- In many ways, I really do love China bulls because they keep me sharp and always honing my arguments and digging for new data. They have such tired and poorly thought out arguments about what is really happening. The Chinese economy is such a mess that I do not even need to demonstrate how manipulated the data is, I can just show them basic official statistics. My favorite today is comparing the increase in absolute GDP in 2015 vs. the absolute increase in total social financing or aggregate financing to the real economy. In 2015, nominal GDP was 4.1 trillion RMB higher than nominal GDP in 2014. However, new aggregate financing amounted to 15.4 trillion in RMB. In other words, China invested (spent on projects and rolling over new loans) 15.4 trillion RMB to create 4.1 trillion RMB in new GDP. That is not a good payoff ratio.
- While the idea that commodity trading is driven by trading volumes, one aspect that has received less attention is the fact that there is surprisingly little pick up in real economic activity. Since December, average daily steel output is virtually unchanged. This gets to one of the driving problems with the Chinese growth, which has not changed, is not consumer driven, and is not rebalancing, is that the boost in investment/credit is having less and less impact on real activity. New financing to the economy through March is up 43% over 2015 but even just using the official data, nominal economic activity is up 7.2% in the first quarter. In other words, even as the investment and credit flood gates have been opened, activity is still simply trending downwards.
- A couple of follow up points to the BloombergView piece that focused on Venezuela but could have spent significant time on numerous other countries like Sri Lanka and Mozambique. As usual, start there if you haven’t read it and come over here for additional reading. There are a number of interesting things that I want to double back to. First, maybe the most interesting thing about these episodes is what it reveals about Chinese economic and geo-political strategy. Oil and copper are some of the most widely traded commodities on the planet with almost anyone willing to sell at the right price. Not even China or the US can corner the market in these basic materials. However, China was so insecure that it would be able to obtain the materials necessary to power its economy, it made a long list of bad investments around the planet to lock in these commodities. This reveals an enormous amount about how Beijing approaches markets, globalization, and relationships with other countries. Second, the first wave of overseas Chinese investment made in sovereigns and corporates let’s say between 2010 and 2014 was made primarily in commodities, energy, financials, and real estate with a little dabbling in technology. Whether on a state to state basis or corporate to corporate, there are large amounts of investments that will have to be written down based primarily just on the assets they invested in to secure resources. This also tells us something about the current wave of outward investment from China. The prices Chinese companies are paying almost always appear to based upon very rosy assumptions about prices, growth, synergy (sorry never bad mouth synergy), or other excessively positive assumptions about the future. I think there is a high probability that in a few years a significant portion of the current M&A frenzy will have to be unwound. Third, it is interesting how China is taking its investment and lending standards global. China basically applied its own internal lending standards (i.e. throw money around like a drunk rock star and hope you’re still alive the next morning) and is now running into real problems because unlike lending inside China it actually wants to get repaid on its foreign loans. However, the reasons it made those loans and how it managed the risk are simply not very good. Given its political clout, there is a good chance its banks will get made whole especially from borrowers like Venezuela, at least in the near term, however the longer term outlook as much murkier. People linked to the Venezuelan legislature has already said it may simply repudiate any debts negotiated with China under some circumstances. Making bad loans to friends inside China, where they can be rolled over indefinitely, may work. However, that doesn’t work when you depend on a specific politician or you expect actual repayment. Fourth, if this is what we see happening on international loans, image how bad the problems are inside of China given the enormity of the credit bubble. I believe we haven’t even begun to scratch the surface of lending problems in China.
I do not normally address other work primarily because a lot of Chinese work is higher quality than it used to be and I will not respond to everyone I disagree with. However, sometimes there are stimulating pieces that catch my attention and Tom Orlik of Bloomberg wrote a good piece on why China would be well advised to proceed very cautiously on market reforms.
Now before anyone expects a pro or anti-free market rant, as I always stress, these decisions or situations, especially with China, involve a lot more nuance and subtly than simple binary decisions. While I do have a general free market bias, I recognize the short comings and limitations of the market but consider it like Churchill considered democracy: the worst possible system except for all others.
