened to the residual $20? Well, it’s still an asset on the balance sheet – the supplier still owes $20 to ABC. That $20 has not disappeared or been “consumed”, it REMAINS a financial asset of ABC.

    In terms of GDP, the contribution of net exports to value-add is the value of exports produced less the value of imports consumed. Now, in the example you’ve worked upon, there’s no debate around the value of the exports, so let’s focus on imports. For GDP to be materially lower, as you argue, the value of imports CONSUMED must be the materially larger number, right?

    However, we can assume with a high degree of confidence that imports as CONSUMED by China were the LOWER number, as reported to customs.

    The HIGHER value of PAYMENTS for imports does not reflect CONSUMPTION within China – i.e. a GDP-affecting item – but the transfer of “excess” value out of China for those same consumed imports. As Simon pointed out in his example in the preceding post, the differential in VALUE between what is PAID for imports and what is actually CONSUMED reflects a TRANSFER of value, not the CONSUMPTION of value.

    Why is it not the consumption of value? Because goods have been delivered to China but a greater value has been transferred “out” in payment. This is only an economic loss to China – as you are implicitly arguing – if that over-payment has been “lost” to those making the payment. However, we have very good reason to believe that those over-payments are simply hidden capital outflows. A capital outflow is NOT the consumption of value, but the transfer of value – i.e. it does NOT affect the creation of value, or GDP.

    Now, in this post when you say that,

    “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.“

    …you are confusing issues again. A trade surplus does NOT equal a “a surplus financial inflow”. Why not? Because there are other elements in “financial flows” that can offset a trade surplus.

    For example if a current account surplus is matched by a capital outflow there is no “surplus financial inflow”. In fact, what China is experiencing right now is, effectively, a balance of payments deficit, i.e. a net financial outflow that is necessarily balanced by the running-down of FX reserves. So there is NO inconsistency in what China is experiencing. In fact, it appears that you have identified a key driver in EXPLAINING why China can report such a large current account deficit and still manifest an apparent tightening of monetary conditions. That is, capital is flowing out of the country in such scale as to overwhelm the current account surplus and force the PBOC to intervene to support the value of the CNY by running down FX reserves.

    • 1. Please don’t apologize for continuing to challenge me. Simon is a bright guy that really knows Chinese data and economy. Even when I don’t agree with him I know I need to have a good reasoned answer and you seem the same way. The internet can actually be of value here.
      2. I actually agree with most of what you say. There are two things where I either disagree or am unsure. First, I am pretty sure (though I need to find a national income accounting PDF somewhere to know for sure) that NX is the part of national accounting that is only measured on a cash/nominal basis. This might be the first case where there is a trade “surplus” which is in cash deficit. Definitely not the only financial flow but if the trade surplus (in financial flow terms) is negative that seems to have implications. I think that is a bigger issue to reconcile than simply saying they have an actual surplus and being content. Second, I am not sure if the intent behind the money counts. Sure it’s capital flight but does the real intent count as compared to how it is classified? Third, even if I agree with you on all these points, I don’t think it is clear and there is lots of data to support this, that this capital is leaving China not with the intent of being owned by China (Chinese citizens or firms) in the future but a complete expatriation of capital. Emmigrants from China are taking their money and leaving China. That capital flight clearly does not count as savings if people and capital are leaving never to return. How much of that “savings” via capital flight is permanently gone and should now be registered as capital in Canada etc.? We really need to find a national income accounting specialist. The primary thing is I definitely do not think it is as black and white and I’m not completely sure on these issues.

      • Chris,

        I think we’re all agreed that at the end of the day, we’re talking about a balance of payments deficit to the tune of $300-400 billion in 2015. There are definitely implications of a trade “surplus” being an actual cash deficit, but it’s largely canceled out by the smaller official capital account deficit than would otherwise be the case if Chinese entities didn’t have to resort to the trade payment channel to move money out.

        It’s easy to blame Beijing for the current predicament, but this overstates how much power policymakers of any stripe, in any political system, actually have over large and complex economic systems in which day-to-day activity isn’t micro-manageable from the top. Those who belittle the present central leadership are probably those who thought too much of it previously.

        And it’s not at all that they don’t have a clue what to do about it. They knew what they had to do 10 years ago – they just haven’t been able to get local governments and vested SOE interests to actually do it.

        This is largely because, while it’s true that capital flight has been a long-running phenomenon, it’s also true that the official accounts didn’t turn overall net negative – definitely not by hundreds of billions – until last year. Even in 2014 there were still significant carry trade inflows which supported the currency at times. With the exception of the United States, India, and some others, in fact, it’s hard to think of other countries/regions that have fared better than China lately…and it’s arguable how well the US is doing – Donald Trump wouldn’t be so close to the GOP nomination if our economy were recovering as strongly as the stock market suggests.

