Follow Up to BloombergView RMB Deinternationalization

So this is my follow up to my BloombergViews on RMB deinternationalization.  One issue that I wanted to address specifically is that I had a couple of people question whether this was more of a short term blip rather than a structural issue.  As usual start there and come here for additional analysis and discussion.

  1. The RMB is deinternationalizing for a very straight forward reason: if the RMB continues to internationalize, Beijing will lose control of the price and flows. Full stop. Unfortunately, there are no other reasons. Fortunately, this makes very clear predictions and mathematical relationships about when it will happen.
  2. Let’s look at the price. The more RMB that is outside of China the more market participants will trade RMB at whatever price they want to trade it and not at the price Beijing wants.  In fact, a major driver of the reduction in offshore RMB, primarily in Hong Kong, is the continual intervention by the PBOC is propping up the RMB.  To hold the value of the offshore RMB (the CNH as it is known) the PBOC buys RMB in Hong Kong selling USD.  If the RMB really internationalized, Beijing would have to manage RMB prices around the world an actively intervene even more than it does.  Beijing is clearly not willing to give the market any real type of influence in setting the price.  How do we know this? If you look at the CNY/CNH spread the CNH is virtually always trading at a not insignificant discount to the CNY, with clear regular intervention. If the CNY was truly following market indicators, with any real interest, the CNY would be significantly lower than it is today.  In short, internationalizing the RMB means Beijing giving pricing control over the RMB much more significantly to the market.  The RMB is deinternationalizing because Beijing is exerting greater control over the price.
  3. Then there is the flow of RMB. If the RMB is to internationalize, the Beijing will have to enormously relax its grip on the flows of RMB.  I know people have cited a couple of examples but if you will notice these are examples that let foreigners invest in Beijing is more than happy to let money flow in one direction: in. However, all recent measures about outflows are tightening.  Before you even start with talk about M&A and FDI, May capital payments (i.e. outflows were only up 1% from May 2015 and are only up about 10% for the year.  If the RMB internationalizes, Beijing must lose its control over RMB flows.  This is not some speculative musing this is empirical reality.  If RMB is to be widely used either around the world or even for transactions involving China people have to be free to use the currency when, where, and how they choose.  If RMB is to be used around the world and challenge the dollar or even the Danish Krone, RMB must flow out into the rest of the world.
  4. Now the price and the flow issues combine to tell us very real information. If RMB needs to flow into the rest of the world to become an international currency, this means there will be downward pressure on the RMB.  If Beijing relaxes its grip on the directionality allowing the RMB to internationalize, this will place long term downward pressure on the RMB reducing its value.  There is another way to think of this: if Beijing wants to hold the value of the RMB higher, it will continue to deinternationalize the RMB. If Beijing is willing to let the RMB depreciate, the RMB will internationalize.  The only way the RMB can internationalize and rise in value is if the demand for RMB assets significantly outstrips demand for foreign assets.  There are two reasons this is unlikely.  There is an asymmetric relationship in that foreign investors are much more able to hold RMB assets than Chinese holding foreign assets.  In other words, there is a lot of pent up demand by RMB holders for non-RMB assets.  Furthermore, given the law of large numbers, China would have to absorb such a vast amount of world savings and investment in the future to push the RMB higher on a strictly flow basis to render this all but impossible.   In other words, this gives us the pre-conditions under which the RMB will internationalize and what we will see both with flows and with RMB.
  5. For all the talk of RMB internationalization, please explain to me how a currency can be “international” when it isn’t allowed to leave the country and is engaged in such a small number of international transactions? Are you aware that almost 80% of all “international” RMB transactions are with China and Hong Kong? Seriously stop and think about that for one minute. Almost 80% of “international” RMB transactions made between China-China or China-Hong Kong.  Put another way, 80% of international RMB transactions are made with domestic counterparties.  The RMB internationalization talk is the equivalent of playing Xbox World Cup in your Mom’s basement and claiming you are a world class athlete.
  6. There is a very clear markers around which we will be able to tell the RMB has internationalized and not the fake IMF version. So far, the RMB is not even close and is clearly going in reverse.

Politics in Beijing Represent the Bad Economic Choices

The potential of political fight at the top in Beijing has galvanized the attention of Chinese and foreigners alike.  With little actual information or press leaks, we are generally left to try and interpret fuzzy shadow puppetry while placing them in a complex play.  I am not any type of connected political insider and can add nothing about the intrigue or personalities.  However, from everything I have gathered there is a distinct economic element that is being overlooked here, which I believe I can add to the discussion.