Let us take a simple starting point. If the PBOC announces before market opening that the RMB is now freely convertible and that people can do whatever they want with the RMB, I think that using a conservative estimate the RMB would fall 20%, creating significant stress in both China and the rest of the world. (Side note: for everyone who says the RMB is fairly valued, ask them what it would trade at if it was allowed to float: then listen to the equivocation and excuses start.)
The problem is that both free and anti market people forget that economics is, among other things, the study of tradeoffs. Raising tariffs may protect jobs but what is the tradeoff in both direct financial cost and longer term economic organization and moral hazard costs? Consequently, there is almost no point in time on any analysis that we couldn’t claim that increased marketization will raise risks. Higher risk with increased marketization will almost always be true.
Even looking at this from a classical risk return payoff framework it will be true: if capitalism has generally proven to have higher growth rates that implies it is also assuming higher levels of risk. The United States had about 50,000 corporate bankruptcies in 2015 while China had about 1,000, there is on a very basic level a higher risk of overseeing a corporate bankruptcy in the United States than in China.
However, the debate about the role of the market turns on much more subtle issues that something as crude as say whether to allow the RMB to float in the next 24 hours. The reality of the debate of marketization in China focuses on two questions: whether or not to let have markets have complete dominion but whether markets will have any influence and whether China is moving towards or away from greater market influence.
Right now I think the clear answer is that China continues to move away from allowing greater market influence. The RMB remains essentially pegged to the USD, financing remains almost entirely political, and the stock market acting as essentially a further way for the government to try and control prices. Even worse the Chinese government appears to be doubling down on the policies that brought them into the current state of affairs. For all of the talk about debt levels, China arrived in early 2016 with some of the highest debt levels in the world because of government policy not a market run amok and not only has it chosen not to address them but rather double down on the exact policies that brought it to this point. It is very difficult to see how in any appreciable way China is even moving in a direction that in anyway increases market influence.
Now before I get emails or comments about the growing number of defaults answer me this: what has ever happened to a company in default besides eventual bailout? A default in China essentially acts as a time out in sports and not a loss or end of season. That is not greater marketization if they always get bailed out.
I would actually be willing to be a Keynesian for China or anywhere else for that matter if it would assume its proper place and recede when appropriate. However, in China, like many places, government stimulus during slack periods becomes a narcotic that can never be pulled with people arguing about the increased risk of pulling it at any time. Consequently, every wave of the Chinese economy in the past decade has not witnessed any lessening of government influence, but rather a continual growth whether through financing channels or regulatory approval because there is always “risk” in reducing the role of the state. Whether the economy is weak or whether the economy is strong, well intentioned technocrats or risk averse commentators can always argue that reducing government support raises risks, which it does in some ways as already noted. However, the story of China in the past decade is not government responding to the needs of the economy but rather permanent domination.
The real risk is that the failed policies promoted by the never ending government support reach a tipping point that the government can no longer control. I actually agree that unleashing complete marketization on China right now would probably result in wide spread firm and bank failures as well as a currency crisis. However, given the state of political and financial oppression, I see little risk of that in the near future. What concerns me is that as China continues to double down on the failed policies that brought it to this point, it will reach a tipping point at which it will be unable to control the outcome. China is now one of the most indebted countries in the world, even using the narrow official data, with key measures continuing to grow much more rapidly than any other country. At the rate debt is increasing, there may come a time when it exceeds Beijing’s ability to control the outcome.
The debate about marketization in China is less about whether you should or should not have markets but what direction do you want the country to go and what risks do you prefer to accept. The answers seem pretty clear: Beijing wants greater control and accept the risk that it can control the outcome.
So just a little more follow up to my most recent piece for Bloomberg Views on disguised capital flows from China. As usual start there and finish here if you haven’t already.
- Here are some slides I prepared for the Foreign Correspondents Club in Beijing this week. You can clear see visually when the outflows really began and the direction they continue to go. Hint: they are not reversing.