        If you take the view – as I do – that China’s problems aren’t separable from the global economy’s as a whole, today’s mess speaks as much to the inflection point that’s been breached in the entire post-Bretton Woods, central bank fiat currency-driven, and specifically “Eurodollar” financialization-fueled monetary system, as it does about specific Chinese problems. This system reached its peak in 2005 or 2006, then declined in 2007 and all but crashed in 2008, only to be rescued by emerging markets led by China from 2009. China hasn’t been the only irrational economic agent by a long shot – nor even the leading one, arguably. Its unbalanced growth model was based on feeding an unbalanced consumption model in the West; that Beijing tried to prolong it these past 7 years well beyond feasibility is more forgivable and understandable if you consider what Western central banks have done in a feverish attempt to bring back the go-go days of the pre-crisis era – with the result that Donald Trump and European neo-fascists have surged in popularity. Both developed and emerging market bubbles have now burst within a decade.

        Like China, the whole world pretty much knows what has to be done to restore economic sense and normality…time is running out though for something to actually be done.

        • I think that is a pretty good summary. The primary reason I rail in the other direction is that if you believe, as you believe and I should note I believe correctly believe, that politicians have much less influence and the global economy is important, then you also have to believe they got really luck early on and didn’t have as much to do with it going up. Too many people want to credit them for the success but argue that they have nothing to do with the downside.

    • 1. Please don’t apologize for continuing to challenge me. Simon is a bright guy that really knows Chinese data and economy. Even when I don’t agree with him I know I need to have a good reasoned answer and you seem the same way. The internet can actually be of value here.
      2. I actually agree with most of what you say. There are two things where I either disagree or am unsure. First, I am pretty sure (though I need to find a national income accounting PDF somewhere to know for sure) that NX is the part of national accounting that is only measured on a cash/nominal basis. This might be the first case where there is a trade “surplus” which is in cash deficit. Definitely not the only financial flow but if the trade surplus (in financial flow terms) is negative that seems to have implications. I think that is a bigger issue to reconcile than simply saying they have an actual surplus and being content. Second, I am not sure if the intent behind the money counts. Sure it’s capital flight but does the real intent count as compared to how it is classified? Third, even if I agree with you on all these points, I don’t think it is clear and there is lots of data to support this, that this capital is leaving China not with the intent of being owned by China (Chinese citizens or firms) in the future but a complete expatriation of capital. Emmigrants from China are taking their money and leaving China. That capital flight clearly does not count as savings if people and capital are leaving never to return. How much of that “savings” via capital flight is permanently gone and should now be registered as capital in Canada etc.? We really need to find a national income accounting specialist. The primary thing is I definitely do not think it is as black and white and I’m not completely sure on these issues.

  4. First of all, I want to add my own voice to those who’ve been following your writings – awesome detective work on this and many other issues.

    But like Fyodor, I’d like to address some of the issues surrounding the trade surplus and GDP, but I want to take another angle.

    A trade surplus does not necessarily have the impact you describe:

    “For instance, the surplus financial inflow creates additional liquidity, demand, wages are pushed up, the currency appreciates, and other spillover effects.”

    Empirically, the effect of a trade surplus on growth is contingent on many other factors – it’s quite common for improvements in the current account to happen with declining economic activity, for example, where a larger trade surplus occurs with a drop in imports. That actually seems to be the case here (going by the customs data). Note also, that trade surpluses are always associated with the export of capital, whether through the public sector (central bank international reserves) or the private sector.

    A surplus on its own says nothing much about the level of growth or economic activity in the domestic economy. The national accounts are a set of identities, not a causal mechanism. This is especially true where a significant portion of international trade is trade in value added (aka part of the global supply chain), where surpluses can be “structural” in nature.

    I think this debate over NX and its contribution to growth, while interesting from a technical perspective, is really beside the point. That capital is leaving, is a much more important consideration than how its doing so. We’re still left with the question of what’s really going on, and what China can or should do about it.

    BTW, here’s a good reference on national accounting: http://www.oecd.org/std/UNA-2014.pdf

    What you’re looking for is under Chapter 5, pg 139-143. A couple of things offhand:

    1. There’s ALWAYS a discrepancy in the customs trade data between exports and imports as reported by different countries. This is because exports are captured FOB, while imports include CIF.

    2. Total imports reported in the national accounts and balance of payments however are adjusted for CIF, which is why it also never tallies with customs data.

    3. For constant price GDP, both exports and imports are adjusted for base year prices in the national accounts i.e. they also never tally with customs data. No, it’s not on a cash basis. GDP at current prices would be closer, but runs up against point 2 above.

    CIF can be significant, especially for trade with geographically distant countries i.e. there would be a bigger CIF component with trade to South America than there would be for trade with ASEAN. By the same token, CIF costs for Hong Kong should be negligible.

    • Thanks for the detailed comment and sorry for not approving it earlier. I don’t actually check it that often probably should. These are very good comments and I will look at that OECD thing as I need to get inside some of the technicals of national income accounting.

  5. BTW, Citi came up with a report last week on the same payment/customs discrepancy you highlighted. No credit given (natch).

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