The whispered discussions about who is siding with who in the palace intrigue that comprises Party politics, omits any focus on the clear economic dividing lines that separate the parties.  As I have noted on numerous occasions, something that is not frequently recognized about the Chinese economic situation is that the longer this situation continues, the narrower the range of reform options at its disposal.  Currently, not only does China have an increasingly narrow range of options to make meaningful change but those options both come with some type of significant risk.

Let’s take a simple example that is relatively realistic.  Last year, total social financing grew at almost four times the GDP growth in absolute RMB terms.  Based upon the rapid rate of TSF through April, that ratio will have only increased.

Beijing faces a simple tradeoff: a) they want strong economic growth of no less than 6.5% to ensure social stability and that there isn’t a wave of defaults AND b) they want to deleverage and lower the rate of growth of debt.  They absolutely cannot have both.

The economic debate then becomes one of priorities.  Do you want to prioritize growth or deleveraging? There are those that understandably prioritize growth over deleveraging.  The rationale is simple: if TSF was four times GDP growth in 2015, economic weakness would become much more pronounced if debt growth was restrained.  Given the already shaky financial condition of firms, it is simply too risky a time to make deleveraging a priority with the economy in such a weakened state.  If you choose to prioritize deleveraging now, you run the risk of a major economic slowdown.  Imagine what will happen to growth if TSF is significantly smaller. GDP growth even by official standards could easily be in the low single digits.

Those prioritizing restraining debt growth are making the same argument in reverse.  They believe that the rapid growth in debt, what Barry Eichengreen has called maybe the largest and most rapid expansion of debt in human history, poses greater risks to long term stability.  The concern being that either deleveraging will be essentially forced on China or it will ultimately result in some type of crisis or event that will result in a much more painful restructuring.

The fundamental question is this: what do you believe is the greater risk to China? Put another way, would you rather face potential labor instability this year or financial risks later?  In all kinds of professions whether a surgeon or a stock trader, people are always looking at too risks with two potential benefits and trying to determine where their risk adjusted return is higher.  China is faced with in reality a simple decision: which risk factor presents the greater risk?

The decision to pump credit now and try to grow your way out of the problem or deleverage now and try and manage the downturn present clear risks.  Continuing to pump credit keeps growth moving but runs later risks that Beijing may be unable to manage the ultimate credit problems.  Deleverage now runs the risks that social stability may escape Beijings controls presenting a clear and present danger to the Communist dictatorship in Beijing.

The other thing to remember, as in any situation where people are trying to manage or assess risk, is that the risks you and I are focused on are not necessarily the risks the others are focused on.  To me and many China watchers it makes perfect sense to focus on the increasing financial risks.  However, while they are certainly aware of the financial risks in Beijing, that is not necessarily the primary risk (which I am about to explain why).

One of the most common mistakes people make when considering risk is they overestimate their ability to manage either a specific or range of risks.  Many might call it hubris.  Beijing is essentially betting that they can manage the risks even if there is a significant financial or economic event that results from their continued economic incompetence which they have been warned about.  They are telling us, even if there is some type of financial or economic event, they believe they have the tools at their disposal to address the situation.

If we unpack this, it becomes a worrying scenario.  First, it implies that Beijing continues to pump credit, money, and investment to drive growth.  If the level of total credit growth was 4x the level of GDP growth in 2015, imagine how bad it would have been without that level of policy support.  We can only expect this level of distortion to continue to increase.  Even as the rate of expansion of credit has slowed so far, it  still is three times faster than cash flow growth of firms and about 2.5x GDP growth rate.  In other words, we should continue to expect more of the same policies that will build up the risks facing the Chinese economy.

Second, when the eventual problems come, and they will come, you can expect a brutal and harsh response by Beijing.  This entire policy of credit expansion when it has already risen faster than probably any other credit expansion in the history of the world in a country littered with bad loan examples with asset prices at eye bleeding levels depends entirely on Beijing’s belief that it can manage the downturn.

The stock market rescue is both a good and poor example of how Beijing will act.  Good in the sense that it shows Beijing will throw any amount of money at a problem regardless of how misguided the policy and no matter how poor the result.  Bad in the sense that rescuing the stock market is relatively easier that say the real estate market or preventing panic with a bank collapse.  The fundamental point is that Beijing will go to virtually any length to prevent or bailout a financial or economic event regardless of cost, either financially or otherwise.

The politics of who supports what merely reflect the basic divide over economic decisions that are increasingly narrowed down to “which bad option can you tolerate”?  How Beijing is handling the current problems should give us pause to consider what comes after?