- You should not believe any of the official data on inflows or outflows. According to China, they had a pre-net errors and omissions balance of payment surplus of nearly $200 billion. The NEO figure just brought the BOP into balance. What country has large BOP surplus is bailing water from the bowels of the Titanic to keep the RMB from dropping 25%? This happens because BOP data is built on other faulty data like official trade surplus data. So whenever someone cites the large trade surplus, they have proven to you that they do not know what they are talking about.
- All of the economic issues that people cite as attracting capital from China like the Fed and interest rates are simply compounding factors rather than driving factors. If China were actually enjoying large cash inflows from a $600 billion trade surplus, then the level of foreign debt repayment we are seeing would be completely and entirely irrelevant. In fact, the PBOC would be forced to push down the RMB rather than prop it up. However, that is not happening and that is why foreign debt repayment matters at all. These are compounding factors but definitely not the driving factor.
- The Bank for International Settlements report a few months back was a classic piece of weak analysis without proper perspective. They cited foreign debt repayment as a primary factor for outflow but even by their own words, this analysis was extremely limited. First, it only focused on the third quarter when the original devaluation took place. This omitted any look at a long time horizon. Why does that matter? Between February 2014 and February 2016, foreign debt declined (drum roll please…..) by a grand total of $7 billion. Second, by their own words, it only accounted for about a quarter of capital flows. How does that count as the driving factor? Given the magnitude of what we know about the gray market flow, foreign debt repayment is nothing more than a compounding factor and not remotely close to what should be considered a driving factor.
- I think there are three things that started this whole outflow process. First, China liberalized current account payments in 2012. Consequently, if you wanted to buy a house in Sydney in 2012, you could either try and legally move it through the capital account, though with lots of difficulty. You could also just import something from Sydney and enormously overpay so that money ended up in Australia so you could buy the house. Guess what people did? Second, economic activity peaked somewhere between late 2011 and early 2013 and has been on a downward trend ever since. Given the vast over capacity and declining investment opportunities, this was likely Chinese seeing the declining opportunities taking some of their money off the table for better destinations. Third, there was a political handover beginning in early 2013 that radically changed the atmosphere and likely well connected were hedging their bets well before it officially happened. This is absolutely also a contributing factor.
- When I say that Chinese are moving their money abroad for additional security, I am using security in a very holistic sense. People are concerned about the cost of real estate, complete lack of the rule of law, the environment, getting caught up even tangentially in a corruption case, or so many other things. No one in China views China as a secure destination, especially if you have any money. Whether it is thoughts about where they want to send their children to school or comparing junk local Chinese government bond yields to high credit quality US corporate debt yields, for many reasons that bring greater security.
- This is not a short term process. Expect the capital outflows to continue. This is not going to turn around even if the economy does turn around for real.
China has released a spate of good data which on the surface give a sense that the economy is turning around and everything will be fine. However, if you look at the data in very straightforward ways, you can quickly see that the data is revealing significant underlying weakness. Today rather than focusing on China, I am instead going to use China as the case study of how we need to analyze economies.
- What is the trend? Too many people will focus on a one month number and less about where does that number fall around the trend of previous months. Economic data is noisy and most of the time simply bounces around a clear trend. Just because it bounces above the trend in one month, does not mean the trend has reversed. The trends with regards to China are obvious and need no revisiting but the key issue is that it is only normal that in some months, the data is above the trend line. Take a simple example, if we believe the “rebalancing” story, which has more holes than a fisherman’s net, this absolute requires a long downward trend in roughly 50% of Chinese industry. There may be short term data around that trend, but that trend is a long term structural shift and we would be advised not to read too much into month to month or quarter to quarter changes. Most every time people call some type of turnaround, plot the data and you can see that it is really just a bounce to slightly above the trend.
- What is the number measuring? Sounds a little simplistic but it is very important to make sure that the number being used is properly understood. As a simple example, joining forces with the previous point, many are rejoicing at the March trade data. However, as China Beige Book so rightfully notes, the “bounce” was not a bounce at all after accounting for the previous years decline to the base and when considering the year to date numbers. Year to date for the first quarter, Chinese trade numbers continue to decline. As another example, the trade surplus measures the declared value of products at customs. Officially China ran a nearly $600 billion goods trade surplus. However, that measures the “declared value” not the cash transfer value.
- Put numbers in perspective. Many times people get excited over headline numbers and forget to put numbers in perspective. Let me give you two examples. I think Chinese GDP data is completely unreliable, however, in most ways it doesn’t matter. GDP is meaningless value to the man on street who pay their bills with cash. Revenue across corporate China is essentially flat for quickly approaching about two years now while liabilities continue to grow significantly. So for instance, while people say GDP is healthy, the key number of cash available to repay those debts is actually behaving very differently. As another example, that thankfully many journalists and specialists picked up on is that Chinese bump in FX reserves was all about EUR strengthening against the USD not a decline in outflows. Outflows remained right on trend. Whenever you see a Chinese number, stop and think what is this number really telling me?
Sorry for the short post today been travelling in Beijing, Shanghai, and about to leave for Hangzhou before returning back to Shenzhen. I’ll have some interesting slides to post in the next couple of days.
I wanted to make some brief follow up points that will be a little more technical than what appears in my BloombergViews piece. As usual start there and finish up here.
- I am decidedly pessimistic about the state of the Chinese economy and finances, but I really do not see a near term risk of what we would think of as a financial crisis. China is saddled with enormous sums of bad debt, people are taking their money out of China, surplus capacity is simply astounding, and cash flow growth through the economy is hovering around zero. There is very little to be positive about, but I see little risk this year of some type of crisis.
- I do not believe we have reached or are even at a near term inflection point, barring some exogenous shock, where financial conditions so escape policy and bankers control that the path is set.
- Maybe my biggest concern is the inability of bankers and regulators to face the problem. I actually should just say regulators as they are clearly the driving force at play. As one simple example, after all the talk about deleveraging in December, debt growth has pretty much exploded. Not only are they not deleveraging, they are adding fuel to the fire.
- The supposed 1 trillion RMB debt for equity swap does not even begin to address the size of the problem. Caixin highlights one steel producer, let me say it again one steel producer, with 192 billion RMB in loans in cannot pay with its largest subsidiary not having paid interest since 2011. Let’s make a simple assumption that you wanted to keep this steel company in business and complete a 100% debt for equity swap. You would immediately use up 20% of the 1 trillion in capital on one company. Even the Xinhua has noted the larger problem of unprofitable steel firms which made only a small profit in 2014 and a large loss in 2015. Accounting for the debt and overstatement of financial health, 1 trillion in capital will not even begin to address the problems in one industry.
- There are so many problems associated with some of proposals I have heard floated but one of them what happens to the firms and industries after completing the debt for equity swap. For instance, if all firms stay in business with lower debt burdens the only thing that will happen is an even more heated round of cost cutting. That is not a real solution.
- Furthermore, many are counting on shutting down a firm and selling the assets at the price they are booked for on the company’s balance sheets. History tells us in these situations corporate assets on sale in a bankruptcy type situation even when bought free and clear simply are not worth anywhere near their booked valued. Then add in the massive surplus capacity and there would likely be little secondary market for these assets. Anecdotally, from people I have talked to the going recovery rate seems to be about 20-25 cents on the dollar. This would imply sales, to use a round number, at 10-15 cents on the dollar to investors. The steel company in the Caixin article supposedly has 290 billion in assets. Let’s suppose these are all real assets, which as the story notes does have some very real questions, this would imply a sales rate of 30-40 billion RMB, an enormous haircut.
- The basic strategy I think of Chinese policy makers is to try and replicate their 2003 strategy of growing their way out of the problem. As I wrote in a paper, there were banks going public in December 2014 with long term bad debt obligations that they used IPO proceeds to payoff. Economic growth post 2000 was such an ahistorical event that I think it is a highly risky expectation to grow your way out of a mountain of bad loans two times in a row. Even just think of the strategy of accomplishing this. Will these bad loans on steel companies be paid off in 5-10 years just putting them off to the side? Unlikely.