Focusing on Obscure Chinese Data: The Importance of Banker’s Acceptances

Yesterday was money and credit data release data in China.  Most of the numbers grew robustly, as is always expected with this specific release, but there were two numbers that I wanted to highlight because of what they mean for other issues.

First, new RMB loans in China were up 9% YoY and 16% YTD YoY.  This represents the ongoing rapid expansion of credit in China that at best seems unsustainable at worst reckless.  Despite talk of restricting credit expansion, credit is growing more than twice as fast as GDP in percentage terms and four times faster in absolute terms.  There are significant concerns about the ongoing sustainability of this rate of credit expansion.

Second, the most unexpected number was the collapse of undiscounted banker’s acceptance notes.  To put the size of the decline in some context, since this specific data point has been collected beginning in 2002, there has never been a decline of this magnitude.  As another point of comparison, New RMB Loans were up 937 billion RMB while banks acceptances declined 507 billion RMB.  This would represent 54% of all loan growth or 77% of aggregate financing to the real economy.

I believe this number is distorted to this magnitude for a couple of reasons which have very real implications.  Banker’s acceptance are used in China in primarily two ways, both of which could be targets for regulators.  One way they are used to disguise the true level of debt by making sales then using banker’s acceptance to access liquidity.  It is not uncommon for sales to be fake, returned at a later date, used for other forms of capital, and a variety of other issues.

If banker’s acceptances fell by such a large amount, this would imply wide spread repayment by firms of their outstanding banker’s acceptances.  If this is what is happening, which I do not believe is the most likely scenario, this would imply that cash flow throughout the economy has dramatically improved as the year has progressed.  While I noted what appeared to be continuing stabilization and some increase of output, the size of this drop appears much larger than I would expect from output gains.  Further, given the continued increase in aging of corporate receivables and payables, it is difficult to see how this would match that number.  While it is possible BA’s may be collapsing due to improved cash flow, liquidity, and real economic activity, I believe this is the less likely scenario.

The other primary way BA’s are used is to facilitate international trade and most importantly capital outflows.  Just as with the previous method, many trades that present BA’s are non-existent, overstated, or misinvoiced to name a few ruses used.  However, now there are additional layers of complexity added.  To take a simple example, the Chinese exporter may move capital Hong Kong to either arbitrage between the CNY and CNH or deposit it in a higher interest rate instrument before returning the RMB back to China.  More worrying however, is when the capital is designed to leave China permanently.  In this case, a BA is used to pay for, in this instance, $100 of imports that either non-existent or overstated and the BA is paid off with domestic capital allowing quasi capital flight.  Given the widely acknowledged discrepancy between Customs and Bank reported imports, this is not an insignificant problem.

Therefore, the drop in banker’s acceptance means not that credit is suddenly falling but more likely that banking regulators are cracking down on capital flight into and out of China.  Given the narrowing of the gap between Customs and Bank reported imports, this seems the more likely scenario.  Anecdotally there are increasingly widespread reports of inability of firms to engage in standard business transactions that involve international payments.  Finally, there is clear evidence that the PBOC or state run banks, actively sitting on FX trading and related derivatives with a specified price target.

Given the rapid increase in outflows YTD in 2016 with the accompanying collapse in inflows, this would imply that Beijing is giving increasing priority to trying to reduce this divergence and prevent further RMB price pressures.  Given the wealth of data, it is more likely the continued drop in BA’s related to capital outflow worries rather than repayment of payables.

Shenzhen is the New Hotpot

So I wanted to follow up the piece for Bloomberg about reforming the Chinese economy along the framework of Shenzhen.  I should say I am somewhat biased in that I have lived in Shenzhen for almost seven years, but also clear up a couple points of confusion.