- The ones that get mentioned the most are coal, steel, and real estate but this same concept holds for virtually any industry in China. Shopping malls, chemicals, and energy suffer from high debt and over capacity. Even assuming asset prices underpinning assets remains high, which is highly unlikely if there is a significant push to reduce over capacity or reign in lending, large amounts of the Chinese economy need to address the NPL problem.
- One of the biggest issues that no one has addressed is what do Chinese banks do with the equity? What secondary market would they sell the equity into? If they are swapping debt for equity at par, will they be required to mark to market? What requirements will there be on lending as the equity owner? This seems like a bad alternative as much of the equity will be near worthless and require haircuts of 90%. Why then go through the debt to equity swap process if the likely outcome for either the loans or business is large write downs? This implies that the intention is to try and salvage the value of these assets which would depend on large amounts of new lending.
Tomorrow marks one of the big days in Chinese data releases: FX reserves. Like with all data releases in general but definitely for China, need to be careful in interpreting what the numbers means exactly.
Let me explain why. SocGen released a note earlier this week where they predicted, very boldly, and I will publicly admit they are right if the final numbers bear them out that Chinese FX reserves would rise almost $50 billion USD. This would be an astonishing reversal if true. The reality both from what the data tells us and how they arrived at that number.
Before turning to the SocGen piece, let me address recent conventional wisdom on outflows. There was some relief in when February data was released showing much smaller drop of I believe $26 billion. The bull thinking was that this was due to increased capital controls and improved economy. However, looking closer this clearly is not the case. In February 2016, China only had 10 working days with very low levels of economic activity. As an example, how much do people really work between Christmas and New Years even the people that are in the office? Given the primary channels of capital outflows then, this level of decline should not come as a surprise.
In fact, if we do nothing more than recalculate the observed FX decline in February to a full working month, we actually have a $58 billion decline in FX reserves. If we then increase economic activity only slightly from very low levels, it is very easy to see how this would represents a $75b+ decline in February without the season factors. In short, there has been absolutely no easing of outflow pressures.
The reason that it is important to provide the seasonal context is that SocGen and others have bought into the idea that outflow pressures are easing. In fact, YOY from February 2015 vs February 2016, the outflow pressures and ratios are significantly worse. Then compared to the recent trend, February is not just in line with previous months ratios and direction, but continues the worsening. Do not believe the hype that outflow pressures are easing. That simply is not the case and as I have noted this is a long term outflow driven by Chinese citizens and firms trying to move money out of China and does not change with daily or weekly events that so many focus on.
With that said, I do believe SocGen is right about one thing and that is Chinese FX reserves will not see a large drop. This however is due exclusively to valuation changes between the USD and EUR. As the EUR has strengthened pretty significantly against the USD in one month this will cause the USD value of the FX reserves to increase. Take a simple guesstimate that one-third of FX reserves, I know some have very complex estimates and as I’m not revealing all my secrets and this is a free blog the guesstimate will do, that would imply about a $50 billion USD value gain to FX reserves. If China held roughly two-thirds of their reserves in EUR that would in a round number be up to $100 billion valuation gain in FX reserves
To reach their forecasted $50 billion USD gain in FX reserves, SocGen is essentially forecasting zero net capital outflows from China in March. I do not believe this is remotely close to a realistic expectation.
Given what I mentioned previously about seasonal factors and the basis of comparison, I believe that you can still expect cash outflow from China in March of at least $45-70 billion. This would be in the range of outflows that we witnessed in November through January and we saw larger FX declines.
The reason this matters is simple: when FX reserve numbers are announced and the decline is much smaller to maybe a small increase, do not be surprised. However, remember that the dynamics between the USD and EUR is what drove this and has very little to do with the health of the Chinese economy. Focus instead on numbers released later about cash outflows. I would be floored if cash outflows did not return to the large outflow trend that we saw pre-February.
Receiving a valuation change is like winning the lottery: a good boost but you cannot count on that. The cash outflows should be the focus instead.