  1. I understand and am not arguing that every city in China should try and become a Silicon Valley like Shenzhen. That is not the point.
  2. Shenzhen has recognizable geographic advantages, primarily being so close to Hong Kong, but in reality few other benefits. In fact, like many great places, Shenzhen has turned its lack of abundance into abundance.
  3. Rarely do people think of scarcity of resources as a good thing but many economies with scarce resources have exemplary outcomes. Whether you look at resource poor countries like Singapore or resource rich countries like Russia and Venezuela.  This isn’t to imply that lack (or abundance) of resources is a good (or negative) thing.  Only that resources are not remotely close to economic destiny.
  4. Shenzhen in reality is a very small town geographically and other than proximity to Hong Kong has very little in the way of natural resources. It is essentially boxed in with mountains to the north and the sea/Hong Kong to the south.
  5. What Shenzhen lacks in political (Beijing) or historical (Shanghai) influence, it makes up for in sheer determination. People from all over China migrate to Shenzhen and people are pretty accepting of other Chinese because most people aren’t from Shenzhen.  People move to Shenzhen because they want to work hard and make money.  Now this has lead to complaints by locals that people aren’t invested in the city personally or there is a lack of civil spirit but even in my time here I sense that is changing.
  6. Even my Chinese friends and colleagues comment how open Shenzhen is to hard work and talent compared to other Chinese cities. Because most everyone here is from other parts of China you do not have those path dependencies you have in other cities.  People know each other first through business ties and talent rises to the top.  I frequently hear, even from some Shanghaiese friends who now live in Shenzhen that in Shanghai, unless you are Shanghaiese, you cannot get accepted into the city. Shenzhen it is about how good you are at what you do.  Shenzhen is like the New York City of China in the sense that people come thinking “If I can make it there, I can make it anywhere.”
  7. One thing I hear frequently is how local government thinks of itself much more as a facilitator. This isn’t to say the Shenzhen government isn’t heavy handed with some of the standard Chinese traits, but I hear frequently from business how they are much better to deal with than other governments throughout China.
  8. Even the internal ethos of the city is different. Conversations here start up about when you hope to IPO the company you work for with little if anything said about politics. It isn’t even that people are afraid to talk about politics, but simply that people have better things to worry about and more important things to do.  Though I don’t think it is as helpful as other cities, people are quicker in Shenzhen to help each other out, make introductions, or just lend a hand on a big project.  I’ve personally found the people relatively welcoming.  We have neighbors that when my children need help with Chinese homework are happy to help.
  9. Not every city can be Shenzhen or should be Shenzhen. I’ve been asked questions about who should Shenzhen try and emulate and I always respond something along the line of why can’t Shenzhen be Shenzhen? What are the advantages Shenzhen has that it can build upon. I was told a story about one city that was told to shift out of heavy industry and was given a list of a couple of preferred industries.  They chose biotech and built a bunch of business parks with good lab facilities.  Did they have any biotech companies? No. University cluster? No. Highly educated population that could start biotech or related companies? No. The point is that to transition, Chinese cities need to focus on building upon what they have rather than pointless expansions.
  10. Shenzhen considers itself a very different city from the rest of China and think of Beijing almost as background noise.  Beijing has the power, Shanghai thinks they have the power, and Shenzhen just goes out and does stuff ignoring whatever comes out of Beijing.  In the old musical Fiddler on the Roof, an old man approaches the village rabbi and asks with a concerned look “Rabbi, is there a blessing for the Tsar?”.  The bespectacled Rabbi strokes his beard thinks and raises his hands: “may God bless the Tsar and keep him very far away from us.”  Shenzhen thinks of Beijing much the same way.
  11. China needs a good dose of creative destruction. One of the very real benefits of Shenzhen is that it has almost no path dependent industries.  There is no steel industry to figure out how to dismantle.  It is creating from scratch.  Many Chinese provinces and cities need to destroy the past to build up the new.  The Chinese are enormously innovative they just use that energy most of the time to evade the ridiculous regulations that are created by their leaders.
  12. There are seriously innovative things going on. Yes, many of them simply derivative and Chinese market remains largely closed to foreign competition but there are very real innovative things happening. Payment systems are light years ahead of anything I’ve seen elsewhere. Life in many ways is somewhat convenient given all the things you can have delivered directly to your door and the ability to just phone a car to come pick you up as you are walking outside.  Yes, Xiaomi is loaded with spyware and Baidu is nothing but an information tool of the Propaganda Ministry but that doesn’t mean they aren’t good at what they do in China.  There are other companies that are doing innovative things and time will tell how much of an impact they make as most of it remains consumer retail type platforms.  It is happening though for sure.
  13. This does not in any way take away from the enormous challenges facing all of China. This slice of the economy remains very small and simply will not provide the job or economic growth gains needed to transition this economy away.  Whether it is the labor frictions of transition coal miners to coding or the massive bad debts that China refuses to face up to.

Follow Up to BloombergViews: Shadown Banking Risks in China

I wanted to write a follow up to my piece from BloombergViews on shadow banking risks in China with a little more technical focus on a few things.  As usual start there, and every thanks to them  and my wonderful editor, before coming here.

  1. Shadow banks is really a catch all phrase for non-bank financial institutions that really encompasses quite a variety of lending types. Trust companies which actually make a couple different types of trust investments.  Wealth management products that can both be created and sold by mainline banks as well as on behalf of third party firms. P2P firms which hold little or no capital but act merely as a platform facilitating financial flows profiting by taking some type of fixed fee.  There are a myriad of products that are designed in a myriad of ways so talking about this industry as a monolith makes no sense.  There are only a couple generalities that are worth mentioning at this point: the products are short term and can cover almost any underlying asset in almost any form from debt to equity.
  2. Many people think of shadow banks in one area and traditional banks in another but this is absolutely not the case. In many ways, shadow banks and traditional banks are almost indistinguishable from each other.  There are two specific ways this happens.  First, shadow banks get large amounts of funding from traditional lenders.  This happens through a variety of different funding agreements from bank purchases of investment securities from shadow banks to wholesale funding agreements.  Bank holdings of the non-loan investment holdings via a number of specific balance sheet line items have exploded over the past few years.  Many banks even admit to making large strategic shifts away from direct lending and into these new products.  Second, commercial banks even have agreements to act as a distributor or sales staff for shadow banking firms.  Consequently, not only are banks purchasing, funding, in some cases directing the funding/locating borrowers, they are then selling for the shadow banks.  Even if there is not a direct ownership agreement, this creates an enormous conflict of interest whereby the bank and shadow bank are essentially almost indistinguishable entities.  (If you want the best example with details that explain the financing practices I am talking about and the overlap, read this example of China Credit Trust from 2014)
  3. Mainline banks are engaging in this behavior for two very simple reasons: financial and regulatory arbitrage. Financial arbitrage means banks earn a higher rate of return from lending to shadow banking customers or the shadow banks themselves.  Even though lending rates have officially been liberalized, in practice this has not really taken place.  There has been little movement in the bank lending rate and customers are not being judged on the risk they present.  As an obvious example, local government debt which banks are being forced to buy is trading at yields lower than sovereign.  If this debt was not priced at a government mandated price, it would clearly be yielding significantly higher.  Banks have even put into IPO prospectuses that they are moving into holding a higher level of these shadow bank products to earn higher rates of returns.  Banks that cannot earn what they deem to be a reasonable risk adjusted return are moving into these other products as a Chinese version of chasing yield.  Regulatory arbitrage is much simpler. If a bank makes a 100 RMB loan to a coal company, they have to report to the banking regulator that they have 100RMB at risk and set aside the appropriate capital to meet their capital adequacy ratios.  However, if they purchase a 90 day security from a shadow bank for 100 RMB, they do not have to set aside anything because Chinese banking regulators allow loans or investment security purchases from financial institutions to have a 0% risk weighting.  In other words, a bank can make the same 100 RMB loan but if they make it to a coal company they have to set aside capital but to a shadow bank, they do not need to.  This has led to many loans made via trust companies that arrive at a specific company through a trust company that the bank does not weight as a loan because the loan is technically made to a trust company rather than the coal company with the trust company lending the money to the coal company.
  4. All of this detail leads to a handful of risks. First, shadow banks are intricately linked with the entire financial sector.  One way to think of this might be similar to the subprime problem in that there were spillover effects from the non-bank financial institutions to the banks.  It is absolutely incorrect to think of Chinese mainline and shadow banks as having some type of dividing line separating them when they are in reality incredibly linked in a variety of ways.  The spillover risks are enormous.  Second, commercial banks enjoy a variety of privileges their non-bank financial institutions do not such as deposit insurance to state ownership.  This provides an implicit government guarantee which shadow banks do not have.  It is dangerous for the government and the general investment population from institutions to retail to think of such a neat dividing line given the overlap in funding, sales, and clients.  In other words, Beijing will ensure that any type of crisis at a major bank like ICBC never becomes a problem maybe never even heard of.  Shadow banks do not have that luxury and could easily trigger liquidity or spillover risks onto the larger banking sector. Third, shadow banks relying primarily on short term funding face very real liquidity risks.  If they cannot get new funding every 30-90 days they will collapse.  Fourth, the large variety of shadow banks could very easily trigger a bank panic given their widely recognized problems of funding causing liquidity to dry up across the shadow banking sector.  This would force Beijing or the banks to step in and guarantee the shadow banks.  Fifth, there is a reason that banks are moving so many of their risks off their balance sheets and on to the shadow banks.  As the old saying goes: if you are at a poker game and you don’t see a sucker, you’re it. There are amazing cases of banks doing this, some of which they ultimately bailed out but anytime a bank moving risks that fast, pay attention.  Sixth, bank risk management practices are weak at best, so you can imagine what the non-bank financial institution risk management practices are like.  There are stories almost daily of different shadow banks going bust and private financing disputes were up more than 40% in 2015 with 2016 expected to be another bumper crop for Chinese lawyers.  Whether it is straight up fraud or simply non-existent due diligence practices on loans, there is a reason that finance is so much more difficult for smaller players.